Asset Location in Various Accounts

asset-allocationLast July, I wrote Asset Allocation Across Multiple Accounts, an article discussing what type of asset (stocks, bonds, REITs, etc.) should be stored in what type of account (taxable or tax sheltered).

Tax efficiency is the main reason to treat all accounts as one large account. You want to have tax inefficient holdings, like REITs and taxable bonds in your tax sheltered accounts, such as your 401(k) and IRAs, and tax efficient holdings, like the Total Stock Market index fund, in your taxable investment account.

I generated a table showing the least tax efficient asset classes to the most tax efficient asset classes with corresponding types of accounts that they should be held in. I have reproduced the table, below.

Least tax efficient High-yield bonds Best held in tax-sheltered accounts
High-turnover active stock funds
REITs
Active stock funds
Taxable bond funds
Target-date funds (contain both stocks and bonds)
Cash Can be held in either taxable or tax-sheltered accounts
Value index funds
Small or mid-cap index funds
Total international index funds
Total US market index funds
Most tax efficient Tax-managed funds

The reason I am looking at this again, is that Rick Ferri recently wrote an article asking, “Does Asset Location Make Sense?”

Rick wrote,

This strategy sounds correct on the surface and it’s often heralded in the media as a smart way to invest. I agree with the concept in general, but that doesn’t mean there aren’t drawbacks. Here are some of the problems I see with asset location for tax purposes:

  1. Tax-favored account capacity: you may not have enough room in your non-taxable or tax-deferred accounts to accommodate enough bonds to have the overall asset allocation that you desire.
  2. Taxable account capacity: the same limited capacity issue may occur in your taxable accounts and the amount of stocks you wish to own.
  3. The choice may not be yours: your employer-sponsored 401(k) may have poor bond choices and good stock fund choices, or there may not be any REITs available.
  4. Accounting across accounts: maintaining a portfolio to a target asset allocation becomes more difficult when you’re monitoring an allocation across several accounts rather the same allocation among accounts.
  5. Rebalancing across accounts: rebalancing a portfolio becomes more difficult when several adjustments need to be made across different account types. Settlement dates may be different, or you may be restricted on when you can trade one account versus another.
  6. Tax rates in the future cannot be known: the tax strategies we employ today tend to be focused on the situation today rather than in the future. A tax-saving strategy today might cost more in taxes than anticipated as your tax rates changes in the future.
  7. Liquidity becomes expensive: your situation is bound to change over the years as your life changes. There may be a time you need liquidity to buy a home or for another purpose and you find yourself selling the only thing you have in your personal account – stocks. This could mean paying a lot in capital gains taxes when you need the most liquidity.

The alternative to an asset location strategy across accounts is to hold the same asset allocation among accounts. Assuming you have one taxable and one non-taxable account of the same value, you would hold the same asset allocation in both accounts.

He goes on to argue that perhaps people ought to do both strategies: divide some asset classes into different accounts based on tax efficiency, and also put some of the same asset classes into all accounts.

My concern with putting the same mix of asset classes in each account you own is that you will pay more taxes during asset accumulation, and not have as much money in retirement.

I think Rick’s concern, which he mentioned above, is that using a location-based strategy is too complicated for most people. Putting the same asset class mix in each account is certainly easier. Doing a mix of both strategies, however, is more complicated than either strategy by itself.

Personally, my wife and I will stay the course with a location-based strategy. I also know of several people who are more happy having the same asset allocation in each account, even though it is less tax efficient. I doubt, however, that many people will follow Rick Ferri’s advice to combine the strategies across all accounts.


8 thoughts on “Asset Location in Various Accounts

  1. We previously had had the same AA in each account, and it’s totally easier. But we’re now switching to try to be more tax efficient, and put our bonds and international stocks in tax advantaged accounts, with our taxable accounts being large & small US stock indexes. For now, there’s sufficient space to make this happen. Plus, rebalancing within our 401k/IRAs is pretty easy, and has no tax consequences. So that’s nice.

    1. Hi Done by Forty, As you get more investable assets, the tax savings of proper asset location can become substantial. Just think about taxable bonds. Their interest payments are taxed at a person’s nominal income tax rate. If they were in my taxable account, I would be paying 25% to the IRS and 9% to my state tax board. So, 34% in taxes. Now if I shift things around and only have stocks that pay dividends in my taxable account, I would be paying 15% to the IRS, and 9% to the state. So, 24% in taxes. Last year, we received roughly $10k in qualified dividends, so we paid $3,400 in taxes on the dividends. If they had been bond interest payments, rather than dividends, we would have had to pay $4,400 in taxes. I personally would rather keep the extra $1,000 in my own pocket.

      Thanks for reading and commenting.

    1. Hi Suburban Finance, I have stated many times that I would rather keep more of my own money than give it to the tax man. Wait until you see Wednesday’s post. It tells how to pay zero Federal income taxes in retirement. And even better than that, it shows that you can convert the holdings in tax deferred retirement accounts (traditional IRA and 401k) to tax free accounts (Roth) also with zero taxes.

      Thanks for reading and commenting.

  2. I don’t invest as much as I’d like to be able to (especially this year, with a wedding and honeymoon approaching that we have to pay for!) so I don’t usually go over the limits set for our tax sheltered accounts. We just put everything in there!

    1. Hi Daisy, Putting “everything” into your tax sheltered accounts is as good as can be expected. Congratulations on your upcoming nuptials. Getting married is one of the biggest changes you can make in your life. Having kids is the other. :-) You can read about our frugal wedding at http://www.saveandconquer.com/our-wedding/

      Thanks for stopping by and commenting.

  3. I’m new to your blog. Glad to find you through the Yakezie network. I’m learning a lot about investing right now. Most of our money is in tax sheltered retirement accounts. This year we’ll have some extra money to start our after tax account. Actually I already did. Right now it’s invested in an index fund at vanguard. But then I also wonder if I should be buying some individual stocks! It’s so hard. There are two sides of this with people having an individual stock strategy that distributes dividends and a philosophy to just buy index funds (passive). Thoughts?

    1. Hi SavvyFinancialLatina, I will always vote for low-cost passive index funds or ETFs over individual stocks. You increase your risk exposure when you buy individual stocks rather than a diversified index fund. Individual stocks may rise faster than a stock index, but they most assuredly will fall faster and farther when the stock market falls. It has been proven over and over again that the total market index fund will have higher returns after a long time (like 20 years).

      Good for you for putting your taxable money into a Vanguard index fund. The key to successful investing is that once you have put your money into the index fund, leave it alone, or add more money. But do not sell if the market goes down, just continue to add.

      There are only two reasons to sell: 1.) you need to sell some equities to rebalance your asset allocation; 2.) You are making planned withdrawals either in retirement, or because you need the money to cover living expenses.

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