Last 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|
|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?”
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:
- 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.
- Taxable account capacity: the same limited capacity issue may occur in your taxable accounts and the amount of stocks you wish to own.
- 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.
- 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.
- 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.
- 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.
- 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.