Imagine you could make one “free” change in your financial structure that could meaningfully add to your total return over the course of the next twenty years. Would you make that change? One such change is referred as “Asset Location” and it is defined as the location of assets in a client’s financial structure to take advantage of the structural tax differences of the investments available. Regardless of the answer to this question, most investors do not understand asset location, its definition, or its power. In 2010, David Blanchett and Paul Kaplan of Morningstar researched the impact of five financial planning strategies and measured the potential benefits to an investor. In the study, updated in 2013 and linked below, they found approximately 22.6% more retirement income was possible through strategic financial planning.
For the purposes of our example, let’s make a few simplifying assumptions. In this, our investor has two accounts, an IRA account with $1,000,000 of cash and an individual taxable account with $9,000,000 of cash. Their financial advisor has determined that the optimal asset allocation is to be 50% stocks and 50% bonds. The investor is in the highest marginal tax brackets. We will assume 0% turnover and no re-balancing in the portfolio for the twenty-year time horizon. We will further assume that returns are linear and that stocks will return 8%, Taxable bonds 5%, and Municipal bonds 3.75% every year for the next twenty years. From a tax perspective, there will be no capital gains tax due on the bonds and the stocks will fully recognize their long-term capital gain at the end of the period. The scenarios below show the effect that Asset Location has on a portfolio. In each of these situations, we change the asset location, but not the value.
In the base case titled Scenario 1, both the IRA account and the taxable account have the same mix of stocks and bonds. This results in a total after-tax wealth of $28,447,842 given the assumptions from above.
Scenario 1:
While the return is appealing, we know this solution is far from optimal. The first asset location item to consider is a shift in the allocation of stocks and bonds between the accounts given the inherent tax differences of the accounts and assets. In Scenario 2, we consider the impact of changing the IRA allocation to 100% bonds and adjusting the taxable account allowing the total allocation to remain 50/50 stocks to bonds.
Scenario 2:
By making just one change in the location of the assets and no change to the returns, we see $89,198 added to the total after-tax wealth value. This money was generated by simply locating existing assets in accounts that offer the most advantageous outcome. However, with Municipal bonds now in the tax deferred IRA account, which is not subject to annual income taxes, there is still further room for improvement. Municipal bonds add value to our High-Net-worth clients due to their tax-advantageous structure allowing the income generated to often be exempt from income taxes. Since Municipals will be unable to add significant value to an IRA, we can seek higher-performing taxable bonds to leverage the tax-deferred nature of the account. In scenario 3, we replace the Municipal Bonds in the IRA account with higher-performing taxable bonds.
Scenario 3:
With these final adjustments made, Scenario 3 was able to generate $423,765 over our base case by simply shifting the account level asset allocation and being smart about product selection.
As we stated at the outset, the above situation has been drastically simplified to allow an unfamiliar reader to follow along and grasp the concept. In practice, there are many more variables. For example, clients seldom have just two account types. Other account types include trusts, split-interest trusts, donor-advised funds, private foundation accounts, Roth IRA accounts, 401ks, defined benefit plans, and the list goes on. Clients will also seldom have only three investment options that are suitable to meet their needs. A more complex solution would include private equity, hedge funds, active management, tax-loss harvesting, inflation protection, and more. Of course, each of these items will interact with the different account types in different ways, so it is important for an advisor to carefully consider these factors and refine a client’s plan over time as the solution will change.
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