When it comes to buying or selling your home, most of us already know that the price depends on three things: location, location, location. Asset location is a similar, if less familiar rule that applies to your investments. By managing asset location within your portfolio, you are able to keep as much of your money as possible – even after taxes take their cut. Given how deep that cut can be, it’s another way your advisor can add value to your total experience as an investor.
Asset Location: A Working Definition
Let’s begin by noting that asset location should not be confused with asset allocation. The two are related, but separate beings.
- Asset allocation is dividing your money among different asset classes, based on the amount of market risk and expected reward inherent to each. For example, a simple asset allocation is equally dividing your holdings 50/50 into stocks and bonds. You may then subdivide your stocks among international versus U.S., small-companies versus large, and so on.
- Asset location is deciding where to locate your stocks, bonds and other holdings within your taxable and tax-sheltered accounts, to maximize your tax savings.
Many Moving Parts
It makes intuitive sense that, by locating your most heavily taxed investments within your tax-sheltered accounts, you can minimize or even eliminate their tax inefficiencies. But it’s not as easily considered as you might think.
First, there is only so much room within your tax-sheltered accounts. Challenging trade-offs must be made to ensure you’re making best use of your tax-sheltered “space.” Second, it’s not just about tax-sheltering your assets; it’s about doing so within the larger context of how and when you need those assets available for achieving your personal goals.
Arriving at – and maintaining – the best formula for you and your unique financial life plan involves many moving parts.
Your Advisor's Role In Translating Theory to Action
Beyond requiring a broad and deep theoretical understanding of your investment and tax-planning needs, properly implementing effective asset location is not a spare-time hobby. At SAGE, this is the deliberate asset location process we follow for each client to ensure we’re maximizing available possibilities:
- We manage within the context of the bigger picture – your goals & timeframes – Is your financial independence near or far? Do you want to leave a legacy? Are your circumstances likely to change in the next few years? There may be withdrawal, estate planning or other needs that override optimal asset location. Only after we thoroughly understand your unique goals is it appropriate to begin the asset location process.
- We inventory accounts or “buckets” – What are your various tax-sheltered account opportunities: Roth versus traditional IRAs versus company retirement plans? What taxable accounts do you have? Are there new accounts we might recommend? How much room is there in each “bucket” for holding assets, and which types of holdings in which kinds of accounts are going to give you the most tax-efficient bang for the buck? How does evolving tax code impact your planning?
- We assess the benefits of holding stocks within taxable accounts – We evaluate each opportunity below as they are unavailable for stocks held in tax-sheltered accounts:
- Harvesting capital losses or gains
- Donating appreciated shares to charity (and eliminating the taxable capital gain)
- Planning for a step-up in basis to heirs
- Taking foreign tax credits
- We rank your fund investments, using an ordering process according to their existing tax efficiency.
- We map out a customized asset location plan for properly filling each “bucket” according to our ordering process.
- We execute the plan, and regularly review it to ensure it remains relevant within your ongoing financial life planning relationship with us.
As we continue to seek out ways to improve oversight of our client's investments, we recently invested in new software which includes asset location planning within its rebalancing tools. Given the multi-factored number-crunching involved, augmenting our professional planning with robust technology helps us work even smarter and more efficiently on our client's behalf.
Why the Fuss? Pennies Saved from Taxes Is Money Earned for You
While many investors may be missing out on effective asset location, the resulting money they may unnecessarily lose to taxes can be very real. Nationally recognized financial commentator Michael Kitces points to a Morningstar analysis indicating that a well-executed asset location strategy can add as much as a half-percent to your bottom line each year. That’s $500/year for every $100,000 invested (which, we might add, can represent a good chunk of your advisor’s fee returned to you). Why leave that money sitting on the tax table? Keep it for yourself.
And yet, perhaps because of the scope and complexities involved, you’ll typically only see asset location planning offered by a tax-conscious advisor (like SAGE Advisory Group) who is well-positioned to provide objective counsel and oversight for your investments. We look forward to continuing to incorporate asset location in its proper place within our client's overall financial life planning.
Michael Kitces, “Asset Location: The New Wealth Management Value-Add For Optimal Portfolio Design,” March 6, 2013; and “Morningstar Tries to Quantify The Value of Financial Planning,” November 12, 2012.
Sheri Iannetta Cupo, CFP®, is Founding Principal of SAGE Advisory Group, based in Morristown, NJ, an independent, Fee-Only Registered Investment Advisory firm, specializing in providing busy professionals and their families with holistic financial life planning and investment management services. You can find more here: www.sageadvisorygroup.com . You can also connect with Sheri on Twitter, Google+ and LinkedIn.