| 05 April 2004
Many investors are familiar with the concept of asset allocation as a way of diversifying a portfolio to protect it in various types of markets and economic conditions. But a new term called asset location has emerged which should play an important part in the design of your portfolio.
Asset location refers to deciding which funds should be placed in taxable versus tax deferred accounts. Under the 2003 tax law, interest income and certain other investment income is taxed at ordinary rates which can be as high as 35%, while capital gains are taxed at a maximum of 15% and qualifying dividends are now just 15%.
This great disparity in tax treatment has altered the strategies that VisionQuest Financial Planning employs regarding placement of funds. Since taxes reduce the net return that an investor receives, optimal location can make the portfolio more tax efficient and thereby boost the after-tax investment return.
Previously, stock funds were recommended for tax deferred accounts, while income based investments would go mainly in taxable accounts. There were several reasons for this; including the fact that income at retirement would normally come first from the taxable accounts. If taxes were not a consideration, we would prefer this approach because it more closely matches the timeframe when money might be needed. Even though the taxable accounts would still be the first source of income for most people, the tax rate reductions for capital gains and dividends are too compelling not to consider in determining in which accounts to place specific funds.
The new laws have prompted VisionQuest to shift income funds, such as bond funds, into retirement accounts to the extent practical. The taxable accounts should now have a greater growth emphasis, especially for people who don’t need much investment income. The overall asset allocation for an individual would not change; therefore, any shift between types of accounts would necessitate a compensating adjustment.
The general rules for placement within accounts are as follows:
Ø High return, highly tax efficient assets should go in taxable accounts. These would include stock index funds and tax-managed stock funds.
Ø High return, less tax efficient assets, such as real estate and high-yield bond funds and many managed stock funds would go into the IRA or employer retirement account.
Ø Low return assets can go in either taxable or tax deferred accounts. Thus, even though short-term bond funds are taxed at ordinary rates and are not very tax efficient, they provide a relatively low return so it doesn’t matter too much where they are placed.
Despite the potential tax savings from optimal asset location, it’s generally not a good idea to overload any one area. The future is uncertain and tax laws seem to change with the weather in Michigan - so it’s important to be flexible with your investment plan.
Of course, asset location does not apply to investors who either have all of their investments in tax deferred accounts or all of their money in taxable accounts. But if you do have a choice – asset location should play a significant role in developing and maintaining a tax efficient portfolio.
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