Over the past 6-months, I have been doing some more research into asset location. Before we begin, it is important to note that asset location is different from asset allocation.
Asset allocation is usually focused on how our funds are invested. Take a 60/40 (60% stocks and 40% bonds) for example. That’s an example of asset allocation.
Asset location is where we are investing our funds. This could be a Roth IRA, pre-tax 401(k), brokerage account, HSA, etc.
As people’s financial lives become more complex, there are opportunities that may arise. In my opinion, asset location can be impactful in specific instances. I’ll walk through those, but this strategy is likely more applicable to those who have built up some higher balances in their investment accounts.
To be a little more blunt, if someone had $20,000 across the board in different investment accounts, the idea of asset location might not really move the meter. For someone with $500,000 or more, it might just add a little more efficiency.
Some people are very against asset location. I understand why that is. The general argument revolves around the fact that asset location is heavily influenced by our ability to be confident in how different asset classes will perform.
Given we work with younger folks, I think that the time horizon plays into this. Of course, future returns are never guaranteed. Yet historically, we have some evidence to support that stocks tend to outperform bonds over long periods of time.
Additionally, I’d argue that things like direct indexing change the landscape. When there is an active tax-aware strategy being run in a taxable account, this can influence the impact of asset location.
Here’s a hypothetical scenario:
Investor A has a pre-tax 401(k) with $500,000 in it. They also have a $500,000 taxable account, allocated to direct indexing, that is actively seeking to generate losses. They also hold some old company stock that they’ve been hesitant to sell given the tax implications.
This investor would like to maintain an 80% stocks to 20% bond allocation.
They could allocate each of the accounts to an 80% stock and 20% bond portfolio.
Or… they could allocate the taxable account to a 100% equities portfolio and invest the 401(k) in a 60% stock and 40% bond portfolio.
This maintains the overall allocation of 80/20, but it stacks more equity power in the taxable account. This could potentially allow for more loss harvesting power.
Additionally, the fixed income position (which is largely associated with interest income) is now sheltered in the pre-tax account.
There are two main ways in which people execute on asset location.
There is the gross method, which does not take into account the future tax liability of the pre-tax funds and the net method which does. The example above would be the gross method.
Generally speaking, neglecting the future tax liability would make the portfolio outlined above slightly more risk-on than 80/20. However, in my experience, I have preferred the gross method as it is slightly more straightforward to understand so long as the additional risk is outlined clearly.
To help understand the example above using the net method, someone would need to assume an effective tax rate on the pre-tax dollars. Let’s use 25% for an example.
If 25% of the pre-tax account were to be directed towards taxes, that’d leave the investor with a net amount of $375,000 in the pre-tax account.
From there, we know that $200,000 of those net dollars need to be allocated to equities and the remainder would be allocated to fixed income.
Gross those back up and ~$266,667 of the pre-tax account would be equity focused and ~$233,333 would be fixed income or roughly 53% stocks and 47% bonds.
Now, there are a few instances in which I think asset location can seriously move the needle:
Our PE/VC friends with carried interest: Carried interest has the potential for LTCG treatment, meaning that any losses generated through the taxable account may have a significant impact on their current tax bills.
Large inherited IRAs subject to RMDs: When there is a large account that is inherited during peak earnings years, distributions can be subject to significant tax drag. This instance can lead to focusing less on growth within the account to mitigate the tax bite.
Concentrated, low basis stock: This is pretty typical of anyone who has been working at a Fortune 500 company in recent years. Some are not inclined to sell the position down for the tax bite alone. Getting more dollars into a loss harvesting vehicle while maintaining overall allocation may give them the losses they need to feel comfortable peeling back some of the low basis position.
As I mentioned, this is a slightly more aggressive tactic in that it does take future assumptions to execute. This is not necessarily a bad thing, it is just something that should be noted.
One of the most interesting aspects of something like this is that it is incredibly subjective. No two people would follow the same execution. They might abide by the overall rules, but their situation and location arrangement would likely be significantly different.
This is for informational purposes only and is not intended as legal, tax, or investment advice or a recommendation of any particular security or strategy. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. Opinions expressed in this commentary reflect subjective judgments of the author based on conditions at the time of publication and are subject to change without notice. Past performance is not indicative of future results.