Asset Location and Roths
Key Takeaways:
There are some benefits to be had from prudently allocating assets with different tax characteristics between accounts offering tax deferral, ones that are exempt from taxes altogether, or are plain taxable accounts.
We run into issues when our neat theoretical examples are put to the test by real world circumstances; accounts of extremely difference sizes, client’s perception of volatility, rebalancing frequency, non-linear returns, etc.
You’ve probably heard so much about “Asset Allocation” that you may have thought I left out “A” in the title by mistake. “Asset Location” is not talked about nearly as often but has the potential to impact the bottom-line of investment account performance. The premise behind this strategy is rather simple; some investments are more tax efficient than others. The 3 most often used investment accounts have different tax treatment. So, there may be tax advantages to buying the least tax efficient investments in the most tax efficient accounts, and vice versa. Right? You may have also just realized exactly why this is not a cocktail party topic – it’s boring, and probably difficult to follow after a few drinks.
First Things First: I need to explain a few details that will serve as a foundation before we can put our nerd hats on. The 3 account types I mentioned above are:
Taxable accounts – these are your regular brokerage accounts without restrictions typical for retirement accounts, but also do not have any tax deferral features. You pay taxes on gains, interest, and dividends in the year they are realized.
Tax-deferred accounts – think of your 401K or your IRA. Gains, interest, and dividends are not taxed in the year realized. Instead, every dollar withdrawn from these accounts during retirement is taxed as ordinary income, because you received a tax deduction when you contributed into your 401K. In other words, dollars in these accounts have never been taxed, grew tax free and therefore are taxed upon withdrawal.
Tax-Exempt accounts – any account with the ROTH prefix and Health Savings Accounts are great examples. Funds contributed into your ROTH account have already been taxed so it would only make sense that withdrawing funds you already paid taxes on would be a tax-free transaction. Gains, interest, and dividends are also not subject to tax upon withdrawal from a ROTH account and is a tax benefit to encourage people to save for their retirement. Health Savings Accounts are completely tax exempt if used to pay qualified medical expenses, we looked into these accounts a while back, you may see the previous blog post HERE.
Moving Assets: When we refer to “moving” assets from one account to the other in this article, we do not mean physically transferring dollars or securities. Moving funds between accounts may result in a taxable transaction and do more harm than good. Instead, we are assuming that dollars are in accounts already and we are purchasing certain holdings in one account instead of the other, thus in theory moving them from one account to the other – but not in practice.
Calculators Out! A good place to start is to try and quantify expected benefits from moving assets into type of accounts best suited for them based on tax characteristics. For this we will turn to Michael Kitces’ article called “Asset Location for Stocks in a Brokerage Account Versus IRA Depends on Time Horizon”. In this analysis we assume that we have $1,000,000 to invest and it will be split 50/50 between Stocks and Bonds and see what the final after-tax result is after 30 years of growth between different accounts. We will assume that stocks grow at 8%, and pay a 2% qualified dividend which is taxed at 15% rate annually, and bonds pay 5% interest that will be taxed annually at 25% tax rate. Let’s take a look at the results:
Please note that I altered the table shared in the original analysis to include ROTH IRA outcomes which are IRA outcomes before taxes, hence same figures in gross and after-tax estimates in Scenario 3.
The conclusion we can make from reviewing the table above, is that any and all investments should be kept in a ROTH IRA. Since that is not realistic, let’s ignore Scenario 3 for the time being. Comparing scenarios 1 and 2 would suggest that bonds are best held in tax-deferred accounts and stocks should be purchased in taxable accounts. That would be true if one would never rebalance their portfolio over 30 year investment horizon. But how does turnover affect our comparison of assets held in taxable accounts? Michael Kitces to the rescue:
Rebalancing your portfolio has a significant impact on the final value of your portfolio and a turnover of just 10% (which means that your portfolio would completely change over a decade) will make it worth less than if you kept stocks in an IRA.
We can say with a great degree of confidence that it would be best to keep high-growth, tax-inefficient assets in tax-deferred or tax-exempt accounts, holdings with low expected returns can be kept in any account as impact will be limited either way and tax efficient assets with high expected returns should be placed in taxable accounts. An intuitive way to visualize this relationship is to graph the expected return of investments across the vertical axis vs. tax efficiency along the horizontal axis:
To button up this discussion we should look at the tax treatment of various investment vehicles and which account would most likely be suitable to keep them in:
Conclusion:
The best account to keep any assets in is a ROTH IRA – if one does not have to incur taxes to fund a ROTH IRA. Keeping assets in tax-appropriate accounts could potentially benefit investors. To some extent Asset Location is already considered when managing a portfolio – you will not find municipal bonds in an IRA or amongst investment choices for a 401K plan. The same applies to Master Limited Partnerships and other holdings that are most beneficial to hold in taxable accounts.
The real issue comes about when theory meets the real world. Most clients retire with a large IRA, a significantly smaller taxable account, and perhaps some funds in a ROTH IRA. This lop-sided dollar distribution will present issues to the asset manager. Therefore, depending on the size of the balance, a ROTH IRA may end up holding ONLY the most aggressive of holdings, due to its small size. Taxable accounts with the most “normal” asset distribution consisting of municipal bonds and equity ETFs. Meanwhile IRAs would have to be largely comprised of REITs, high-turnover mutual funds, and corporate bonds.
Aiming for tax efficiency is all well and good but explaining why someone’s ROTH IRA is 10 times more volatile than the other two accounts is an entirely different story. Another thing to consider, since assets with the highest expected returns tend to also be most risky – and if we stuff a ROTH IRA full of them which then blows up during a market downturn – we just eliminated the most tax efficient account a client may have had. In this situation it is best to abide by the “Everything in Moderation” rule or as most advisors will tell you – “This is where science meets art”.
Limitations:
It is important to understand that this analysis looks at how to allocate assets that are ALREADY IN these accounts and is NOT a good source of information to determine which accounts to save INTO. It is because one would have considered income taxes on dollars to be placed into taxable accounts and ROTH IRAs. This would change our starting point to $500,000 for IRAs and $350,000 for taxable accounts and ROTH IRAs if we assume 25% income tax rate. Needless to say – the outcome could be very different and is beyond the scope of this review.
Another limitation of this review is that we look only at results at the end of 30 years; shorter investment horizon results could have different outcomes and different breakeven points.
Sources:
IMPORTANT DISCLOSURE INFORMATION
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