Where to hold stocks and bonds for maximum benefit.
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By Sue Stevens, CFA, CFP, CPA | 01-19-06 | 06:00 AM | Email Article

You probably already appreciate the beauty of asset allocation. When you spread your money among investment categories that share little in common, you help control your portfolio’s risk and squeeze out the highest returns possible for the amount of volatility you can stomach.

Sue Stevens, CPA, CFP, MBA, and CFA Charterholder, runs her own financial planning firm, Stevens Portfolio Design, and manages over $100 million in assets.

Few investors appreciate another smart strategy that goes hand-in-hand with asset allocation. This strategy, called asset location, requires you to consider what type of accounts you should be putting all of those diversified investments into.

Suppose, for instance, that you own the classic balanced portfolio of 60% stocks and 40% bonds. Maybe it’s divided among large- and small-cap stock funds, as well as international equities, a large dose of treasuries and corporate bonds, and maybe a REIT fund. Your task is to determine which of these investments should be tucked inside tax-deferred retirement accounts, and which should be saved for taxable accounts.

Who Should Pay Attention to Asset Location?
Not all investors need to fret about asset location. This strategy won’t be necessary if you’ve got nearly all your cash tied up in tax-protected accounts, such as IRAs, 401(k)s, and 529 college savings plans. 
 
Focusing on asset location, however, is invaluable if you’ve also got money stashed in taxable accounts, where the taxes can erode your net worth. The goal of affluent investors is to divide their investments among taxable and retirement accounts in a way that will defer taxes and ultimately provide the best aftertax returns.

According to the authors of a 2004 study published in The Journal of Finance, placing investments in the wrong type of accounts can easily rob young investors with moderate retirement savings of 20% of their aftertax nest egg over their lifetimes. The costs of misplacing assets can be greater with young and middle-aged investors because the investments have longer to compound, which ultimately provides a bigger target for the IRS.
 
Experts Disagree
Placing assets in the right cubbyholes sounds great, but experts disagree on how to pull it off. Some have suggested that IRAs are ideal repositories for bonds, while others have advocated putting stocks in retirement accounts. Still others recommend that investors hold a mix of stocks and bonds in both types of accounts.

A variety of reasons exist for this head-butting. It doesn’t help that the federal tax code changes frequently, which can make a tax strategy that’s ideal one year obsolete the next. In 2003, for instance, Congress slashed the maximum capital gains rates to 15% and dropped the top tax for stock dividends to 15%. The optimal location for an investor’s assets can also vary depending on tax bracket, investment holding periods, and the tax and return characteristics of the securities.

The Ivory Tower
Two recent studies have attempted to provide investors with guidelines on taxable and tax- deferred assets.

The authors of the first paper were three university professors, including Chester S. Spatt, who has since become the chief economist at the U.S. Securities and Exchange Commission. They recommend confining the considerably more tax-friendly stocks in taxable accounts because of the lower capital gains rate and the ability to defer gains. Tucked inside a taxable account, you can also sell pummeled stocks for captured tax losses. What’s more, if an owner dies while holding stocks or stock funds in a taxable account, heirs will inherit the securities with a new stepped-up cost basis. So, if a stock portfolio was originally worth $10,000 and it’s now valued at $50,000, an heir would owe no capital gains taxes on the original owner’s appreciation. In contrast, if the heir took a distribution from the appreciated stock in an inherited traditional IRA, he would owe income taxes on the full amount. 

The study, which was funded by the TIAA-CREF Institute, also concludes that investors should devote their retirement accounts to taxable bonds. If this would tip the overall portfolio too heavily toward fixed income, the researchers recommend including stocks and bonds in the tax-deferred accounts, but only if the taxable accounts contain equities exclusively. You can take a look at the study, titled “Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing,” by clicking here.

The other research paper was published in the Journal of Financial Planning in January 2005. The authors of “Asset Location: A Generic Framework for Maximizing After-Tax Wealth” advocate putting the high-return tax hogs into IRAs. Included in this category are REITs, commodities, and active large-cap domestic-stock funds that generate high yearly capital gains distributions. In concurring with the other study, the researchers determined that higher-performing, tax-efficient assets belong in taxable accounts.

The study concluded that lower-return assets, such as short-term bonds and corporate bonds, can be placed in either type of account. The researchers also looked at assets they considered to be sitting on the bubble. That is, those of medium returns and tax efficiency, such as international large-cap stock funds, emerging-market stock funds, and active small-cap stock funds. In the study, placement of these assets made no difference for a 60-year-old in the 35% federal tax bracket with a $1 million portfolio that was divided evenly in a traditional IRA and a taxable account.

An important finding in this study was that by using optimal asset locations, investors may increase their aftertax returns by an average of 20 basis points (0.2%). Click here to read the study.

Action Items
If you adjust your investment portfolio to reduce its future tax drag, you will be doing better than most investors. That small 20-basis-point advantage on aftertax returns can turn into big cost savings over time.

Here are a couple more tax-savvy points to remember:

  • Don’t invest in tax hogs in taxable accounts. Not all mutual fund managers worry about the tax consequences of their trading  (in fact, not many do), but you need to. Aftertax returns are frequently ignored in fund advertising.
  • It’s easy to check the tax efficiency of all the funds that Morningstar tracks. On any Morningstar Fund Report, the Tax Analysis section provides several indicators of a fund’s tax efficiency. One tool is the tax-cost ratio, which represents the percentage-point reduction the fund experienced in its yearly return because of its tax bite.
  • Consider indexing. It’s been estimated that only 15% of investors use index funds, even though studies have shown that most actively managed funds can’t beat their benchmarks over the long term. But beyond that, index funds, as well as the increasingly popular exchange-traded funds (ETFs), are valued for their tax efficiency and low costs.

A version of this article appeared in the July 2005 issue ofMorningstar Practical Finance

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Sue Stevens, CFA, CFP, CPA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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