Your asset allocation – the way your invested money is distributed among various asset classes – plays a significant role in determining the levels of return and risk reflected in your portfolio. But beyond making decisions about your portfolio’s asset allocation, you also need to think about asset location.
Asset location involves selecting appropriate accounts to invest in with an eye toward keeping your assets and overall portfolio as tax-efficient as possible. This requires you to look at each type of asset you own and decide whether it should be held in a taxable, tax-deferred or tax-exempt account. Typically, taxable accounts should be reserved only for the most tax-efficient assets – assets that tend to generate relatively low tax liabilities. Examples of tax-efficient assets include low-turnover stock index funds, international investments that generate foreign tax credits, and tax-free municipal bonds and funds. Generally, tax-inefficient assets, including real estate investment trusts (REITs), actively-managed, high-turnover stock funds and corporate bond funds, are best kept in tax-deferred or tax-exempt accounts. Tax-deferred accounts include 401(k) and 403(b) savings plan accounts and traditional IRAs, while Roth IRAs and Roth 401(k) plan accounts are tax-exempt under certain guidelines.
Creating and following an asset location strategy is particularly important for you if you pay a high marginal income tax rate, although you don’t have to be in the highest tax bracket to benefit from such a strategy. Also, having an asset location strategy makes good sense if you expect to remain invested for the next 10 or more years, because the longer you keep your assets invested, the greater the potential benefits from tax deferral.
In deciding how to invest, start by figuring out an appropriate asset allocation, based on your goals, return objectives and tolerance for risk. Then, work to render your asset allocation as tax-efficient as possible by focusing on asset location.
At Grand Wealth Management, we place a high priority on providing each client with an active asset location strategy as part of offering tailored asset allocation services.