asset location

The ‘Yield-Split’ Method Of Asset Location To Improve Tax Efficiency Of Index Funds

March 30, 2022 07:05 am 12 Comments CATEGORY: Taxes

Financial advisors have many ways to add value to clients’ investment portfolios, from selecting an appropriate asset allocation to rebalancing when appropriate. However, because the investor ultimately only gets to spend what they can keep after taxes, another important way advisors can add value to a portfolio is to improve its tax efficiency; after all, if the same returns can be generated in a more tax-efficient manner, in the end, investors will generate more spendable wealth (a form of ‘tax alpha’). And when it comes to individual investors and their typical mix of investment accounts and retirement accounts, one of the best ways to enhance portfolio tax efficiency is through strategic asset location, where the advisor places assets into taxable or tax-advantaged accounts depending on the assets’ specific characteristics.

Implementing an asset location strategy begins with identifying the yield, tax rate, and potential tax drag of each investment in an individual’s portfolio. The investments are then sorted into an asset location priority list based largely on tax efficiency, which can be used to help identify where to house each type of investment, with the least tax-efficient holdings being placed into the most tax-advantaged account. Which means a stock fund with a low yield (and low tax drag) might be placed in a taxable account, whereas a high-yield bond fund (with high tax drag) might be placed in a tax-deferred account, thereby reducing the amount of taxable investment income in the current year.

In addition to using asset location to strategically place investments, advisors can further enhance tax efficiency by replacing the use of broad-based index funds with a corresponding pair of funds – one low-yield tax-efficient fund and another higher-yield, tax-inefficient fund. This process, called “yield splitting”, emulates broad-based index funds in such a way that allows for their component (low- and high-yielding) parts to be invested into separate accounts by tax efficiency.

For example, with a yield-split asset location strategy, rather than investing in a single total-stock-market index fund, an advisor would instead invest in both a low-yield growth index fund and a higher-yield value index fund. The intent would be to maintain a similar return overall, but also to allow the advisor to invest the funds separately, placing the higher-yield value fund in a tax-advantaged account and the low-yield growth fund into a taxable account. Similarly, replacing a total-bond-market fund with a high-yield corporate bond fund invested in a tax-deferred or tax-exempt account and a lower-yielding Treasury bond fund invested in a taxable account would potentially reduce the tax drag while maintaining comparable expected returns.

Over time, asset location can reduce the ongoing tax drag of the portfolio by nearly 10 basis points per year (of hard-dollar tax savings!), and layering the yield split methodology on top can double the asset location tax alpha by another 10 basis points (to a total of 20 bps). Cumulatively, this can add up to a 6% increase in long-term wealth accumulation over an investor’s multi-decade time horizon, simply by restructuring (i.e., yield-splitting) their core index holdings into the component parts for better asset location.

Ultimately, the key point is that while asset location is already a beneficial strategy to create tax alpha, the tax efficiency of a portfolio can be further improved upon with a yield-splitting approach to allow for even more-finely-tuned asset location implementation… all while maintaining a substantively identical overall risk/return profile for the portfolio as a whole. This not only leads to potentially significant tax savings for clients – particularly those who have the capacity for both tax-advantaged and taxable account holdings, and who pay a high Federal tax rate (and/or who live in states with high tax rates) – but also provides a tangible way for the advisor to demonstrate their own value!

Generating Tax Alpha With Effective Asset Location

Course Review Date:

October 30, 2018

Kitces Topic Areas:

Investments
Retirement Planning
Taxes

Session Description:

While it is ‘standard’ for advisors to diversify into an asset allocated portfolio, the question of where to locate those asset classes is more challenging. In this session, we will explore the various ways to handle asset location, taking into consideration tax efficiency, expected returns, and time horizons. We also take a look at how to build, use, and implement an asset location priority list based on the expected return and the tax efficiency of various assets. Finally, we review the caveats and concerns of asset location and approximate the value of utilizing an asset location strategy with your clients.

Learning Objectives:

LO #1: Identify the ways to “asset locate” and the impact of each.

LO #2: Describe the impact that turnover has on the final portfolio value and how it changes the optimal location of stocks in a portfolio.

LO #3: Be able to explain where various types of assets fall within the asset location priority list.

LO #4: Identify the factors in building an asset location priority list

LO #5: Illustrate how a financial planner can implement an asset location strategy.

Key Terms::

Asset Location: This is the personal finance term that indicates how or that investors can distribute money across different investments, but more importantly investments with different taxation.

Taxable Account: A good example is a brokerage account, and the tax treatment for this type of account is based on what is in the account – stocks or bonds.

Tax-Deferred Account: A good example is an IRA or a 401(k), taxes are not paid when the money goes in, but are taxable as ordinary income when withdrawn, and that ordinary income treatment applies

Tax-Exempt Account: A good example is a Roth IRA or a 529 college savings plan, and these accounts grow initially tax-deferred and allow withdrawals of the growth to be tax free assuming the requirements are met.

Long-term capital gains: These can also be long-term capital losses, and different from short-term gains and losses based on taxation. For instance, long-term capital gains stem from selling an investment that has been held for longer than 12 months at the time of the sale.

Buy-and-hold: This is a passive investment strategy where once the investor purchases his or her stock, s/he then holds it for an extended period of time regardless of fluctuation in the marketplace.

Dividends: Most often paid on a quarterly basis, this is a distribution of a portion of a company’s earnings, paid to the shareholders. Dividends can be cash, stock, or other property.

Tax-efficiency: This is another way to describe an investment strategy that minimizes tax liability.

Equities: This is referring to stocks or shares of a company.

Bonds: This is a fixed-income investment. The investor loans the money and in return receives a variable or fixed interest rate in return to pay back the loan over a certain period of time.

Time Horizon: The is the length of time over which an investment can grow (or not) and is held before liquidating or selling at some point in the future.

Level of Complexity:

CFP / IWI (formerly IMCA): Advanced
NASBA: Basic

Specialized Knowledge:

CFP: General Principles of Financial Planning / Investment Planning / Retirement Planning
NASBA: Specialized Knowledge (Personal Financial Planning)

Recommended CE Hours:

1.0 CFP hours
1.5 NASBA hours
1.0 IWI General Financial Planning hours
1.0 IWI Taxes & Regulations hours

Availability:

All self-study courses will be available at least through December 31, 2022.
Live courses are only available for the scheduled date.
All of our courses are reviewed on a yearly basis and renewed or discontinued every December.

For additional information about our programs, click here.

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Asset Location For Stocks In A Brokerage Account Versus IRA Depends On Time Horizon

April 22, 2015 07:01 am 22 Comments CATEGORY: Investments

In an environment where generating portfolio alpha is difficult, strategies like managing assets on a household basis to take advantage of asset location opportunities to generate “tax alpha” are becoming more and more popular. The caveat, however, is that making effective asset location decisions is not easy, either.

For instance, while the traditional asset location strategy “rule of thumb” is that tax-inefficient bonds go into an IRA, while equities eligible for preferential tax rates go into a brokerage account, the reality is that for investors with long time horizons the optimal solution may be the opposite. Once stock dividends and portfolio turnover are considered, the ongoing “tax drag” of the portfolio can be so damaging to long-term returns that placing equities into an IRA may be more efficient, even though they are ultimately taxed at higher rates!

In fact, it turns out that almost any level of portfolio turnover will eventually tilt equities towards being held in IRAs given a long enough time horizon (and especially while today’s low interest rates result in almost no benefit for bonds to gain tax-deferred growth inside of retirement accounts). Which means in the end, good asset location decisions depend not only on returns and tax efficiency, but an investor’s time horizon as well!

March/April 2014: Advanced Portfolio Asset Location Strategies Quiz

March/April 2014 – Advanced Concepts & Strategies In Asset Location

Course Review Date:

October 25, 2018

Kitces Topic Areas:

Investments
Retirement Planning
Taxes

Session Description:

In this month’s newsletter, we take a deeper dive into asset location concepts and strategies, including a look at how the introduction of Roth-style accounts adds further complexity, the potential to “create” new asset location accounts (e.g., non-qualified deferred annuities) to take advantage of tax-deferral, and how viewing investments on an after-tax basis can impact not only the asset allocation itself but also the after-tax volatility of an investment that can itself further change asset location priorities. In addition, we also look at some of the practical implementation challenges, and some of the client psychology and communication issues that arise in trying to effectively implement asset location.

Learning Objectives:

LO #1: Decipher which high-return investments belong in taxable versus retirement accounts based on their tax efficiency.

LO #2: Explain when and why high-return, tax-efficient investments should be placed inside a Roth IRA instead of a Traditional IRA and/or taxable brokerage account.

LO #3: Be able to describe when asset location should not be performed and why.

LO #4: Clearly illustrate why it is that an investor’s asset allocation on an after-tax basis may be materially different than their current, before-tax allocation.

LO #5: Articulate to client’s the importance of viewing assets as a household, while also mentally “accounting” for separate accounts in order to help clients overcome the psychological impact of some accounts not performing as well as others.

LO #6: Establish and maintain an asset location priority list.

Key Terms:

Asset Location: This is the personal finance term that indicates how or that investors can distribute money across different investments, but more importantly investments with different taxation.

Taxable Account: A good example is a brokerage account, and the tax treatment for this type of account is based on what is in the account – stocks or bonds.

Dividends: Most often paid on a quarterly basis, this is a distribution of a portion of a company’s earnings, paid to the shareholders. Dividends can be cash, stock, or other property.

Tax-efficiency: This is another way to describe an investment strategy that minimizes tax liability.

Equities: This is referring to stocks or shares of a company.

Bonds: This is a fixed-income investment. The investor loans the money and in return receives a variable or fixed interest rate in return to pay back the loan over a certain period of time.

Time Horizon: The is the length of time over which an investment can grow (or not) and is held before liquidating or selling at some point in the future.

Level of Complexity:

CFP / IWI (formerly IMCA): Advanced
NASBA: Basic

Specialized Knowledge:

CFP: General Principles of Financial Planning / Investment Planning / Retirement Planning
NASBA: Specialized Knowledge (Personal Financial Planning)

Recommended CE Hours:

1.5 CFP / IWI (formerly IMCA) hours
1.5 NASBA hours
1.5 IWI General Financial Planning hours
1.5 IWI Taxes & Regulations hours

Availability:

For additional information about our programs, click here.

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Jan/Feb 2014: Exploring the Benefits of Asset Location Tax Alpha Quiz

January/February 2014 – Exploring The Benefits Of Asset Location

Course Review Date:

October 20, 2018

Kitces Topic Areas:

Investments
Retirement Planning
Taxes

Session Description:

In this month’s newsletter, we explore the concept of asset location and its prospective benefits when executed well, along with examining the available research on how to make the best decisions regarding asset location when taking into account the tax treatment of the available accounts, the tax treatment of the chosen investments, and the expected risks and returns of those investments.

Learning Objectives:

LO #1: Decipher between which type of account (taxable or retirement) equities and bonds, respectively, should be held in and explain why.

LO #2: Describe why equity turnover and ongoing dividends erodes much of the value of tax deferral that is normally associated with buy-and-hold strategies.

LO #3: Explain why tax efficiency doesn’t matter all that much when expected returns are low.

LO #4: Construct an asset location priority list based on high-return assets and their level of tax efficiency.

LO #5: Be able to illustrate the “outside-in” concept for building a portfolio based on asset location.

Key Terms::

Asset Location: This is the personal finance term that indicates how or that investors can distribute money across different investments, but more importantly investments with different taxation.

Taxable Account: A good example is a brokerage account, and the tax treatment for this type of account is based on what is in the account – stocks or bonds.

Dividends: Most often paid on a quarterly basis, this is a distribution of a portion of a company’s earnings, paid to the shareholders. Dividends can be cash, stock, or other property.

Tax-efficiency: This is another way to describe an investment strategy that minimizes tax liability.

Equities: This is referring to stocks or shares of a company.

Bonds: This is a fixed-income investment. The investor loans the money and in return receives a variable or fixed interest rate in return to pay back the loan over a certain period of time.

Time Horizon: The is the length of time over which an investment can grow (or not) and is held before liquidating or selling at some point in the future.

Level of Complexity:

CFP / IWI (formerly IMCA): Advanced
NASBA: Basic

Specialized Knowledge:

CFP: General Principles of Financial Planning / Investment Planning / Retirement Planning
NASBA: Specialized Knowledge (Personal Financial Planning)

Recommended CE Hours:

1.5 CFP / IWI (formerly IMCA) hours
1.0 NASBA hours
1.5 IWI General Financial Planning hours
1.5 IWI Taxes & Regulations hours

Availability:

For additional information about our programs, click here.

Sorry, but you do not have permission to view this content.

Asset Location: The New Wealth Management Value-Add For Optimal Portfolio Design?

March 6, 2013 12:03 pm 25 Comments CATEGORY: Investments

For the past several decades, asset allocation has been the cornerstone of portfolio design, with a focus on diversification and the addition of non-correlated investments to the portfolio to reduce overall volatility and improve risk-adjusted returns. This trend has been accelerated in recent years, as weak returns in both bonds and stocks have helped to fuel a drive towards "alternative" investments that further increase the intended diversification and the number of asset classes in the portfolio.

Yet running in parallel with this trend has been the rise of various types of tax-preferenced accounts, with first the IRA and 401(k) and more recently the Roth IRA and Roth 401(k), in addition to the ongoing presence of tax-deferred annuities and the standard taxable brokerage account. As a result, a new challenge is beginning to emerge: the question becomes not only which asset classes should be owned and in what amounts, but also where should those asset classes be held? In other words, it's not just about allocation of the assets to build a diversified portfolio now, but also about the locations in which to place those diversified investments.

Given that recent research has shown effective asset location strategies can add 20-50+ basis points of "free" value to annual returns, providing guidance on asset location is becoming increasingly popular. Yet unfortunately, asset location strategies are often dominated by myths and misperceptions! Ultimately, the reality is that good asset location decisions actually should be influenced by both the tax efficiency of investments and also their expected returns, which makes the analysis somewhat more complex... but also reveals why in today's environment most bonds actually should NOT go into tax-deferred accounts!

The Emerging Next Generation Of Investment-Only Variable Annuities (IOVA) – An Asset Location Tool?

December 12, 2012 12:06 pm 13 Comments CATEGORY: Annuities

For the past 40 years, variable annuities have been on a rollercoaster, where the popularity of various features and benefits rise and fall as the contracts shift and adapt to the then-current environment. In the early years, variable annuities were popular for tax-deferred investing as top tax rates of the time were 70%, and remained popular in subsequent years as the burgeoning bull market made equity investing more appealing overall, even as tax rates declined. As the 2000s approached, variable annuity companies innovated, creating a wave of so-called "living benefit" riders that included GMIBs and GMWBs, to make variable annuities appealing to the coming onslaught of baby boomer retirees. Unfortunately, though, with the financial crisis, living benefit riders became far less appealing - old contracts forced annuity companies to raise reserves, and new contracts experienced a significant cost increase as annuity companies struggled to hedge and manage risk in a more volatile post-crisis environment.

As a result, annuity companies are now entering a new wave of innovation - where variable annuities are bolstered by more innovate active management and alternative investment strategies, and the annuity itself is used as a tax shelter for these rather tax-inefficient investments, at a drastically lower cost than the annuities of recent years. Whether this new line of investment-only variable annuity (IOVA) contracts will catch on remains to be seen, but the potential is for variable annuities to become a major part of portfolio design in the future - where the variable annuity becomes an asset location tool and clients can voluntarily choose how much of their most tax-inefficient investments will be sheltered by tax deferral.

Valuation-Based Tactical Asset Allocation In Retirement And The Impact Of Market Valuation On Declining And Rising Equity Glidepaths

September 17, 2014 07:01 am 11 Comments CATEGORY: Retirement Planning

For retirees who are more concerned about running out of money in retirement than leaving a large inheritance behind, the optimal retirement asset allocation strategies shift from focusing on wealth maximization and owning as much in equities as you can tolerate (to provide the greatest return on average), to approaches that do a better job of preserving wealth in adverse scenarios (even if it costs excess upside when times are good).

This retirement approach of focusing on minimization to spending risks over maximization of wealth accumulation has led to a wide range of retirement asset allocation and product strategies, including the use of annuities with guarantees, bucket strategies with cash reserves, and most recently the “rising equity glidepath” approach where portfolios start out more conservative early in retirement and become progressive more exposed to equities over time as bonds are spent down in the early years.

The caveat of risk minimization strategies, though, remains the simple fact that most of the time, they turn out to be unnecessary, as the risky event never actually manifests. As a result, tools like Shiller CAPE that allow advisors to understand whether clients are more or less exposed to a potential decade of mediocre returns (which brings about the “sequence-of-return risk” in retirement) can be remarkably effective at predicting when it’s necessary to focus on risk minimization in the first place, and when wealth maximization may be the more prudent course.

In fact, as it turns out, market valuation measures like Shiller CAPE can actually be so predictive of the optimal asset allocation glidepath in retirement, that the best approach may not be to implement a rising equity glidepath or a static rebalanced portfolio at all, but instead to adjust equity exposure dynamically based on market valuation from year to year throughout retirement. While this kind of tactical asset allocation approach is not necessarily a very effective short-term market timing indicator, the results suggest nonetheless that it can help to minimize risk when necessary, take advantage of favorable market returns when available, and have some of the best of both worlds – albeit with the caveat that markets can still deviate materially in the short run from what valuation alone may imply regarding long-term returns!

April 2009 Issue of The Kitces Report – Dynamic Asset Allocation and Safe Withdrawal Rates

Below is the April 2009 Issue of The Kitces Report on "Dynamic Asset Allocation and Safe Withdrawal Rates". Click here for more information on The Kitces Report and our Members Section.

Download (PDF, 176KB)

The Rise of Tactical Asset Allocation

June 20, 2012 11:06 am 16 Comments CATEGORY: Investments

The foundation of investment education for CFP certificants is modern portfolio theory, which gives us tools to craft portfolios that effectively balance risk and return and reach the efficient frontier. Yet in his original paper, Markowitz himself acknowledged that the modern portfolio theory tool was simply designed to determine how to allocate a portfolio, given the expected returns, volatilities, and correlations of the available investments. Determining what those inputs should be, however, was left up to the person using the model. As a result, the risk of using modern portfolio theory - like any model - is that if poor inputs go into the model, poor results come out. Yet what happens when the inputs to modern portfolio theory are determined more proactively in response to an ever-changing investment environment? The asset allocation of the portfolio tactically shifts in response to varying inputs!Read More...