By Gary Brooks, CFP®
Asset allocation (your weighted mix of stocks, bonds and cash) is a key determinant of portfolio outcomes. Asset allocation has demonstrated more influence on returns for balanced portfolios than has the underlying investment selection or transaction timing.
While asset allocation is a key tenet of portfolio construction, an investment mix can be further optimized by applying asset location. Asset location deals with placement of certain types of assets in more advantageous types of accounts based on the tax characteristics of the account.
Generally, income producing investments (bonds, real estate investment trusts, high-dividend stocks) are better held in tax-deferred retirement accounts. Non-dividend paying stocks are better suited for taxable brokerage accounts. And your investments with the highest expected returns should be held in Roth accounts. This mixes elements of ordinary income tax (tax-deferred accounts), capital gain income tax at a lower rate than ordinary income in brokerage accounts and tax-free growth in the Roth.
Thornburg Investments produces an annual study of Real, Real Returns. It examines what return is truly left over for the investor after removing costs and adjusting for inflation. The August 2015 edition of this report cites research from Morningstar and the Money Management Institute which suggests that “an additional 54 basis points (0.54%) in incremental annual after-tax returns can be achieved” by optimally locating assets in tax-qualified and taxable accounts.
Of course, everyone’s portfolio has different investment holdings and different amounts in tax-qualified vs. taxable accounts. But to generally understand what an additional 0.54% of annual return would mean, consider this very simple example.
Investor A is 40 years old, has $100,000 of invested savings and is a 50% stock, 50% bonds/cash investor. The return expectation is 5% average annual.
Without considering any additional contributions or withdrawals from the account, Investor A reaches age 85 with $943,425.82.
But what could the balance be with the more optimal extra 0.54% per year due to tax savings? A 5.54% average annual return would balloon the balance to $1,194,499.94. You likely wouldn’t need much time to think of what you might do with $250,000 more. Or, I’m sure your heirs or your favorite charitable organizations would be excited to receive $250,000 more simply because you were wise about how to locate certain types of investments.
Certainly this is a simplified example. Tax rates will likely change over time and not everyone has the same opportunity to optimally split tax-deferred vs. taxable accounts in the most ideal way.
But even without achieving the most optimal results, there is potentially meaningful extra money generated when you extend asset allocation to include asset location.
~ Brooks, Hughes & Jones Wealth Advisors – Gig Harbor, WA – www.BHJadvisors.com