The Truth Behind The Asset Location Controversy

I've always been a proponent of the "tried & true" asset location priorities: inefficient assets (bonds) in the IRAs, efficient assets (equities) in taxable accounts, and high risk/high return assets in the Roth. I still believe this theory to be the best one. And, I disagree that the decision of where to locate investments between taxable and IRAs should be dependent on expected returns. (This is different for Roth IRAs, to be discussed below.)

First, just like Modern Portfolio Theory (asset allocation), trying to time the market just doesn't work. Location decisions should be based on long-term expected returns not predicted near-term returns. These are long-term decisions and it is not efficient to move holdings back & forth when selling from taxable accounts can cause taxable gains (and selling from anything causes transaction fees).

The market can have a bearing when deciding between municipal bonds and taxable bonds. From an investment standpoint, if munis provide a higher return than after-tax returns of taxable bonds, the advisor should choose munis for the client. In this case, the fixed income (municipal bonds) should be held in the taxable account and another tax-inefficient investment should be held in the IRA.

Tax inefficient assets typically produce high distributions of ordinary income with less appreciation - and long-term lower (although less volatile) returns. Holding these assets in the IRA ultimately results in lower required minimum distributions (RMDs) during the client's lifetime and less "income in respect of a decedent" to the heirs.

Tax-efficient holdings belong in a taxable account, especially when they they generate larger returns than tax-inefficient asset classes. While it is true that equities held in taxable accounts will generate income (primarily dividends taxed at capital gains rates) and produce taxable gains when rebalancing, tax loss harvesting can be a significant offset. Ultimately, appreciation will be subject to capital gains rates during the investor's life or zero tax upon death. Holding these assets in IRAs converts zero tax or, at most, capital gains tax to ordinary tax that never goes away (due to "income in respect of a decedent" rules).

Because Roth IRAs never get taxed, they are typically the last "pot" liquidated by the investor. Thus, high return/high risk investments should be held in a Roth IRA. Any initial value declines can be taken out of the Roth through recharacterization. Once past this early phase, the Roth can handle volatility (due to its long-term nature) and the ultimate higher growth will avoid taxation - even to the next generation!

On Michael's second point, that the client's relative balances in the various types of accounts might make asset location difficult, I agree. However, to effectively deal with this issue, the advisor should set location priorities. For example, fill up the IRAs with fixed income first, then use REITs; put U.S. large stocks in the taxable account first, then use international large stocks. Essentially, the advisor needs to rate holdings from most tax-efficient to least tax-efficient and set priorities accordingly.

Absent automation, applying this strategy in practice can be difficult, at best. This is where the commercial comes in ... a program like Total Rebalance Expert allows the advisor to choose location preferences as well as priorities.

Taxes are a big concern for our clients - and if we don't do everything possible to lower this burden, they will seek out an advisor who does. I believe it is our duty to do the best we can for our clients. Location optimization is a big part of that.


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