How Good is your Asset Location?

Most pre-retirees and retirees have a combination of taxable, tax-deferred, and tax-free accounts. Different asset classes have different characteristics that make them better candidates for each of these types of accounts.

In general, an asset class that generates a high amount of taxable income, like high yield bonds, bank loans, and emerging market debt, are relatively LESS tax efficient in a taxable account compared to a tax-deferred or tax-free account. Alternatively, an asset class that generates a small amount of taxable income, like U.S. growth stocks, emerging market equities, and commodities, are relatively MORE tax efficient in a taxable account. This is because, of course, assets that don’t generate much taxable income and instead generate most of their return from unrealized gains over time don’t pay taxes until desired and at a preferred lower long-term capital gains tax rate if held more than one year.

I am sometimes surprised when I see a tax-deferred account with a large allocation to some clear long term equity winners like Apple or Amazon. Sure, stocks like these have generated outsized gains over time, but the gains will be taxed at usually higher ordinary income rates when withdrawals are made from the tax-deferred accounts instead of at lower long term capital gains rates. Maybe it is counter-intuitive to some, but stocks like these are better off held in a TAXABLE account to make use of the lower long term capital gains rate, or even the cost basis markup upon bequeath after death!

Vanguard and others have done work defining the benefits of investing with a focus on tax-optimized asset location (“Vanguard Advisor’s Alpha”). It depends on a number of variables, but Vanguard has published that it can be worth from 0 - 75 basis points. It is worth understanding the pros and cons of tax asset location, and then customizing a mix that suits the needs of the investor.