Asset Location Vs. Allocation and Their Roles in Tax Efficiency
Location, location, location. It isn’t just the mantra of the real estate industry. It applies to investing as well. And just like where you live affects what you pay in taxes, where you locate assets will mean a difference – possibly a substantial difference – in your tax bills and in how much money will be available to spend in retirement.
Unfortunately, financial advisors deal daily with investors who have accounts spread out among multiple firms but don’t disclose that information. To do asset location properly, and increase the tax efficiency of portfolios, advisors need to know:
- Where are all the accounts members of a client household held (location!)?
- What type of tax treatment do those accounts have?
- What investments do clients hold in the accounts?
Another key factor in managing portfolios is the like-sounding process of asset allocation, or how investments are divided among categories that include stocks, cash, bonds, and other instruments to balance risk with potential rewards.
Two of the most important factors to consider when handling assets and portfolios are how funds are allocated and where they are located. Together, asset allocation and asset location contribute to the overall tax efficiency to provide more income for clients in the long run.
What Is Asset Allocation?
Asset allocation is a portfolio technique used to balance risk and potential reward. It recognizes that each asset class offers different levels of risk and return, and each one behaves differently over time.
Most financial professionals strongly believe that asset allocation is one of the most important decisions that an investor makes. Every investor’s asset allocation will be different, as every investor has a different tolerance for risk and a different timeline for keeping assets invested.
Risk Vs. Return
At its very core, asset allocation is about the risk-return relationship of the portfolio. While it is easy for any investor to tell you that they want the highest possible return from their portfolio, wishing doesn’t make it happen. A financial advisor must evaluate the risk tolerance of an investor and the investor’s timeline before suggesting the allocation of investments among asset classes in the portfolio.
Ideal Asset Allocation Approaches
Every client account is different. The approach that works for one client may not work for another. So, it becomes imperative to individualize the approach to asset allocation. Some of the asset allocation approaches that advisors, working in their clients’ best interests, are:
- Strategic Asset Allocation – a proportional combination of assets based on the expected rates of return for each class. A traditional “buy-and-hold” strategy.
- Constant-Weighting Asset Allocation – the constant rebalancing of a client’s portfolio. There are no hard-and-fast rules for portfolio
- Tactical Asset Allocation – to use this approach wisely, short-term opportunities must be identified so investors can make small and temporary moves for those assets in a portfolio.
- Dynamic Asset Allocation – the constant adjustment of the asset mix as the market rises and falls.
- Insured Asset Allocation – the amount set by the investor in which the portfolio is not allowed to drop under.
- Integrated Asset Allocation – combines aspects from other allocation strategies and accounts for the expectations, capital market changes, and risk tolerance.
Allocation is a critical foundation for any client’s investment account. It is, however, only the beginning.
What Is Asset Location?
Asset location is a tax minimizing strategy that takes advantage of different tax treatments on investments in an investor’s portfolio. Asset location cannot be the first step when looking at a client’s profile. It begins with the allocation of the portfolio.
Asset location within these accounts helps with:
- Managing the bigger picture – Before you can organize your client’s assets across accounts, you must determine the household allocation based on unique investment goals and risk tolerances. That is why allocation comes before location in the investment account
- Planning the goals and timeframe – What is the point of the account? Retirement? How long will the client have before they begin to withdraw these funds? The location of the assets tends to take the backseat in comparison to allocation, but it shouldn’t. Location is what increases tax efficiency and ultimately yields more money for clients in the long run.
- Managing tax-advantaged accounts – A large part of the location strategy is determining what account opportunities clients have. Tax codes frequently change and are subject to political swings. As an advisor, you must get into the habit of checking them regularly (or you could let LifeYield do that part for you).
Types of Investment Accounts
Taxes are an inevitable part of the investment process. While not every trade results in a taxable event, frequent trading, buying, and selling can build up a relatively large tax bill – unbeknownst to your client. That is where you step in, to give them the right strategies for the assets in their portfolio. The more they minimize taxes on their accounts, the more they end up with come retirement (and the less they pay in their overall tax bill).
There are three types of accounts in terms of tax treatment. These include taxable, tax-deferred, and tax-exempt. Each of these offers different benefits for assets located within those accounts.
Taxable accounts, like traditional brokerage accounts, are accounts that hold securities like stocks, bonds, exchange-traded funds (ETFs), and mutual funds, among others. These assets are taxed when the accounts earn dividends or interest or realize capital gains by selling investments that have gone up in value.
Tax-deferred accounts include 401(k)s, individual retirement accounts (IRAs), etc. These allow for tax payments to be deferred until money is withdrawn. Once it is withdrawn, it is then taxed as ordinary income.
Tax-exempt accounts, like Roth IRAs and Roth 401(k)s, require investors to pay income taxes upfront before they make contributions. Investors get to avoid further taxation if they follow the rules governing these types of accounts.
Higher and Lower Tax-Advantaged Accounts
Higher tax-advantaged assets that your clients may have include:
- Individual stocks – As a general rule, these are reasonably tax-advantaged when bought and held for at least one year.
- Equity Index Mutual Funds – ETFs are reasonably tax-advantaged
- Tax-Managed Equity Funds – These are the equity funds that explicitly name tax-advantage as the funds’ goals.
Lower tax-advantaged assets that your clients may have include:
- Bonds and Bond Funds – These accounts are highly tax-disadvantaged due to the interest payments generated and their taxation at higher ordinary tax The potentially higher return types of bonds and investments are the ones that are the most tax-disadvantaged. These do not include tax-free municipal bonds, funds, and US Savings Bonds.
- Actively Managed Stock Funds – Higher turnover rates are less tax-advantaged because they have higher capital gain distribution rates. If they happen to distribute short capital gains, they are taxed at higher ordinary income tax
When an Asset Location Strategy is Beneficial for Clients
Asset allocation is a time-honored practice. Clients who are opening new accounts (or working with new advisors) will usually complete questionnaires to help evaluate their risk tolerance, timeline, and goals for investing. With deeper conversation, advisors will recommend asset allocations.
Asset location, unfortunately, is sometimes put on the back burner. This can happen unintentionally – for example, a client gets a new job and begins to invest in a new 401(k) or a client heeds an accountant’s advice to open and invest in a Roth IRA. What you don’t know about you can’t control, right? It’s also the consequence of people accumulating and investing over time and never stepping back to examine their investments as one, integrated, household portfolio.
There are scenarios that you can investigate, criteria that determine whether your client’s accounts are candidates for a strong asset location strategy.
Is Your Client Currently Paying a High Marginal Income Tax Rate?
If your client’s account is exposed to a high marginal income tax rate, there may be a larger potential for benefits using an asset location strategy. As a rule of thumb, the more money that is earned, the higher the marginal tax bracket the client ends up in. Consequently, income is significantly reduced due to the higher tax rate.
Do You Expect That Your Client Will Pay a Lower Marginal Tax Rate in the Future?
If you expect that your client will pay a lower marginal tax rate in the future, using an active asset location strategy may make it possible for them to defer or reduce their taxes now. One situation where this occurs is when an investor retires. They usually see a large drop in their marginal income tax rates.
Does Your Client Have Significant Assets in Tax-Inefficient Investments That Are Held in Taxable Accounts?
When a client has assets tied up in tax-inefficient accounts like bonds or bond funds, there is greater potential to increase the client’s after-tax returns using the asset location score. This can be done by executing a plan based on asset location technology that your firm adopts. LifeYield’s technology supports advisors and firms in this process.
Will Your Client’s Investment Period Be Ten Years or More?
Choosing an asset location strategy does not usually result in instant rewards. It can take up to ten or more years for a client to see the results they hope for, even with asset location is properly addressed and implemented. The longer assets are invested, the greater the potential for seeing the impact of the strategy.
LifeYield’s Taxficient Score
Even though taxes can have an outsize effect on the income a client household has in retirement, clients’ eyes may glaze over when you begin to talk about tax efficiency and asset location. Fortunately, there’s a way to break the topic down into information that clients can digest – and will rally to.
LifeYield Asset Location software uses a proprietary algorithm to scan all the accounts in a client household’s portfolio to pinpoint the tax-smart location for every asset – in seconds. The software produces an asset location score, called the Taxficient Score, that shows on a scale of 0-100 how tax-efficient the household’s current portfolio is. Then it shows how, with shifts in the types of investments held in different accounts, how they can improve that score.
Advisors can present to clients in dollars and cents what their potential tax savings can be if they apply proper asset location. Persuasive, no?
How the Asset Location Score Works
Let’s say you have a client that comes into your firm. They have a few accounts that they have accumulated over the years, but they want to invest and save for retirement. LifeYield’s asset location score can give you the client’s tax efficiency score before and after optimization. These scores allow you to provide the client with tangible and quantifiable numbers related to their investments.
For example, say you have a client whose accounts return an asset location score of 45 unoptimized. While this score isn’t terrible on its own, there may be room for improvement. After running the optimization, you find out that with a different asset location strategy, the account’s score increases to 70. The increase of 35, based on the analysis, results in an additional $100,000 over their retirement years. This amount is something you can share with the client, including the techniques to get there.
LifeYield becomes your tool for increasing the amount of overall retirement income. And it doesn’t mean any ripping out of your current tech stack. LifeYield technology is available as an application programming interface or API, so it can work within your current platform for client account management.
Why Asset Location Isn’t Talked About Like Other Strategies
Asset location is not as dazzling a topic as others that financial advisors discuss with investors. And without software, it’s almost impossible to do manually and achieve the best possible results. The impact that asset location has on investment accounts, however, is undeniable.
Asset location is not a “get rich quick” strategy by any means. Clients who don’t choose a systematic approach to asset location could wind up with more problems than they realize, including:
- Missing Pieces – The best approach for asset location involves looking at the entirety of a household’s investment accounts. For clients who have been saving over time, some of those accounts may have dropped off their radar. They may have drifted from their original asset allocation and failed to keep up with the passing of years and the introduction of new. Investment options.
- Missing Expertise – Even with the most up-to-date picture of accounts and holdings, asset location is not a simple job and more than most can undertake manually. It must consider some complex wealth management needs among clients with $500,000 to $3 million or more in investments. The technology available to the advisor is what reveals how advantageous it is to optimize accounts for tax efficiency.
- Missing Oversight – Asset location is not a one-and-done solution to any asset. The evolution of the market, fluctuations in the economy, and changes in regulations require ongoing coordination and review to keep things working as smoothly as possible.
Asset location has the potential to increase the amount of money that is working in each portfolio. Many clients don’t know what should be done, or they don’t have the tools they need to handle the process. LifeYield makes it easier for firms and advisors, giving each one the tools they need to make the most out of an asset location strategy – which will benefit clients from the perspective of tax efficiency.
How LifeYield’s Asset Location Technology Brings a Tax-Efficient Competitive Advantage
Using software for asset location strategy can give your firm a competitive advantage. “Trust me,” only goes so far. Quantifying the tax efficiency of a household portfolio and then showing how it can improve is powerful stuff.
The quantification of the benefits of asset location is a massive opportunity for advisors to:
- Instantly improve the client’s tax efficiency using a proprietary asset location algorithm that scans all your client’s accounts within the portfolio, pinpointing the tax-smart location for every asset within seconds.
- Measure the tax efficiency of each client’s portfolio on a scale of 0 to 100 and produce the roadmap that will improve their asset location
- Quantify the benefits in dollars by assessing a dollar value on asset location optimization across different horizons.
- Avoid replacing the technology your firm uses. LifeYield solutions integrate with resources that are already in place. Avoid tech disruption while becoming more proficient for your clients.
The key benefits of using LifeYield’s API library are:
- It functions as an overlay, coordinating the accounts that run on different systems and in different ways. This eliminates the need for replacing existing technology.
- Avoid unnecessary taxes for the clients, allowing them to keep more assets You get to build trust and increase clients’ after-tax returns.
- Boil tax efficiency down to a single, understandable score.
- Increase your assets under management by helping your clients keep more of the earnings they invest through the asset location
LifeYield makes it possible to create a smart-householding solution and execute a well-developed asset location strategy. Your firm can provide tax-efficient solutions through asset location and exponentially increase the after-tax returns on retirement accounts.
Want more wealth technology podcasts and articles like this?
Get the monthly WealthTech on Deck Newsletter