In this Video, Andy Stolz, CFA discusses the benefits of Asset Location as it relates to the value of a financial advisor.
This Friday, I have what I think is a treat. This is something that you can be using to help build and grow your wealth, especially on an after-tax basis potentially faster than you would otherwise. So, to do this, you don't have to take more risk in your portfolio, I'm not asking you to change your overall investment philosophy, but this is a great trick that you can be using to build your wealth. So, let's just jump into it.
The trick I want to give you today is called asset location. This is not to be confused with asset allocation, which is how much stocks, how much bonds, how much US, international, etc. -that's asset allocation. Asset location is where you put the components of your asset allocation. It’s the account type that you use to hold them in.
Let's just start with an example.
Our average client has somewhere around a $1 million investment portfolio. And this is somewhat of a common breakdown that we see when they come to us. They’ll have a Roth IRA. This is usually a smaller component of the portfolio because there's limits on who can contribute and how much. Then, there's usually a taxable investment account, which was savings that they did after they maxed their 401(k) during their working career. And then there's a traditional IRA. Generally speaking, for someone who's retired, this was their 401(k) at work, and when they retired, they rolled it out into an IRA.
Then, we take those accounts and determine the asset allocation we want. In this case, basically taking what the global market looks like. I have 35% US stock, 20% international stock, 5% real estate, and 40% fixed income or bonds.
One thing that we'll find commonly happening is this allocation, what somebody will do is they'll take this allocation of these four asset classes and they'll put all four in each of the accounts above. They’ll have those four at those weights in the Roth IRA, and then they'll have the same four at the same weights in the taxable account, and the same four at the same weights in the traditional IRA. Now, I don't want to paint the picture that this is a terrible thing because you do have a thoughtful investment allocation. You're doing it in each of the accounts. And assuming that history continues to prove itself correct, you would expect some positive performance from this and you might not feel like anything wrong happened if that was your allocation.
But the point of what I want to talk about today is asset location. If you think of these three account types, they each have different tax characteristics. Let’s go back up to the Roth IRA. Any growth that happens there in that account is tax-free. So that's an after-tax account. It grows tax-free. When you take it out, it's tax-free. It's tax-free from here on out.
Regarding the taxable account, there will be a certain annual tax component. Dividends and interest have different levels of taxability each year. You’ll pay a little bit each year from that account. And then at the end, if you wanted to take everything out, you'd have to pay capital gains tax, probably long-term capital gains tax on most of it. So, I just assumed it's 15%.
Then, there’s the traditional IRA, anything that you take out of there in the future is taxed at ordinary income rates. So again, for this projection, I assumed 30% ordinary income. So, the Roth is tax-free; taxable account, 15% capital gains rate; traditional IRA, 30% ordinary income rate. So, you can see, some of these are more favorable to have your growth and some of them are less favorable.
Let’s go back to that allocation. Different companies will put together capital market assumptions. In this case, I'm using J.P. Morgan's. They do this on a 10-year basis and they say, "Hey, over the next 10 years this is what we expect this asset class to do." Now, this is a guess, it's not a guarantee. History would suggest that stocks do better than bonds over the long run, but US versus international is somewhat guesswork being done here. So, they guessed US stocks would have 7.9% return. You can ignore the parenthesis here, unless you're trying to rerun my calculations. International would have an 8.4% return; real estate, 6.8; fixed income, 4.5.
If you look at that and you just say, "Okay, if we want to have the Roth be our most growthy asset, J.P. Morgan would suggest international stock is what you want to hold there." We have $200,000 in the Roth, and our allocation for our $1 million portfolio suggests $200,000 in the international stock. So let's put that in the Roth.
As we sort of move down, the next best place for that growth to happen is at that 15% tax rate for the taxable account. Okay, there's a lot of nuance here. If you're a CPA, you're hearing what I'm saying. You're saying, "Wait a second, there's other things to consider." I'm using a ballpark estimate, about 15%. So, the US stock we'd put there, now we want $350,000 of US stock and we only have have $300,000 in our taxable account. So we'll only take $300,000 put it in the taxable, and we'll take the extra $50,000 along with the real estate and the fixed income, and we'll put it in the traditional IRA.
So now, we have the right asset allocation that we wanted. We're still keeping the same allocation, but we're moving the pieces to the right accounts rather than holding all of them at the same weights in all of the accounts. There’s two options. I call it the mirrored portfolio, where you hold all of them at the same weights in each account. And then there's the tax-efficient version or the tax-located portfolio where you're holding them in a little bit more of a tax-conscious way in the "right" accounts.
Assuming these assumptions hold true, when you look at the after-tax ending values, you find out that the mirrored portfolio had an after-tax ending value of $1,533,077. This is, again, a 10-year projection with the assumptions I've mentioned. And then the tax-located portfolio had an ending value of 1,597,444. That difference is $64,367 over a 10-year timeframe, which ends up being 41 basis points of additional growth or 0.41% additional growth per year.
So just by doing this, you can add 0.41% return, basically, to your portfolio's return because you held things in a tax-efficient way in the right places in terms of tax location.
So, when we think of the value of an advisor, maybe an advisor's charging 1%, this strategy alone, assuming these assumption's all true, suggests that it should provide 0.41% benefit. So almost eating into half of what you'd pay for an advisor. The value of an advisor, I think, is comprised of many things, this being one of them. I think this is a great way that advisors can be taking your same portfolio, moving it into the right places, and helping build your wealth faster.
You can do this on your own. Everyone has different individual situations. Maybe your ordinary income tax rate is different, maybe your capital gains tax rate is different. It's good to talk to an advisor on this stuff, but this is something to be aware of that maybe you want to hold different asset classes in different account types because of their differences in taxability.