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Location, Location, Location

mature couple learns the importance of asset location from financial advisor

The Importance of Asset Location

Generally this phrase is used in relation to the value of real estate, but it can have important implications for regular investment accounts as well. Understanding how to efficiently utilize asset location strategies is the one freebie we have in investing. What I mean by this is that investors can increase their wealth over the long run while taking on no additional risk and paying no additional cost. In fact, it doesn’t require making any changes in what one is investing in at all. While this may sound cryptic and complex, it’s actually a very simple idea, given an investor meets two specific requirements:

  • They have money invested in both pre-tax (IRA, 401k, etc.) and after-tax (Roth) accounts
  • They have some money invested in growth-oriented investments (stocks) and some money in safer, less volatile investments (bonds, cash, etc.)

In my experience, the majority of investors fit this bill … especially if they’re at or nearing retirement. For these investors, the key is understanding the tax ramifications of different kinds of accounts. If I want to spend $1 out of a Roth account, I take the dollar out and spend it, end of story. If I want to spend $1 out of a traditional IRA, I give the government their portion (e.g., 30%), and I get what’s left (70 cents).

So why is this concept important? It’s because every $1 of growth in a Roth has MORE spending power than every $1 of growth in an IRA. Therefore, if I have money invested in both Roth and IRA accounts, if I invest the growth-oriented assets in the Roth account and less growth-oriented assets in the IRA, I’m only allowing the government to take their cut on the low-growth assets, whereas I’m keeping every penny of the high-growth assets.

Looking at an example is always simpler, so let’s say I have $100,000 in a Roth and $100,000 in a traditional IRA, and I’m a 50/50 investor (50% stocks, 50% cash and bonds). For simplicity of math, let’s assume the stocks grow at 7% per year for 20 years, which results in $100,000 growing to $400,000. Let’s also assume that I kept the other $100,000 in cash, so it’s still worth $100,000 after 20 years. Altogether, my $200,000 grows to $500,000.

Many investors would have just maintained a uniform allocation between their IRA and Roth accounts, resulting in each one starting with $100,000 and growing to $250,000. The Roth’s after-tax value would remain at $250,000, but the IRA (using a 30% tax rate) would have an after-tax value of $175,000, producing a net after-tax value of $425,000.

Now let’s see what would have happened if I had kept that exact same mix of 50/50, but instead of keeping it uniform among the two accounts I invested the entire $100,000 in the Roth in stocks and kept the entire $100,000 in the traditional IRA in cash. At the end of the 20 years, I have the same $500K — but with one important difference. Because I invested the stock portion in the Roth, that account has grown to $400,000, while the IRA remained at $100K. The kicker is that the Roth is tax-exempt, and therefore my after-tax value of the Roth account is still $400,000. This also can allow one to lower their taxable income, thus reducing their tax rate. But even if we keep it at the same 30% rate, the combined after-tax value would be $470,000. Compared to the basic strategy where asset location wasn’t considered, this exact same investment would net a minimum of an additional $45,000 over 20 years. Who says there’s no free lunch in investing?

Obviously this was just a hypothetical scenario, so how has this played out in real life? I looked at every 20-year period since 1930 and plotted the results below, using the assumptions above of an equal weighting of stock/bond and traditional IRA/Roth with a 30% tax rate but starting with $100,000.

In every 20-year period, optimizing the asset location by putting stocks in the Roth and bonds in the IRA resulted in a greater after-tax value than having the same mix blended between the two accounts. On average, the optimized portfolio yielded an extra almost $50,000 in value, which works out to be about an 8% premium.

In general, investing is difficult and comes with many unknowns. We do everything we can to eliminate as many unknowns as possible and squeeze out as much risk-adjusted return as we can. This is one strategy that isn’t difficult to implement, bears no additional risk and has no additional cost, yet it can provide a substantial long-term premium for many investors. Opportunities that meet this criteria are few and far between and should absolutely be taken advantage of by all investors.

The chart represents the S&P 500 Index and the five-year U.S. Treasury note 20-year average value on the first day of every calendar year. Using a 30% tax rate, a portfolio with a 50/50 location-allocation in a Roth IRA and IRA was compared to a portfolio with 100% in stocks located in a Roth IRA and 100% in bonds located in a traditional IRA.

This commentary is provided for general information purposes only, should not be construed as investment, tax or legal advice, and does not constitute an attorney/client relationship. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.


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