Many investors and their advisors spend a lot of their time on asset allocation. By spreading assets over different asset classes, you can help to control the risk of a portfolio and potentially earn higher returns with a reduced level of volatility.
Much less attention is spent on asset location, where you consider the type of account where your diversified assets should be placed.
For example, let’s say you are a typical retired investor with 40% in stocks and 60% in bonds. For your stock portfolio, you would probably own mainly dividend paying stocks or funds, but you might also own a few growth stocks that do not pay a dividend. In your bond portfolio, you might own US Treasuries, Corporate and Municipal bonds. You might also own some REITs, foreign stocks and bonds and commodity oriented investments.
The task of asset location is to figure out which of your investments should be placed in tax deferred accounts like IRAs, and which should be placed in taxable accounts.
For some investors, the asset location question is not terribly important, because more than 95% of their assets are in tax deferred accounts. But asset location becomes very important when a good percentage of your assets are in taxable accounts, especially if you are in a high marginal tax bracket.
I have read some misguided financial advice that says you should never let tax consequences affect an investment decision. While it is true that tax consequences should not be the only factor, they are certainly a key factor in where you place an investment and on the timing of the sell decision.
For an affluent or high net worth investor, the goal of an asset location strategy is to divide your investments between taxable and tax-deferred accounts to defer taxes and maximize your after tax returns. Experts have different opinions on how to do this. Much of the research considers only two asset classes- bonds and stocks and where to locate them.
One research paper by Dammon, Spratt and Zhang (“Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing”) concludes that bonds should be put in an IRA before stocks. They reason that stocks have a lower capital gains rate and the ability to defer gains. In a taxable account, stocks that drop sharply in price can be sold for a tax loss. If the owner dies, heirs can inherit the securities with a stepped-up cost basis. But if the stock were placed in an IRA, the full value would be taxed.
But another research paper by Shoven, Poterba and Sialm (“Asset Allocation for Retirement Savings”) comes to a different conclusion. They did a 37-year study (1962-1998) where they found that investors would acquire more wealth if they held their equity mutual funds in tax-deferred accounts. Their explanation for this apparent contradiction of the “bonds in taxable accounts” advice has two parts:
1) Many equity mutual funds impose substantial tax burdens every year with income and capital gains distributions. This raises the effective tax rate for investing in a mutual fund versus a buy-and-hold personal portfolio.
2) Taxable investors who wish to hold fixed income assets can choose to hold tax-exempt bonds as well as by holding taxable bonds
The best strategy is probably to sub-divide these asset classes more finely based on tax efficiency. For equities, the tax efficiency can vary dramatically. Stocks like BRK.A or AAPL which do not pay dividends and are held long term are highly tax efficient. I purchased one share of BRK.A in March 2000 in a taxable account. I am still holding this position, and have not paid a dime in income taxes.
At the other extreme, there are covered call equity funds like AOD or mortgage REITs like NLY or DX, that pay out large distributions every year that should preferably be owned in tax-deferred accounts.
For equity mutual funds, you should look at the turnover ratio. High turnover funds are best held in IRAs. Low turnover funds are better candidates for taxable accounts. For taxable accounts, it also pays to look for funds with loss carryovers from prior years which will be more tax efficient going forward.
For the municipal bond asset class, there are several tax aspects to be considered:
1) You should generally not own tax free municipal bond CEFs in tax-deferred accounts. By doing this, you are converting a tax-free investment into a tax-deferred investment. But Build America Bonds are taxable municipal securities that are good candidates to be owned in tax-deferred accounts. I have posted previously on some of these funds. Here are a few closed-end funds that own investment grade Build America Bonds and are currently available at a discount to NAV and have attractive yields around 8%: GBAB, NBB, BBN.
2) If you live in a state or municipality which has a high state and local income tax (like New York City) it may be worthwhile to look for bond funds that invest exclusively in bonds from that state/city which are triple tax exempt. Again, these would be held in taxable accounts.
3) Are you exposed to the Alternative Minimum Tax? The only way to know for sure is to compute your taxes two ways and see if you pay more using the AMT method. As a general rule, affluent investors in the $150-$500K income range that live in states with a high income tax and high property values are more exposed to the Alternative Minimum Tax (AMT). Ironically, the super wealthy, earning in the millions, are not usually affected by the AMT, because their itemized deductions are small compared to their total income.
If you are exposed to AMT, and want to buy a municipal bond CEF, it is worthwhile to check what percentage of the income is subject to the AMT tax. For some funds it is very low or zero, but for others it can exceed 20%.
Over the next few weeks, I plan to write reports on some specific municipal bond closed-end funds that look attractive. Some of the moderate risk funds (A rating) with longer duration are offering tax free yields over 8% with tax equivalent returns of over 12% for those in the 35% tax bracket. Some lower risk, lower duration funds with AA ratings are yielding over 7% with tax equivalent returns in the 11% range.
Disclosure: I am long GBAB, BBN, NBB.