Most investors are familiar with the concept of asset allocation: the percentage of total investments allocated to different areas, such as stocks, bonds and cash. But if your clients are wealthy investors, asset location, i.e., where they put the different investments, may be even more important.
Let’s start with a simple example. Assume your client has $2 million in investments: $1 million in a personal account and $1 million in an individual retirement account. The investments in your client’s personal account are subject to taxes: income taxes on bond interest and stock dividends, and capital gains taxes on any sales of the stocks and bonds. By contrast, there are no taxes on the investments in your client’s IRA—no income or capital gains taxes at all. (When your client turns 70 ½, the required minimum distributions from the IRA will be taxable, but for now let’s focus on the the pre-distribution or “accumulation” phase of life.)
Assume that your client’s overall asset allocation is 60 percent stocks and 40 percent bonds. Simplistically, there are two types of bonds your client could buy: (1) government and corporate bonds, which pay a higher rate of interest, but which generate taxable interest; and (2) municipal bonds, which pay a lower rate of interest, but have tax-free interest. Which bonds should your client buy in their personal account and which bonds should they buy in their IRA?
The Right Answer
For most investors, the right answer is to buy the municipal bonds in their personal account and the government/corporate bonds in their IRA. In your client’s personal account, all the interest on the municipal bonds will be tax-free, because municipal bonds aren’t subject to income taxes. In your client’s IRA, the interest on the government/corporate bonds will also be tax-free, because your client pays no income taxes on investments in an IRA.
Let’s look at the numbers. In your client’s $2 million portfolio, 40 percent is invested in bonds, which is $800,000. Let’s assume the personal account and the IRA each have the same 60/40 asset allocation. This means there are $400,000 of municipal bonds in the personal account and $400,000 of government/corporate bonds in the IRA.
Historically, the annual rate of interest on municipal bonds is 4 percent and the annual rate of interest on government/corporate Bonds is 5 percent. So, your total client’s annual interest, all tax-free, would be:
Personal account: $400,000 Muni Bonds @ 4 percent = $16,000 annual interest
IRA Account: $400,000 Gov’t/Corp Bonds @ 5 percent = $20,000 annual interest
Total: $36,000 annual interest
Avoid a Common Mistake
Many investors make the mistake of buying government/corporate bonds in their personal account. They think they’ll be better off because these bonds pay a higher interest rate. They’re making a big mistake.
Let’s look at the numbers. Your client’s overall allocation to bonds is 40 percent, or $800,000, of their $2 million portfolio. If your client invests that all in government/corporate bonds, their pre-tax interest is $40,000 ($800,000 x 5 percent). Initially, that looks better than the first example. However, because your client owns these bonds in their personal account, all the interest is subject to tax. If they’re in a 40 percent income tax bracket, their after-tax income is $24,000 ($40,000 x 60 percent). This is one-third less income.
Putting your client’s investments in the best location can significantly increase their after-tax return. In the example above, I illustrated this using bonds. The result is even more powerful when this principle is applied to stocks. I explore this application of asset location in a forthcoming post.