Optimizing Asset Location: Is It Worth the Effort?
December 17, 2013
by Joe Tomlinson
Asset location – the choice of whether to hold stocks and bonds in taxable or sheltered accounts – is receiving increased attention as advisors seek more ways to add value. New research has challenged long-held beliefs. I’ll examine that research and answer a question that should concern every advisor and client: Does the value provided by asset-location advice justify the fees for the work involved?
A popular view has been that stocks, with their low tax rates on dividends and capital gains, should be concentrated in taxable accounts, while taxable bonds are better candidates for tax-deferred or tax-free accounts. But that view has been challenged recently. Michael Kitces, a prominent voice in financial planning research, argued in this 2012 blog post that, with low interest rates, "most bonds should NOT go into tax-deferred accounts."
Baylor University Professor William Reichenstein, who has been publishing research on asset location since 2001, still advocates stocks in taxable accounts and bonds in tax-favored accounts. He made his case most recently in The Asset Location Decision Revisited, co-authored with William Meyer in the November 2013 Journal of Financial Planning.
Let’s look at what each side has to say in the debate.
Measuring the effect
This debate hinges on how one measures the financial impact of asset location. The most straightforward approach involves projecting financial outcomes under a hypothetical asset-location arrangement, and then swapping assets between taxable and tax-favored accounts and re-running the numbers to determine which arrangement produces the best results.
Here's an example based on the following assumptions:
- Income tax rate: 28.75% (25% federal, 5% state deductible from federal)
- Capital gains and dividend taxation: 18.75% (15% federal, 5% state deductible from federal income tax)
- Bond return: 2.6%, based on late-November 2013 10-year Treasury rate
- Stock return: 7.4%, assuming a 4.8% premium over the bond return
- Stock turnover: Just barely more than yearly, so that stocks are taxed annually at the capital gains rate
- Investments: $500,000 in taxable, $500,000 in tax-deferred accumulating for 20 years
Arrangement 1: Stocks in taxable, bonds in tax deferred
Stock accumulation: $500,000 * (1 + .074 * (1 - .1875)) ^ 20 = $1,607,354
Bond accumulation: 500,000 * (1.026) ^ 20 * (1 - .2875) = $595,254
Total = $2,202,608
Under this arrangement, the 7.4% annual stock returns are subject to annual "tax drag" at the capital gains tax rate. The bonds accumulate free of the tax drag but are taxed at the ordinary income rate at the end of 20 years.