By Tom Sedoric

What is the difference between asset allocation and asset location? 

It is a simple distinction that too many investors, or even their advisors, don’t understand to their detriment. Asset allocation, based on years of economic research is intended to hedge the risk on your investments by efficiently dispersing them across diverse bond, fund or stock sectors. Asset location, or what we call tax efficiency in our practice, is the strategy used to structure your assets to efficiently optimize the return on your investments in the real world where taxes are likely to be any investor’s greatest lifetime expense. 

One striking aspect I have observed over the years is that too many investors and advisors neglect how asset location and asset allocation should work together to help maximize returns while minimizing taxation. This collaboration, properly executed, can make a huge difference in the long run. The great economist John Maynard Keynes said “the importance of money flows from it being a link between the present and the future” and how that future unfolds depends in part on the effectiveness of asset location. 

Why is this distinction important today? 

It’s actually important all the time; but I believe asset location and the importance of tax planning will become quite crucial in the coming years as tax cuts expire and political and economic reality change the tax code. If we are lucky, this will result in a less complex and more straight-forward tax code that will help and allow people to plan accordingly. Regardless of one’s political views, taxes are unlikely to move lower. I believe there are going to be massive changes in tax policy and, for good measure, a need to plan on it being even more complex (if it isn’t, you will be no worse for wear). The goal is to get ahead of this wave and not get swallowed up in it as one attempts to efficiently draw on their nest egg as the boomers step up to retirement. 

What is the concept? 

As a virtual Chief Financial Officer for many of our clients, we pay close attention to Modern Portfolio Theory (MPT) and attempt to optimize risk and return across a broad array of assets in strategies uniquely designed for our client’s investment policy, risk profile and plan. We also acknowledge that MPT has its flaws, especially when the market becomes unhinged and slips into a crisis (examples: 1929, 2008). Highly correlated assets can occur in times of crisis and proper allocation does not insure against risk or loss. What we can guarantee is that taxes will likely be minimized by laying out a tax efficient asset location over a prudent asset allocation. 

What does this mean in practice?

People who do not create diversified tax efficiencies in their long-term plans may find themselves hit with much greater tax burdens than they expected or needed to pay in later years. I’ve cautioned previously that there is often confusion about the benefits and mathematics of “tax deferral” because sometimes a tax deferred account or investment only defers one from paying potentially more down the road, which may, in fact, not always be to an investor’s advantage. 

For example, if a sleeve of income earning bonds or high yield bonds is part of an investor’s overall allocation, should these holding be held in an individual’s taxable or tax deferred account? Why does it matter? What is the cost differential if done improperly? 

Another example I am fond of using when describing this concept has to do with my favorite hypothetical company XYZ. In our theoretical portfolio, Investor A has $1 million in a taxdeferred IRA savings account in which the fund is heavily invested in XYZ. Investor A also has $1 million directly invested in XYZ stocks in his or her personal trust or investment account. On paper, both assets are worth the same except for one significant difference – the tax liability. 

The obligation of the tax-deferred IRA is set at the income tax rate which could currently be as high as 39 percent – or higher if the ordinary income tax rates increase. The sales of stock in a taxable account would be subject to a much lower, long-term capital gains tax bite of 15 or 20 percent. Assuming a zero cost basis, the IRA investment would be worth an estimated $650,000 while the stock investment would be worth $850,000, as much as a $200,000 difference. The same investment in XYZ could have dramatically different outcomes depending on the type of account in which it is held.1 

And nothing makes me crazier than when we onboard a new client with his prior advisor’s “hot strategy du jour” that crashed and the position is held in the new client’s IRA account. The lost opportunities are two-fold: first, had the story worked, the client would have likely paid more taxes when he needed the eventual distribution from his IRA, and secondly, and even more painfully, the loss cannot be written off for tax purposes since it is held in the IRA. 

How do you maximize asset location potential? 

Though too many investment products from Wall Street reek of rocket science complication, the steps for successful asset location are similar to asset allocation.

It is about the honest assessment of risk and long-term lifestyle goals with a keen eye on expense control and tax efficiency in the process. From our experience, those who are happiest in retirement are those who have the greatest flexibility in their future sources of cash flow with the lowest tax burden available. Once these options are explained, boomers and their advisors can and will understand the subtle changes that have long lasting effects.


1This is a hypothetical example for illustration purposes only. Actual investor results will vary.

This information has been obtained from sources deemed to be reliable but its accuracy and completeness cannot be guaranteed. The views expressed by Tom Sedoric – Partner, Executive Managing Director and Wealth Manager do not necessarily reflect the opinion of Raymond James or its affiliates. Raymond James does not provide tax or legal counsel. Specific tax or legal questions should be directed to one’s tax or legal professional. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns.