Putting the ‘Location’ in Asset Allocation

You’ve heard about the importance of asset allocation. But what about asset location?

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We investors spend so much time on security selection that we tend to forget about best allocation practices to preserve or even boost the returns of those investments we have so diligently researched. It’s a classic case of missing the forest for the trees.

If you want to make your money work harder than you in building and boosting your nest egg, you’d be wise to pay attention to how and where you place your investment assets. The location, or type of account, in which you place your investments can be just as important as the way in which you allocate them. Ignore this fact at the peril of your own portfolio.

It doesn’t take a CPA, CFP, MBA or any other of the alphabet soup financial planners to know that an investment portfolio’s total return is not just a result of investment selection and asset allocation. There are also the all-too-often overlooked performance variables that include commissions, transaction fees, and taxes that can be significant and unnecessary drags on returns.

So I’ll demonstrate the ideal location for assets and investment types into two primary categories — taxable accounts and tax-deferred accounts.

Asset Allocation: Taxable Accounts

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These accounts are categorized as taxable because investments here can generate taxes on either interest, dividends or capital gains, or all the above, depending upon your holdings.

Therefore when you think taxable accounts, think regular bank accounts, individual brokerage accounts and joint brokerage accounts. To make your money work hardest, you’ll want to allocate investments that don’t generate much in the way of taxes or trading costs to these accounts.

Bank accounts: Do people still use traditional banks for investing? For the most part, use bank accounts (i.e. checking, savings and CDs) sparingly. Not only will you get extremely low interest rates but they’ll probably be taxed as well, bringing your yields significantly below inflation. In other words, use banks for banking, not for investing.

Individual and Joint Brokerage Accounts: You may have all three major asset types (stocks, bonds and cash) in these accounts but you’ll want to allocate the lowest-yielding assets here. For stocks, that means small-cap stocks, growth stocks, and stock index funds here because they kick off very little or no dividends. If you must have bonds in these accounts, and you don’t need immediate income, you might consider zero-coupon bonds because they don’t pay a penny in interest until maturity. Even better, make it triple-tax free by buying municipal zero-coupon bonds. For cash, ideally you’ll have cash in municipal money market accounts.

Best Practices: Beyond keeping tax-efficient investments in your taxable accounts, be sure to keep your trading activity tax-efficient as well. Try to keep trading frequency to a minimum to keep capital gains taxes low.

Granted, this asset allocation and account location for the mentioned investment types may not be ideal for retired people and those wanting to generate income with their investments now or in the near future. But if you need current income, you can keep taxes low by “creating your own” with the right asset allocation. For more on this, see my previous story, “How to Get Income Without Dividend Funds.”

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Asset Allocation: Tax-Deferred Accounts

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Accounts such as 401(k)s and IRAs are called tax-deferred because taxes on earnings are deferred until the time withdrawals are made. As for allocation, this means you can hold high-yielding investments in these accounts. You may also be able to do more trading at lower costs.

Here are investment types for each account.

401(k)s: There usually isn’t much choice of investment types in 401(k)s because they are employer-sponsored and you don’t choose the investments, although you could volunteer to be on the investment committee and suggest more options. Otherwise, the plan advisors or plan trustees choose the plan investments, which usually consist of a combination of around 10 mutual funds. Many funds in 401(k) plans have above-average to high expense ratios, which is for the purpose of offsetting plan expenses and/or paying the service provider. Look for low-cost index funds here. Although some 401(k) plans limit trading, and mutual funds don’t trade intra-day, you can usually make changes to investments without any additional transaction fees.

IRAs: This is where you can fill in the asset allocation gaps remaining from any limitations you may have from other accounts. For example, an IRA is a great place to fill your need for investment types such as bond funds, dividend stocks and stock funds, which will increase current taxes and thus reduce your total returns in taxable accounts.

Best Practices: When building a portfolio, begin with the best 401(k) options and build from there, especially if the 401(k) is where most of your new money is going. For example, if the best offering in your 401(k) plan is an S&P 500 Index fund, you can use this as your core holding, which will represent the largest portion of your portfolio. Then go to your IRA and allocate the stocks, bonds and mutual funds that typically kick off interest and dividends. And whatever you are still lacking, you can then allocate to your individual brokerage account.

In summary, there is no one-size-fits all asset allocation strategy that works best. In general, just do your best to keep taxable investment types and taxable activity within your tax-deferred accounts and everything else in your taxable accounts.

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