Asset Allocation and Asset Location

The following papers examine the optimal division of asset classes between taxable and tax preferenced accounts. A fine tool for determining asset location can be found at Easy Allocator.

Maximizing Long-Term Wealth Accumulation:It’s Not Just About "What" Investments To Make,But Also "Where" To Make Them

Robert M. Dammon, Carnegie Mellon University
James Poterba, Massachusetts Institute of Technology
Chester S. Spatt, Carnegie Mellon University
Harold H. Zhang, University of Texas at Dallas

EXECUTIVE SUMMARY

Individuals who are saving for retirement are likely to know that the level of savings and the asset allocation of their savings are two very important factors affecting wealth accumulation. Another factor called asset location — which refers to the placement of certain types of assets in tax-deferred accounts and other types of assets in taxable accounts — is far less understood
The winners of the 2004 TIAA-CREF Paul A. Samuelson Award tackled this issue head-on, and concluded that equities are far better suited for taxable accounts than for tax-deferred accounts, and that bonds are far better suited for tax-deferred accounts than for taxable accounts. The reason for this preference is the different tax treatment of equity investments compared to fixed-income investments. Other research findings include:

• Choosing the right asset location for a pair of asset classes is more important when the tax rate differential between the two types of assets is greater and when the rate of return on the relevant assets is high.
• The relative proportions of taxable and tax-deferred wealth are an important factor in determining one’s optimal asset allocation. According to the Samuelson award-winning authors, other factors being equal, an investor’s optimal equity allocation will be higher when a larger proportion of his/her total wealth is held in taxable accounts, and that his/her optimal bond allocation will be higher if the bulk of his/her wealth is held in tax-deferred accounts.
• The ideal situation occurs when the desired asset allocation is reached by investing the entire tax deferred account in bonds and the entire taxable account in equities. More often, the proportions of financial assets don’t match up neatly with the desired asset allocations, and so adjustments may be needed. The authors state that for maximum tax efficiency, individuals should not hold mixed portfolios of equities and bonds in both their taxable and tax-deferred accounts.

Tax Efficient Saving and Investing

By William Reichenstein, Ph.D.,
TIAA-CREF Institute Fellow, Baylor University
February 2006

EXECUTIVE SUMMARY

A central component of investment advice in recent decades both for individual and institutional investors has focused on asset allocation, and rightly so since it plays a critical role in determining returns. For individual investors, tax management also plays a significant role in maximizing wealth but it typically does not receive the attention it deserves. This Trends and Issues examines four types of tax considerations that can reap benefits to investors:

• Choice of Savings Vehicle. To the degree possible, individuals should take maximum advantage of tax-favored savings vehicles, including tax-deferred accounts such as 401(k)s, 403(b)s and traditional IRAs, as well as after-tax accounts such as Roth IRAs, Roth 401(k)s, and Roth 403(b)s. All of these accounts essentially allow for tax-exempt growth on their after-tax values.

• After-Tax Asset Allocation. As noted, most individuals are aware of the importance of asset allocation but they calculate it as though assets in tax-deferred accounts are worth the same amount as those in taxable accounts. As a result, they overstate the allocation to the dominant asset class held in tax-deferred accounts. When calculating their asset allocation, they should convert all assets to after-tax values and then calculate their asset allocation using these after-tax values. For example, assets in tax-deferred accounts should be converted to after-tax funds by multiplying the pretax value by 1 minus the expected tax rate during retirement. Sometimes assets in taxable accounts also need to be converted to after-tax values, but the adjustments generally are not as large.
• Tax-Efficient Investing (Including the Role of the Stock Management Style). Examples of tax-efficient investing in one’s taxable account include: a) tax-loss harvesting, in which capital losses are realized in order to offset capital gains or ordinary income; and, 2) passive, index-type investing where unrealized gains are allowed to accumulate, thus providing tax deferral and even exemption if assets ultimately receive a step-up in basis or are donated to charity.
• Asset Location. This concept refers to appropriate location of equities and fixed income. In general, fixed income should be held in retirement accounts such as 403(b)s and Roth IRAs and equities, especially passively-managed stocks, should be held in taxable accounts. The reason for this preference is that, when held in taxable accounts, equities are generally taxed more favorably than fixed income. Equities in taxable accounts can benefit from lower capital gains tax rates, and taxation on gains can be deferred as long as the investor continues to hold the equities. Taxation on gains can even be avoided altogether if the owner holds the equities until death, at which time they receive a step-up in basis. In addition, capital losses can offset capital gains and reduce income.

Non-qualified Annuities in After Tax Optimizations


William Reichenstein, Baylor University

Abstract

This study first explains why individuals should calculate an after-tax asset allocation. This asset allocation distinguishes between pretax funds in say a 401(k) and the generally after-tax funds in a taxable account. Separately, it performs mean-variance optimizations for individual investors. It concludes that, in general, almost all investors should locate bonds in Roth IRAs and qualified retirement accounts (e.g., 401(k)) and stocks, especially passively held stocks, in taxable accounts. At lower levels of risk tolerance, investors should substitute bonds held in non-qualified annuities for stocks held in taxable accounts. At higher levels of risk tolerance, they should substitute stocks for bonds held in Roth IRAs and qualified retirement accounts. The analysis suggests that the people who should be most interested in holding stocks in annuities are those who trade too frequently to qualify for preferential capital gain tax rates. Finally, this study may be the first to demonstrate that an individual investor bears more risk when an asset is held in an annuity instead of taxable account, and it considers the implications of this conclusion for optimal asset-allocation and asset-location decisions.