Are Your Investment Assets in the Right Location?

The old saying “It isn’t what you make, it is what you keep” is at the core of building an effective wealth management plan to achieve goals.

I have recently had a lot of conversations regarding efficiently locating assets for clients in order to better manage tax liability. One such instance occurred through an engagement with a prospective client. Upon having our first several conversations it became clear that the reason this person and his family were having conversations with potentially new financial advisors wasn’t because of the rate of return he was getting. The reason he was having conversations as he stated it was “My broker, whom I have had for many many years, has done well against our benchmarks but when I look at my net worth year over year the returns do not appear to be increasing my net worth as much as I feel it should. I think something is wrong and I am interested in figuring out what it is and how to address it.” We gathered all of his financial information including his brokerage statements, tax returns and personal financial statements and started to take a look for him. What we uncovered was that he was paying a large amount of tax each year. Although he had done some very sophisticated estate planning it was clear that some of the investments he had were not in the most efficient locations. While effectively addressing this is a challenge it can often be accomplished with a degree of proficiency that can offer enhancement to one’s wealth.

Taxes are inevitable and after tax returns are crucial to achieving wealth planning goals. A strategy called Asset Location is a technique that can greatly enhance the amount of return that is kept and not paid out in taxes. Asset Location refers to how an investor distributes their investments over taxable accounts such as a Trust brokerage accounts, tax-deferred accounts such as IRA’s and 401ks, and tax-exempt accounts such as Roth IRA’s and Roth 401k’s. Allocating assets that pay the lower long term capital gains tax rates to your taxable accounts and allocating assets that pay higher income tax rates to tax deferred and tax exempt accounts allows investors to keep more of the return they make.

One simple example: An investor with $1 million in an IRA and $1 million in a Family Trust may have an asset allocation of 50% Equities and 50% Fixed Income. If currently both portfolios are situated with this allocation, shifting the assets that are taxed as ordinary income, 39.6% Federal rate, to the tax-deferred IRA and shifting assets that are taxed at the more favorable long term capital gains rates of up to 20% Federal to the taxable trust account could generate tax savings. The potential shift may be to move the taxable fixed income assets over to the retirement account and move the more tax favorable long term capital gains taxed assets, such as equities and ETFs intended to be held for longer than a year, to the taxable account. This will change the allocation percentages inside of each account; however with proper execution the overall 50% Equities, 50% Fixed Income allocation will remain constant in order to achieve the desired total investment allocation and risk profile.

Shifting assets in this way must be looked at and executed carefully. It may take time to implement in order to keep fees generated low and to minimize the unnecessary triggering of a realized tax liability.

Ultimately asset allocation, diversification and rebalancing, although at the very core of long term successful investing also need to be accompanied by a prudent eye on where those assets live so that unnecessarily higher tax rates can be avoided. Maybe real estate isn’t the only thing that derives benefits from “location, location, location.”

To learn more about James Liotta, view his Paladin Registry research report.

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