The Value of an Advisor Part Two: Asset Location

Over the years, we have reviewed many non-client advised asset statements, and are always shocked to see instances where the asset allocation in tax-advantaged accounts is identical to the asset allocation in taxable accounts. More often than not, this is done because an advisor does not have the technological capabilities to rebalance a portfolio across different accounts. The allocation of assets between taxable and tax-advantaged accounts, known as asset location, is a tax minimization strategy that takes advantage of the fact that different types of investments receive different tax treatments.

Increase Returns without Increasing Risk with Asset Location

According to Vanguard’s Advisor’s Alpha® study, proper utilization of asset location strategies can add up to 0.75% to an investor’s average annual returns without increasing risk. Unlike some of the other value-add strategies, asset location can add value each and every year with the benefits compounding over time. From a tax perspective, optimal portfolio construction minimizes the impact of taxes by holding tax-efficient broad-market equity investments in taxable accounts and by holding taxable bonds and tax-inefficient assets, like REITS or commodities, in tax-advantaged accounts. Taxable bond income is taxed at the federal marginal income tax rate which could be as high as 39.6%. The arrangement of fixed income cited above takes maximum advantage of the yield spread between taxable and municipal bonds – this generates a higher and more certain return premium.

Tax-Efficient Broad-Market Equity Investments

We reference “tax-efficient broad-market equity investments” rather than actively managed mutual funds, ETFs, or individual stocks. This is important because actively managed equity investments consistently produce much higher levels of capital gain distributions than their passive, broad market counterparts. As these distributions are taxed at 15% or 20% depending on income, fewer and smaller distributions benefit investors. There is also a significantly lower fee level of passive strategies vs. actively managed strategies, more on this in a later blog post.

A very important rule for investors to remember is that their investment returns should be viewed as what they keep after taxes and expenses. At the end of the day, this is what the investor gets to spend. After all, a good return is not worth much if one gives it back in the form of taxes and expenses.

Stay tuned for part three of our Value of an Advisor series where we explore the importance of asset allocation. Read more about the 7 strategies to quantifying value, or contact Claris with any questions.

Read Part 1: 7 Strategies to Quantifying the Value
Read Part 3: Asset Allocation

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