Location, Location, Location?

The oldest adage in real estate investing is “Location, Location, Location.”

(I learned this lesson the hard way.  I sold my beach front condo for $200,000 and then watched it zoom up in value to $1 million. But that’s a story for another day.)

While location may be incredibly important in real estate investing, I’ll admit that it is NOT the most important thing in investing in stocks & bonds.

But location still matters in investing, and could be worth a ton of dough to you over time.

What Goes Where?

By now you are probably sick of hearing about the importance of asset allocation – but you probably haven’t even heard much about the benefits of asset location.

If asset allocation answers the question “how much of what should I own?” then asset location answers the question “where should I put it?”

Depending on your situation, getting asset location decisions right could be worth 0.10% to 0.40% additional after-tax returns on your portfolio each year.  Over time, this could be significant for you.

Let’s say you have a total portfolio of $2 million (in taxable, IRA’s, 401-k) growing at 5% per year, and that you can enhance returns by 0.20% per year through asset location.  That works out to $206,000 in additional wealth after 20 years.  Without additional risk.

Let’s Consider An Example

Let’s say you’ve settled on a pretty standard asset allocation like this one:

  • US Stocks (40%)
  • REITs (10%)
  • International Stocks (30%)
  • Bonds (20%)

And let’s say your portfolio is equally divided among two different types of accounts:

  • IRA Account (50%)
  • Taxable Account (50%)

So where do you put what?

Consider Tax Efficiency

Conventional wisdom would suggest you put your tax inefficient assets in your IRA (or other tax deferred accounts), and your tax efficient assets in your taxable accounts.

Conventional wisdom works some of the time, but not all the time.  (In a moment I’ll explain when you should consider bucking conventional wisdom in your asset location decisions.)

Let’s say you maintain a small “Vegas” account where you buy and sell stocks for fun.  Well, you should be doing this in your IRA because buying and selling stocks tends to be tax inefficient.  Just as conventional wisdom says.

Similarly, REIT’s are tax inefficient because they pay dividends taxed at ordinary income tax rates, which tend to be high.  So REITs should go in your IRA, just as conventional wisdom says.

But What About Bonds?

Bonds (and bond funds) are certainly tax inefficient, so you would think they belong in your IRA.

Not so fast!  This is where conventional wisdom could fail you…

In turns out that the yield on bonds is so low that you could actually be better off holding them in your taxable accounts and just paying taxes on them. This is admittedly counter-intuitive, but it is correct.

Locating your bonds in your taxable account frees up precious capacity in your tax deferred accounts for much higher returning vehicles like equities, which will benefit much much more from a nice long uninterrupted run of tax deferred growth!

If you do decide to keep bonds in taxable accounts, you should consider holding tax free municipal bonds in those accounts if your marginal tax rate is high enough.

(But keep in mind, if bond yields ever go way up some day, it could once again make sense to put bonds in tax deferred accounts.)

Wouldn’t You Like Some Credit?

So let’s say we put our 10% REIT’s in our IRA, and our 20% Bonds in our taxable account.  We still need to decide where to put our US Stocks and International Stocks.

Let’s turn to your 1040 tax return for some guidance.

There’s something called a Foreign Tax Credit, which you probably never paid much attention to.  But it plays a role in asset location decisions.

When you own international stocks, bonds or mutual funds, foreign taxes are often taken directly from those vehicles.  The Foreign Tax Credit is just a tax credit designed to make you whole for those foreign taxes you paid.

But if you hold your internationals stocks in an IRA, you don’t get the Foreign Tax Credit!  

You read that correctly.  The IRS will happily give you the credit, but only for international stocks in taxable accounts.

So Where Did We End Up?

So here’s where our portfolio above ends up when we apply asset location concepts:

Taxable Account (50%)

  • Bonds 20%
  • International Stocks 30%

IRA Account (50%)

  • REIT’s 10%
  • US Stocks 40%

Now It’s Your Turn

When you try this exercise on your own portfolio, it won’t work out perfectly like this.  That’s fine!   Don’t stress out about getting it perfect. Even if you get asset allocation mostly right, we’re talking about free additional extra returns.

If you’re working with a financial advisor, and your current portfolio doesn’t look like it’s benefiting from asset location, now you can ask your advisor some tough questions!

If you’re interested in reading about other examples of what I call “tax alpha” – the idea that you can enhance your investment returns through smart tax planning – click here.