The Asset-Location Decision and Related Topics

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The advisory industry is unaware that the traditional asset-location rules (i.e, put bonds in tax-deferred accounts and stocks in taxable accounts) don’t work in our low interest rate environment. The exact opposite is appropriate for most retirees and individuals entering retirement who do not have substantial unrealized capital gains in their taxable accounts.

This article begins with an analysis of effective tax rates on bonds and stocks held in one of three savings vehicles: a tax-exempt Roth account, like a Roth IRA; a tax-deferred account, like a 401(k); and a taxable account.1 This background information is necessary to discuss the asset-location literature, which is the main topic of this article. In addition, I will respond to several of the seven points raised by Reed (2019) in his recent criticism of prior asset-location studies. leverages Dr. William Reichenstein’s research and methodology to help advisors optimize how to generate retirement income and coordinate Social Security. In addition to identifying the best tax efficient withdrawal sequences, incorporates Asset Location methodology showing advisors the “alpha” they can find by applying different approaches to their clients’ portfolios.

The asset-location decision asks whether an investor should 1) locate stocks in taxable accounts and bonds in retirement accounts (that is, Roth accounts and tax-deferred accounts) to the degree possible, while attaining the target asset allocation; or 2) locate bonds in taxable accounts and stocks in retirement accounts to the degree possible, while attaining the target asset allocation.

As we shall see, with the exception of when interest rates are extremely low like they are today, the consistent asset-location advice from what I call “Group 2” studies is that investors should locate stocks in taxable accounts and bonds in retirement accounts to the degree possible, while attaining their target asset allocation. The advice for investors in today’s extremely low interest rate environment depends in large part on whether they have substantial unrealized capital gains on stock held in their taxable account. This advice is presented later near the end of this article.

Effective tax rates across savings vehicles

Table 1 considers two asset classes – bonds and stocks – and three savings vehicles – tax-exempt Roths, tax-deferred accounts (TDAs), and taxable accounts. For each savings vehicle, the investor begins with $1 market value and I calculate its current and future after-tax values. To hold everything else constant, I assume the underlying investment is the same across the savings vehicles. The annual pretax rate of return is r, the investment horizon is n years, the marginal tax rate on ordinary income this year is t0, the marginal tax rate on ordinary income in the withdrawal year n years hence is tn, and the tax rate on long-term capital gains and qualified dividends in all years is tc. Since the asset-location literature is concerned about savings strategies for retirement, the usual investment horizon is until some date during their retirement years. In this section, I develop models of the effective tax rate on stocks and bonds when held in each of the three savings vehicles. The portion of an asset’s pretax returns earned by the investor is 1 minus the effective tax rate.

Roth account

Tax-exempt Roth accounts include Roth IRA, Roth 401(k), and Roth 403(b). The $1 market value in a Roth account is $1 of after-tax funds. For bonds and stocks, its after-tax value grows from $1 today to (1+r)n dollars n years hence.2 As the name implies, the effective tax rate on funds held in a tax-exempt Roth is 0%; that is, investors receive all returns on funds held in a Roth.