Optimizing Asset Location: Increase Portfolio Tax Efficiency and Mitigate Family Rise

Segmenting investments according to tax efficiency, purpose, and time horizon often works better than simple risk-tolerance models.

“Never put all your financial eggs in one basket” is prudent, time-tested financial advice.  Diversification is one of the golden rules of investing, as devising an asset allocation based on an investor’s risk tolerance.

But basic, one dimensional allocation models, that simply assign a proportion of investments to higher- or lower-risk segments, are missing several key dimensions, including tax-efficiency, tolerance for volatility, and purpose.

More complex allocation models overlay asset location to better achieve specific goals while strategically assigning risk. Here are two key factors that wealthy families should consider:

1) Consider the time horizon for each type of account

 Common asset allocation strategies determine risk tolerance and choose investment vehicles accordingly.  A simple example is a moderate investor might decide on a 60/40 allocation between stocks and bonds. They would then apply that allocation across all investment accounts.  Each account, whether it be a taxable, retirement, trust or charitable would be invested the exact same way. These simple risk models work for many investors because their goal is to achieve financial security and enjoy a comfortable retirement. They tend to have only a few accounts that will all be spent down during their lifetime.  However, wealthy families build wealth not only for themselves but are often concerned about leaving a legacy.  Estate Planners often create trusts designed to last for multiple generations or charitable foundations designed to last in perpetuity.  As the number of entities grows, it is imperative to think about each entity in terms of its own time horizon.

Asset location for family risk management

Families might want to designate certain accounts as “financial security accounts.”   By working with a financial planner, a family can determine the proper amount to set aside for financial security. The accounts earmarked for financial security may be drawn upon within an investor’s lifetime.  These accounts would include retirement accounts, annuities and accounts with income producing stocks and bonds. The specific investment choices tend to be more conservative (e.g., fewer stocks and more bonds) because financial security is the goal.

Investments in excess of the determined financial security amount or assets held in trust for heirs may be designated as “long-term, to be passed on, accounts.”   The main purpose of these accounts is to maintain and grow intergenerational wealth or perhaps go to charity. Trusts are a typical mechanism for passing on this wealth. Often times, these accounts are not meant to be accessed in the near future or even within an investor’s lifetime.  Investment choices should be tax-efficient, and they can be riskier. Long term accounts can weather volatility better, because they have time to grow. In essence, this is “extra” money—and a wealthy investor can take more chances with it to potentially realize significant long-term gains.

The proportion of investments might look riskier—but the strategic asset location is more efficient

To illustrate how this concept plays out, let’s go back to that very simple 60/40 stock/bond risk scenario. Instead of applying a 60/40 distribution across all investment accounts, the financial security accounts might be a more conservative 40/60 allocation with the proportion of stock and bonds flipped with more of the allocation going to bonds.  This will minimize volatility and perhaps focus on income.  However, this allows the long-term assets to be invested more aggressively, perhaps 80% equities and only 20% bonds.  As the family wealth grows beyond what is necessary for financial security, the family allocation might be much riskier than the 60/40 portfolio but, in reality, the family security is greater because those assets are only 40% equities. In this scenario, an investor exercises due caution while planning their personal financial security, but chooses some riskier, tax-efficient investments to achieve family goals. These latter investments enjoy deferred taxes, the time to weather market volatility, and the potential to achieve exceptional gains.

 2) Carefully think about tax-efficiency

Beyond considering goals and risks, tax efficiency must also be assessed when locating assets. In general:

• Personal Financial Security Accounts— These assets are taxed at the individuals personal effective tax rate. High Income earners, with high effective rates should consider owning tax inefficient Investments, like high yield bonds, real estate or high turnover hedge funds in Tax Deferred Accounts. Investments that have low turnover or that generate income at preferential tax rates (dividends and capital gains) are generally better off held outside retirement accounts.

• The Long-Term, to be passed on, accounts – Asset location for long term assets largely depends on the tax rate and who pays the tax. Roth IRAs aren’t required to pay taxes, don’t have required minimum distributions and transfer to heirs tax free.  Therefore, all attention should be on return without regard to the type of tax or amount of tax generated.  Trusts, on the other hand, are in a much higher bracket than individuals or in the case of Grantor Trusts, the grantor is responsible for the tax even though they don’t receive the income. Therefore, using tax efficient investments like Large Cap stocks or municipal bonds is judicious or consider having the trust utilize a private placement annuity to control the grantors tax liability.

• Many investors only assess their risk tolerance and apply this simple model across all of their investments. But if they more carefully consider their goals and the tax-efficiency of individual accounts, they can reduce their personal risk while upping the odds of increasing family wealth.

• Lindberg & Ripple offers customized wealth management, investment, and insurance solutions to wealthy families and successful businesses. We help our clients craft a comprehensive financial planning model to achieve their goals with minimum fuss and maximum savings. Connect with us to learn more.