Asset location
Encyclopedia
Asset location is a term used in personal finance
to refer to how investors distribute their investments across savings vehicles including taxable, tax-deferred and tax-exempt accounts (e.g., 401(k)
, IRAs
, ISAs
, TESSAs
, SIPPs
), grantor retainer annuity trusts, generation-skipping trusts
, charitable remainder trusts or charitable lead trusts, variable life insurance
policies, and foundations
.. Although the tax rates
of different types of income vary internationally, broad conclusions have been drawn about where to locate an asset, depending on the nature and amount of income being generated. Internationally, consideration could also be extended to determining which assets to hold onshore and offshore.
The location of assets is insignificant only when capital gains and losses are taxed on an accrual basis (i.e., no deferral option) and at the same tax rate that applies to ordinary income. Complications arise when comparing tax systems where capital losses can only be applied towards realized capital gains, where capital loss carry-over may not be permitted, and where there are deduction limitations dependant on wealth or income level.
Bodie and Crane studied TIAA-CREF participants and concluded that investors chose similar asset allocations in their taxable and tax-deferred accounts, with little apparent regard for the benefits of tax efficient asset location. Barber and Odean surveyed brokerage records and found that more than half of the households held taxable bonds in their taxable accounts, despite available alternatives, and that the preference for holding equity mutual funds in retirement accounts appeared to be stronger than that for holding taxable bonds.
Other commentators suggest decisions concerning the use of home equity and mortgage debt as a substitute for consumer debt have driven choice of portfolio location. An idealized example shows that over a 25 year interval, the difference between extreme asset location choices yielded a compounded 18% differential in return.
) into tax-deferred or non-taxable accounts and place equity investments (e.g., index fund
s) into taxable accounts. This is to fully utilize any long-term capital gain, or capital gains allowances available, to provide the optimal after-tax return on investment.
Actively-managed mutual funds
or unit trusts
may also prove to be better located in tax-sheltered vehicles, because equities held through financial intermediaries tend to be taxed more, due to high turnover, than individual equities held by an investor for the long term, who has the opportunity to plan the realization of gains and offset losses. Siegel and Montgomery demonstrate conclusively that taxes and inflation substantially dampen compound returns especially for equity investors.
Tax-exempt bonds
, national savings certificates
and other similar tax-privileged securities are best located in fully taxable accounts. Shoven and Sialm provided an analysis of the decision point when income producing equities should be sheltered and optimal portfolio choice for each type of account. Individual stocks, passive index funds, or exchange-traded funds
are generally regarded as tax-efficient and, consequently, better placed in taxable accounts, when more heavily taxed income generating assets, such as bonds, real estate investment trusts
, and so on, are available for secretion in a tax sheltered location.
One school of thought advocates putting higher-return assets (such as stocks) in the tax-advantaged accounts. The other proposes locating tax-inefficient assets (such as bonds and real estate investment trusts) in the tax-advantaged accounts. Although this is an evolving debate, the best and most current critical thinking supports sheltering the tax-inefficient assets in the tax-advantaged accounts.
. The latter is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio
according to the investors risk tolerance, goals and investment time frame.
Personal finance
Personal finance is the application of the principles of finance to the monetary decisions of an individual or family unit. It addresses the ways in which individuals or families obtain, budget, save, and spend monetary resources over time, taking into account various financial risks and future...
to refer to how investors distribute their investments across savings vehicles including taxable, tax-deferred and tax-exempt accounts (e.g., 401(k)
401(k)
A 401 is a type of retirement savings account in the United States, which takes its name from subsection of the Internal Revenue Code . A contributor can begin to withdraw funds after reaching the age of 59 1/2 years...
, IRAs
Individual Retirement Account
An individual retirement arrangement is the blanket term for a form of retirement plan that provides tax advantages for retirement savings in the United States...
, ISAs
Individual Savings Account
An Individual Savings Account is a financial product available to residents in the United Kingdom. It is designed for the purpose of investment and savings with a favourable tax status. Money is contributed from after tax income and not subjected to income tax or capital gains tax within a holding...
, TESSAs
Tax-Exempt Special Savings Account
In the UK, the Tax-Exempt Special Savings Account was one of a number of tax-free savings accounts. The TESSA was announced by John Major in his only Budget as Chancellor of the Exchequer in 1990...
, SIPPs
Self-invested personal pension
A Self-Invested Personal Pension is the name given to the type of UK-government-approved personal pension scheme, which allows individuals to make their own investment decisions from the full range of investments approved by HM Revenue & Customs ....
), grantor retainer annuity trusts, generation-skipping trusts
Generation-skipping transfer tax
The U.S. Generation-skipping transfer tax imposes a tax on both outright gifts and transfers in trust to or for the benefit of unrelated persons who are more than 37.5 years younger than the donor or to related persons more than one generation younger than the donor, such as grandchildren...
, charitable remainder trusts or charitable lead trusts, variable life insurance
Variable universal life insurance
Variable Universal Life Insurance is a type of life insurance that builds a cash value. In a VUL, the cash value can be invested in a wide variety of separate accounts, similar to mutual funds, and the choice of which of the available separate accounts to use is entirely up to the contract owner...
policies, and foundations
Private foundation
A private foundation is a legal entity set up by an individual, a family or a group of individuals, for a purpose such as philanthropy. The Bill & Melinda Gates Foundation is the largest private foundation in the U.S. with over $38 billion in assets...
.. Although the tax rates
Tax rates around the world
Comparison of tax rates around the world is difficult and somewhat subjective. Tax laws in most countries are extremely complex, and tax burden falls differently on different groups in each country and sub-national unit. The graph below gives an indication by rank of some raw...
of different types of income vary internationally, broad conclusions have been drawn about where to locate an asset, depending on the nature and amount of income being generated. Internationally, consideration could also be extended to determining which assets to hold onshore and offshore.
The location of assets is insignificant only when capital gains and losses are taxed on an accrual basis (i.e., no deferral option) and at the same tax rate that applies to ordinary income. Complications arise when comparing tax systems where capital losses can only be applied towards realized capital gains, where capital loss carry-over may not be permitted, and where there are deduction limitations dependant on wealth or income level.
Patterns of Behavior
Surveys of households have shown that there is often a gulf between where assets are located and where they ought to be to provide an optimal tax outcome. Amromin argues that job income insecurity, penalties and restrictions on withdrawals from tax-deferred accounts explain why people are tax-inefficient with their investments. Employers’ matches in defined contribution retirement plans and the structure of the social security system also play a part in driving low tax equity investments into sheltered accounts.Bodie and Crane studied TIAA-CREF participants and concluded that investors chose similar asset allocations in their taxable and tax-deferred accounts, with little apparent regard for the benefits of tax efficient asset location. Barber and Odean surveyed brokerage records and found that more than half of the households held taxable bonds in their taxable accounts, despite available alternatives, and that the preference for holding equity mutual funds in retirement accounts appeared to be stronger than that for holding taxable bonds.
Other commentators suggest decisions concerning the use of home equity and mortgage debt as a substitute for consumer debt have driven choice of portfolio location. An idealized example shows that over a 25 year interval, the difference between extreme asset location choices yielded a compounded 18% differential in return.
Optimal Portfolio Choice
In order to maximize performance of a financial portfolio, it is often advised that an investor place income-generating investments (e.g., bondsBond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
) into tax-deferred or non-taxable accounts and place equity investments (e.g., index fund
Index fund
An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.-Tracking:Tracking can be achieved by trying to hold all of the...
s) into taxable accounts. This is to fully utilize any long-term capital gain, or capital gains allowances available, to provide the optimal after-tax return on investment.
Actively-managed mutual funds
Mutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...
or unit trusts
Unit trust
A unit trust is a form of collective investment constituted under a trust deed.Found in Australia, Ireland, the Isle of Man, Jersey, New Zealand, South Africa, Singapore, Malaysia and the UK, unit trusts offer access to a wide range of securities....
may also prove to be better located in tax-sheltered vehicles, because equities held through financial intermediaries tend to be taxed more, due to high turnover, than individual equities held by an investor for the long term, who has the opportunity to plan the realization of gains and offset losses. Siegel and Montgomery demonstrate conclusively that taxes and inflation substantially dampen compound returns especially for equity investors.
Tax-exempt bonds
Municipal bond
A municipal bond is a bond issued by a city or other local government, or their agencies. Potential issuers of municipal bonds includes cities, counties, redevelopment agencies, special-purpose districts, school districts, public utility districts, publicly owned airports and seaports, and any...
, national savings certificates
National Savings and Investments
National Savings and Investments , formerly called the Post Office Savings Bank and National Savings, is a state-owned savings bank in the United Kingdom. It is an executive agency of the Chancellor of the Exchequer...
and other similar tax-privileged securities are best located in fully taxable accounts. Shoven and Sialm provided an analysis of the decision point when income producing equities should be sheltered and optimal portfolio choice for each type of account. Individual stocks, passive index funds, or exchange-traded funds
Exchange-traded fund
An exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
are generally regarded as tax-efficient and, consequently, better placed in taxable accounts, when more heavily taxed income generating assets, such as bonds, real estate investment trusts
Real estate investment trust
A real estate investment trust or REIT is a tax designation for a corporate entity investing in real estate. The purpose of this designation is to reduce or eliminate corporate tax. In return, REITs are required to distribute 90% of their taxable income into the hands of investors...
, and so on, are available for secretion in a tax sheltered location.
Conclusions
The broad consensus is that households can raise their after-tax wealth by holding highly taxed assets in their tax deferred account, and lightly taxed assets outside, but the specific asset location choices will vary depending on taxation policy, tax and income level, and the degree of stock capital gain compounding. The consensus breaks down when deciding how to do this.One school of thought advocates putting higher-return assets (such as stocks) in the tax-advantaged accounts. The other proposes locating tax-inefficient assets (such as bonds and real estate investment trusts) in the tax-advantaged accounts. Although this is an evolving debate, the best and most current critical thinking supports sheltering the tax-inefficient assets in the tax-advantaged accounts.
Asset location & asset allocation
Do not confuse asset location with asset allocationAsset allocation
Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment time frame.-Description:...
. The latter is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio
Portfolio (finance)
Portfolio is a financial term denoting a collection of investments held by an investment company, hedge fund, financial institution or individual.-Definition:The term portfolio refers to any collection of financial assets such as stocks, bonds and cash...
according to the investors risk tolerance, goals and investment time frame.