Asset location strategies - A key to tax-effi cient investing
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Asset location
strategies
A key to tax-efficient
investing
Asset location strategies: A key to tax-efficient investing | 1
Asset location
in focus
As clients and advisors continue to work together
to adjust to the world after the financial crisis,
a frequent discussion is whether investors have
the appropriate asset allocation to account for
market movements or risk profiles:
• Are my investments positioned to avoid the
next market correction?
• How should I adjust my investments as I age?
• What investment decisions should be made to
account for pending Federal Reserve activity?
This is a just concern, given the recent history of
the markets. Having an optimal asset allocation
will always be a prominent factor in maximizing
returns. However people often overlook whether
they have an intelligent tax strategy and whether
tax impacts are being minimized within the
portfolio. Spending the time to make sure your
accounts and holdings are established in a
tax-efficient manner can enhance returns and
does not require an increased ability to select
investments. Firms and clients are starting to
realize that there is a systematic method for
increasing returns without changing out any
assets. It is the concept of asset location, or
the logical distribution of investments to the
most tax-efficient account type based on the
tax impacts of each investment. Firms that take
advantage of technology that can optimize the
location of clients’ assets can drive a meaningful
increase in after-tax returns — improving client
satisfaction and retention.
2 | Asset location strategies: A key to tax-efficient investing Asset location strategies: A key to tax-efficient investing | 3
Gamma factor Asset location in action
Morningstar recently introduced the concept of 4. Liability-relative optimization: including While implementing the proper
“gamma,” which involves quantifying “the additional inflation, currency and other funding risks in the asset location strategies is not
expected retirement income achieved by an portfolio optimization process always straightforward, guidelines Least tax efficient
individual investor from making more intelligent exist for whether an asset belongs
5. Asset location and withdrawal sourcing: placing
financial planning decisions.”1 The five components in a taxable or a non-taxable Pre-tax accounts (401(k),
investments in the most tax-efficient account 403(b), traditional IRAs) • High-yield bonds
of gamma are:2 account. The general rule is to
type and withdrawing capital from taxable • Taxable bonds
place the most inefficient holdings
1. Total wealth asset allocation: incorporating accounts before more tax-deferred accounts • Treasury inflation-protected
from a tax perspective into the securities (TIPS)
human capital, the individual’s potential future
According to Morningstar’s research, asset location, most sheltered tax accounts and
savings, with his or her financial capital when Post-tax accounts (Roth • REITs
when combined with an intelligent strategy for to hold the securities with the • Balanced funds
determining risk tolerance IRAs, Roth 401(k))
drawing down assets, can produce a gamma- least impact on tax in fully taxable • Stock trading accounts
2. Dynamic withdrawal strategy: determining equivalent alpha of 52 basis points (0.52%) of accounts. For example, a real estate • Small-value stocks
a withdrawal amount annually, based on the additional return.3 Moreover, EY research indicates investment trust (REIT) mutual • Small-cap stocks
evolving likelihood of portfolio survivability and that intelligent asset management and distribution fund, whose dividends are taxed at • Large-value stocks
mortality experience methodologies can increase income in retirement by the ordinary income rate, belongs • International stocks
up to 33% and the remaining assets to pass on as a in a non-taxable account so the • Large-growth stocks
3. Annuity allocation: allowing a retiree to hedge • Most index stock funds
bequest by up to 45%.4 client can be sheltered from the
out the risk of outliving one’s resources • Tax-managed stock funds
higher ordinary income tax rates.
• I/EE savings bonds
However, separately managed
• Tax-exempt (muni) bonds
accounts (SMAs), due to their ability Taxable accounts
A breakdown of Morningstar “gamma” elements Increased returns
to harvest tax losses during the
Total wealth asset allocation Asset allocation based on the investor’s risk preference 38 bps year, can be managed in a taxable
and risk capacity Most tax efficient
account, as the portfolio manager
Annuity allocation Contribution of an annuity within a total portfolio based 24 bps can control how taxes impact the
on benefit, risk and cost household. In addition, with the
Source: “The Key To Tax-Efficient Investing: Asset Location,” Forbes.com, 7 May 2010.
limited tax capacity of certain
Dynamic withdrawal strategy Annual withdrawal amount from multiple accounts based 54 bps
on likelihood of portfolio survivability and mortality expe- retirement accounts, variable
rience annuities can hold tax-inefficient
investments and be used to reduce
Liability relative optimization Includes hedging inflation and currency risks 14 bps
the tax impact for a household.
Asset location and withdrawal Tax-efficient investing across multiple account types by 52 bps For estate planning, another option would be to buy a hedge fund inside a variable life insurance policy. The
sourcing locating asset types in optimal account registrations, as value will grow tax-free, and upon death the cash value of the policy passes to the heirs tax-free.
well as intelligent withdrawal sequencing from multiple
accounts that differ in tax status Certain steps should be taken so that the benefits of proper asset location are captured. Individual investors
should work with their advisors for optimal execution of an asset location strategy. Wealth management firms
Total 182 bps
should analyze their platforms to fully understand their capabilities with respect to notifying the advisor on
the ideal location for an asset and being able to move assets seamlessly between accounts. Additionally, a
vendor assessment would apprise the wealth manager of any shortcomings within its current platform, as
well as the benefits that a different provider could offer.
The graphic above shows the order in which accounts should be filled with tax-inefficient assets, starting from
the top of the left side, if the objective is to maximize after-tax returns.
1
David Blanchett and Paul Kaplan, “Alpha, Beta, and Now … Gamma,” Morningstar, September 2012.
2
Ibid.
3
Ibid.
4
“Improving After-Tax Returns, Retirement Income, and Bequests Through Tax-Smart Household Management,” LifeYield and EY,
October 2010. 5
Martin Silfen, “A Systematic Approach to Asset Location,” CFA Institute, 2005.
4 | Asset location strategies: A key to tax-efficient investing Asset location strategies: A key to tax-efficient investing | 5
Regulation Asset location in goals-based wealth
management
When implementing a strategy that includes the objective of an account. For instance, a
use of asset location, the legal and regulatory conservative tax-deferred retirement account may
aspects of the implementation must be be the ideal place for holding high-yield bonds,
Goals-based planning is a trend in wealth advisor. This results in a better understanding of
considered. For example, taxation constraints on which have their coupon payments taxed at an
management that is gaining popularity after the each goal, its priority relative to other goals, the
investors involve 5: ordinary income rate. However, adding too many
2008 market crisis. Goals-based planning focuses amount of savings devoted to each goal, and the
risky bonds to a portfolio may increase its risk/
• Federal income tax on developing a financial plan that requires a ability to view the trade-offs and priorities across
return profile above what its investment objective
discussion of trade-offs and confidence levels to all goals. Including asset location as part of the
• State income tax states. When viewed by a regulator, this may
reach specific goals. With the appropriate tools planning and investing process will improve results
cause some concern. While the overall household
• Federal gift and estate tax and technology in place, financial institutions can for the client, lowering the cost to achieve each
assets may align with the client’s overall portfolio,
help advisors and customer-facing associates goal by reducing the tax impact the investments
• State gift and estate tax current regulations for the SEC, FINRA and the
talk to customers about their goals and align will have. Employing an asset location strategy
OCC still dictate that an account-level risk profile
• Unrelated business income tax investments appropriately to those goals by in a goals-based environment allows the advisor
must be maintained. Adjusting an account to be
considering how important they are and when to align investments to goals to improve returns.
In addition, moving assets across accounts may more conservative than its profile may not be an
they need to be realized. These goals-based For instance, moving high-yield taxable bonds to
skew the underlying risk profile of an account and issue, but pushing a conservative account to a
planning conversations equip financial institutions a traditional IRA will allow higher returns to be
cause a misalignment with the stated investment more risky profile may raise some red flags.
with the capabilities to provide customers with generated for a client without the threat of paying
more suitable advice for both the accumulation taxes on interest earned. And a client will be more
and de-accumulation phases of their lives. likely to meet a retirement goal with a 20-year
horizon if it is aligned with his or her IRA.
The overall benefit of goals-based planning is a
sharper, more focused plan for both client and
5
Martin Silfen, “A Systematic Approach to Asset Location,” CFA Institute, 2005.
6 | Asset location strategies: A key to tax-efficient investing Asset location strategies: A key to tax-efficient investing | 7
Asset location scenario analysis
The following analysis 6 will show the positive bracket is 35.0%, with a long-term capital gains
impact an asset location strategy can have on a tax rate of 18.8% and a short-term capital gains
typical portfolio. The below example assumes an tax rate of 38.8%. Scenario 1 is the baseline case,
even split between the investor’s taxable and tax- and Scenario 2 shows the impact of a simple asset
deferred investment categories. The marginal tax location strategy.
Scenario 1 — Baseline: Scenario 2 — Asset location strategy:
Taxable bond funds in taxable accounts and index equity funds in tax-deferred accounts: Index equity or tax-managed funds in taxable accounts and taxable bond funds in tax-
deferred accounts:
Taxable Tax deferred Taxable Tax deferred
Taxable bond funds $500,000 Index equity funds $ 500,000 Index equity funds $500,000 Taxable bond funds $ 500,000
Dividends $ 25,000 Dividends $ 50,000 Dividends $ 10,000 Dividends $ 25,000
Balance before taxes $525,000 Long-term capital gains $ 2,500
Unrealized gain $ 37,500
Less taxes on dividends $ 9,700 Balance before taxes $550,000
Ending balance $515,300 Ending balance $ 550,000
Total asset balance (pre-liquidation) $1,065,300 Less taxes on Dividends $ 1,500
Long-term capital gains $ 470
Less taxes on liquidation $ 0 Less taxes on liquidation $ 213,400
Ending balance $548,030 Ending balance $ 525,000
Total asset balance (post-liquidation in one year) $ 851,900
Total asset balance (pre-liquidation) $1,073,030
In both of these scenarios, when proper asset location is implemented, the ending asset Less taxes on liquidation $ 7,050 Less taxes on liquidation $ 203,700
balance difference is $10,380, the primary driver of which is the $9,700 in taxes in Total asset balance (post-liquidation in one year) $ 862,280
Scenario 1 and $1,970 of taxes in Scenario 2.
6
Colleen Jaconette, “Asset Location for Taxable Investors,” Vanguard, September 2007.
8 | Asset location strategies: A key to tax-efficient investing Asset location strategies: A key to tax-efficient investing | 9
How EY can help Ernst & Young LLP contacts
At EY, our planning and investment management Kelly Hynes Ugur Hamaloglu Charles Smith
experience has taught us that a proper investment Executive Director, Financial Services Senior Manager, Financial Services Senior Manager, Financial Services
and product allocation framework can guide financial kelly.hynes@ey.com ugur.hamaloglu@ey.com charles.smith@ey.com
advisors to help individuals select the proper mix +1 704 350 9046 +1 212 773 8386 +1 212 773 3518
of products to help them achieve their goals — e.g.,
having sufficient funds for retirement, a second
home, unexpected expenses — rather than investing
to achieve higher returns as measured against
various market benchmarks. A proper allocation
approach will increase the options a client may have
for achieving his goals while minimizing the impact
of external factors such as market movements and
taxes. With this approach, an advisor can strengthen
the connection with his clients and increase the
potential for long-term, even lifelong, relationships.
Optimizing asset location for your clients is not a
simple task. It can be done manually, but that would
require time and effort that will take advisors or
other front office personnel away from business
development or other client-focused tasks. Firms
should look to implementing a technical solution to
provide optimal asset location as part of a scalable
onboarding or annual review process. The return
on this type of technology investment can be
justified via improved after-tax returns, enhanced
client satisfaction and additional assets that can be
captured from existing clients; investors will realize
that a true asset location strategy can provide
measurable improvements in after-tax returns.
EY’s Wealth & Asset Management Advisory network
has experience supporting financial institutions in
implementing sophisticated investment allocation
techniques such as asset location. We help firms
develop retirement planning and portfolio modeling
services to assist their clients with maximizing tax
efficiency and investment returns. EY leverages
its deep skills in the wealth management space to
meet the challenges that advisors encounter. Our
team has worked with the industry leaders and has
helped investors reduce the tax burden faced by the
suboptimal placement of financial assets.
Contact us to join you in defining and implementing
your firm’s unique goals-based planning and
investment strategy.
10 | Asset location strategies: A key to tax-efficient investing Asset location strategies: A key to tax-efficient investing | 11EY | Assurance | Tax | Transactions | Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more of, the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. © 2014 Ernst & Young LLP. All Rights Reserved. SCORE NO. CK0880 1412-1362948 ED 01/15 This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com
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