power your advice

A Strategic Approach to Managing Taxes: Asset Location in Three Simple Steps

Written by: Thomas J. Quinn, Chief Investment & Research Officer, Jefferson National

Sixty-five percent of respondents to the annual US Trust Insights on Wealth and Worth Survey say that minimizing taxes is an investment priority for managing their wealth, compared to just 35 percent who focus on pursuing higher returns regardless of tax implications. Taxes can be your clients’ biggest expense—as much as 50 percent in taxes a year, when federal, state and local taxes are combined. In fact, the average American spends more days working to pay off federal, state and local taxes than they do to cover the costs of housing, food and clothing combined. [i]

Taxes are not only a costly out of pocket expense for your clients, but also a drain on the performance of their portfolios. This is especially true for your high net worth clients, and when working with your clients to meet long-term financial goals such as retirement saving and legacy planning. But there are solutions. As my recent study shows, advisors can implement a more strategic approach to managing taxes by using Asset Location. The result? Asset Location is a proven strategy to mitigate the impact of taxes on your client’s portfolio and increase returns 100-200bps per year—without increasing risk. [ii]

The concept of tax-deferred accumulation is integral to most clients’ portfolios—a fundamental tool for achieving long-term financial goals. And to maximize tax deferral to its fullest potential, Asset Location is a strategy that is simple, predictable and reliable.

Identifying Opportunities for Asset Location

Asset Location can potentially increase returns and lead to faster growth of assets by strategically minimizing the impact of taxes. This is accomplished without changing the portfolio allocation, but instead by “locating” assets in the appropriate vehicle—taxable or tax-deferred—based on tax-efficiency. Quite simply, Asset Location is implemented by locating tax-inefficient assets—such as fixed income and real estate—in tax-deferred vehicles, and locating tax-efficient assets—such as equity ETFs—in taxable accounts.

Using Asset Location, you can add more value for your clients—helping them accumulate more wealth, generate more retirement income and leave a larger legacy. While nearly all clients can benefit from some level of Asset Location, there are certain clients likely to benefit the most:

  • Clients who can use more tax deferral alongside qualified plans
  • Clients taxed at a high marginal rate—especially if their tax rate will be lower at distribution
  • Clients whose taxable investable assets exceed their liquidity needs
  • Clients whose portfolio holds more tax-inefficient assets or employs a tactical trading strategy
  • Clients who seek to maximize accumulation for retirement or legacy planning
  • Asset Location can add value, even with a short time horizon—and in some cases even within the first year, depending on the type of assets and investment strategies being used.


    As shown in Figure 1, starting with a $1 million dollar portfolio, with $925,000 in a taxable account, and $75,000 in a tax-deferred IRA. When the advisor uses an Asset Location strategy, the value of tax deferral almost doubles over 15 years, from $24,856 to $44,502.

    Three Steps to Optimize the Benefits of Asset Location


    To optimize the benefits of Asset Location, you should follow a systematic approach including three key steps:

  • Evaluate the tax-inefficient areas of your clients’ portfolios
  • Extend asset location beyond the low limits of qualified plans
  • Regularly identify new asset location opportunities
  • Start by Evaluating Tax-Inefficiencies: Consider both the retrospective and prospective tax implications of various asset classes and investing strategies. Key indicators include the Tax Cost Ratio, Yield and Tactical Trading.

    Tax Cost Ratio


    Mutual funds will distribute taxable income, dividends and gains based on how the fund was managed. The Tax Cost Ratio is a retrospective indicator, calculated by Morningstar, to show how much of a fund's annualized return was reduced by the taxes investors pay on distributions. The higher the Tax Cost Ratio, the more tax-inefficient the fund.

    Impact of Yield on Fixed Income


    Many fixed income funds offer a blend of capital appreciation and income (also referred to as yield). The amount of return coming from yield is directly related to the size of the tax bill. For example, a client invested in High Yield Bond funds over the past ten years would have paid more than 41% of their return to taxes on distributions. When investing in fixed income funds where returns are distributed primarily as yield, clients can quickly realize more value through Asset Location. This benefit will increase the longer taxes can be deferred.

    Impact of Tactical Trading


    Certain assets are tax-efficient, but become tax-inefficient based on how they are managed. Tactical allocation strategies try to improve the risk/return profile of a portfolio by actively shifting allocations across investments. But this return seeking turnover has the potential to lead to more short term capital gains—and higher tax bills. When using tactical management or investing in actively managed funds, Asset Location can add more value.

    Next, Extend Asset Location Beyond Qualified Plans


    Qualified plans have their limits. This past year, the maximum annual contribution to a 401(k) plan was $18,000, plus a $6,000 catch up option for individuals age 50 or older; for IRAs the annual contribution is only $5,500, with a $1,000 catch up option. Many clients can benefit from additional tax-deferred growth.

    To increase the size of the tax deferred pie and extend the Asset Location opportunity, one proven solution is an Investment-Only Variable Annuity (IOVA). Several factors must be considered before choosing the right IOVA, including no commissions, low or flat fees, and a broad suite of investment options, to allow you to execute your investment strategies as necessary.

    Considering the same client from Figure 1, with a starting balance of $1 million, the advisor can instead allocate $550,000 in the taxable account, locate $75,000 in the tax-deferred IRA, and locate an additional $375,000 of tax-inefficient assets in an IOVA. As shown in Figure 2, by extending Asset Location with an IOVA, the value of tax deferral over 15 years increases even further, from $44,502 (Figure 1) to $68,250 (Figure 2).

    Finally, Seek New Asset Location Opportunities


    Throughout the year, you can identify new opportunities to implement Asset Location. This can include periods of normal portfolio rebalancing or year-end tax-loss harvesting, when you can locate more assets into taxable and tax-deferred vehicles based on tax-efficiencies.

    Conclusion


    In recent years US tax rates have increased, creating an even larger tax bill for clients. In 2015, Americans paid a total tax bill of $4.8 trillion, or 31% of national incomei. But using these three steps to implement an Asset Location strategy, you can minimize the impact of taxes and help your clients grow more wealth, potentially increasing returns by 100 – 200 bps per year—without increasing risk. In this challenging environment of high taxes, a strategic approach to managing taxes using Asset Location can add greater value for your clients, and your firm.

    To download the full white paper “A Strategic Approach to Managing Taxes” by Thomas J. Quinn, please use this link: www.jeffnat.com/investing-insights .


    [i] Tax Freedom Day 2015 is April 24h”, Kyle Pomerleau, March 30, 2015. Link: http://taxfoundation.org/article/tax-freedom-day-2015-april-24th
    [ii] Taxes and Investment Performance, Morningstar, 2013.