Asset Location, Location, Location…

There’s an old joke –

Q. Why is kissing a lot like real estate?

A. Because what matters most is location, location, location.

The same could be said for investing.  Where you plant that investment matters.

Let’s assume that you read my last blog regarding asset allocation and you did some homework on what is the ideal asset allocation for you. How do you proceed from there?

The Bucket List

I view there are essentially 3 kind of buckets for you to invest your money in from a tax perspective, Taxable, Tax Deferred, and Tax Free.

Taxable Buckets – Think your Brokerage Account
Taxable buckets –There are two tax rates one faces in taxable investment account, the higher ordinary income and short-term capital gains tax rates; and the bit lower long-term capital gains and qualified dividend tax rates.  An investor who is taxed at the 35% Federal tax rate for ordinary income and short-term capital gains will be taxed at the 15% Federal tax rate for long-term capital gains and qualified dividends.

What To Emphasize in The Taxable Bucket: Tax Free Municipal Bonds, Domestic Stocks and International stocks.

Tricks: Focus on buy and hold.  Sell investments which have unrealized losses since you will be able to use those losses to lower taxes by lowering your  taxable ordinary income and realized taxable capital gains.  If you must sell, try to wait until you have held the investment for over a year so that you pay the lower long-term capital gains tax rate.

Tax Deferred Buckets – Think your IRA, 403B, and 401K
Tax Deferred Buckets – The good news is you usually get a tax deduction when putting money into the tax deferred bucket.  This way you pay less in taxes and have more money to put in to begin with. Also, no taxes are paid on any interest, dividends, and realized capital gains earned prior to withdrawing funds. The bad news is you pay the higher ordinary income tax rate when you eventually do pull out the money.  You have deferred that tax at least.

What to Emphasize in the Tax Deferred Bucket:  Taxable Bonds, Real Estate Investment Trusts (REITs).  Mutual funds which are tax inefficient by their nature.  Focus on investments which pay a lot of taxable interest, ordinary income and/ore which generate a lot of short-term capital gains.

Tricks:  Unlike common stock dividends REIT dividends are taxed at the higher ordinary income rate so tax deferred accounts are a good parking spot.  When you need to rebalance your overall portfolio, rebalancing in your IRA/403B/401K will allow to rebalance without creating any capital gains taxes.  Consider weighting assets with lots of long-term appreciation potential in your taxable bucket, or better yet, your tax free bucket where you can pay the lower capital gains tax rate or no taxes at all in the case of the tax free bucket.

Tax Free Buckets – Think your Roth IRA, Roth 401K
Tax Free Buckets – After-tax money usually goes into tax-free buckets.  While you have paid taxes on the earnings which funded the tax free bucket, all income and appreciation thereafter are tax free.

What to Emphasize in your Tax Free Bucket:  I call this my shoot for the moon bucket.  I recommend a well-diversified mix of one’s riskiest highest expected return assets.  Shoot for the moon but keep in mind it took a lot of technology, math, and research to get man on the moon, so be aggressive but be diversified and well thought out following the best academic research.

Tricks:  I pretty much just put equities in Roth IRA accounts.  I focus on a well diversified broad market allocation, but then skew the portfolio from there to include small agressive stocks and emerging markets.  I shy away from individual holdings particularly in the Roth since tax losses cannot not be taken in a tax free account.  Finally there is a strategy when one is retired to convert Roth IRA assets to regular IRA assets between retirement and receiving Social Security.  When you get there, talk to me about it and I will walk you through the issue.

Please note I used the word “emphasize” several times above regarding what to include in each bucket type.  You still want each of your buckets to be well diversified and include several asset classes if possible.

Hoping not to get too lost in the details, here’s a really simple way of looking at it:

Figure out your target allocation then break it out as such –

Taxable Accounts
More Stocks (Domestic and International)
Less Bonds – Consider Municipal Bonds when you do
Generally no REITs

Tax Deferred Accounts
More Bonds – Corporate and US Government Bonds
Less Stocks (Domestic and International)

Tax Free
Little to No Bonds
Lots of Diversified Equity (Domestic and International) – especially riskier and/or high dividend equity investments
Some REITS perhaps

That’s it for now.


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