Asset allocation, meaning the weighting of stocks, bonds, and cash an investor holds, is a very critical investment subject. There are a lot of tools out there that take basic information and gives someone a good starting recommendation. What I think people overlook is where to “park” their investments. Asset location can very helpful in providing flexibility and better returns for the savvy investor.
I want to describe this in two scenarios: younger millennials like myself, or younger, trying to save money for short-term goals and retirement. Secondly, I want to cover someone drawing down on their investments later in life when they are retired. Starting with younger people, I believe you can’t overlook how advantageous tax-deferred accounts are from a couple of points. When you utilize an IRA, 401k, or other retirement plans the dividends and gains are not taxed while you grow your money. Only when you decided to take out the money a taxable event occurs. So a younger person can take advantage of these benefits for many years, if not decades, not having taxes reduce their savings. Taxes aren’t the most exciting thing in the world for most people, but they should be considered when making any investment location decision.
For those fortunate to have money saved and are now utilizing those savings for their living needs, there are a couple of points to mention. Financial planners like myself can provide long-term strategies and recommendations for someone creating both a long-term and short-term distribution plan. For example, let’s cover a bond mutual fund. This type of investment is usually conservative in nature and provides income for the investor. Bonds, in general, are more productive holding in a tax-deferred account like a 401k or IRA. Let’s suppose this bond fund pays an annual income of $5k for example. Holding this bond fund in a taxable account will result in $5k of income the investor will have to claim as income. Generally, in most cases, holding income-producing investments is more advantageous in retirement, or tax-deferred, accounts.
The second example is a stock mutual fund. Typically stock mutual funds appreciate over the long run, more so than a bond fund. They typically don’t pay as much income compared to a bond fund. If you hold a stock fund and you later sell your fund for a profit, you will incur capital gains taxes. A capital gain is the difference between what you bought the investment for and later sold it for. In general, for most people, this rate is lower than ordinary income rates. Generally, it’s more advantageous to hold stock funds in a brokerage, or non-retirement, account.
I hope this has helped describe what asset location means and ways one can benefit from the concept. Knowing your investment allocation is important, however more importantly is knowing where to hold these investments. If you or an advisor you work with doesn’t factor this into investment decisions they are missing a big piece to the puzzle.