The Pivotal Role Asset Location Plays in a Portfolio’s Success

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Zach – Hey everyone, Zach Holcomb here with Certified Financial Planner Michael Reese here with another blog. Mike, we have a pretty exciting program this week. We came across a very interesting article and it’s about the pivotal role that asset location not allocation plays in a portfolio’s success. 

Michael – Oh yeah, notice the difference the word there, I like how you really highlighted it. We’re not talking today. We are not, N-O-T, not talking about asset allocation, instead we’re talking about asset location, which are two different things. So, when we talk about asset allocation, we all know what that means, right? That means, you know, what percentage in stocks, what percentage in bonds, that kind of thing. Zach, you just brought up asset location. What are we talking about there? 

Zach – Well, it’s having the right types of funds, put in the right types of accounts. 

Michael – Yeah, really a tax play, isn’t it? And by the way, what we’re really responding to, I’m just going to see if I can share this article for everyone here. If you’re watching the blog, I’m sorry. Yes, if you’re watching the blog I said that correctly, I’ve just shared my screen. And the article comes from Morningstar. The title is The Pivotal Role Asset Allocation Plays in a Portfolio’s Success. So, this is the article we are linking it. The link will be on the blog. If you’re listening to us on a podcast, we’ll have the link on the show notes. So wherever we find those, but this is the article we’re referencing. So I’m gonna stop sharing because, I don’t think people just want to look at a type they’d rather look at our beautiful faces, right Zach? 

Zach – They want to see us, absolutely. 

Michael – But anyway, the point that Morningstar is making it’s the same point that I’ve made for many years. Is that where you place your stocks or the accounts in which you place your stocks, in which you place your safer investments like your bonds or annuities if you have them, it matters, and it doesn’t matter a little bit. It matters a lot. So let me give you an example Zach, of what I’m talking about here. The other day someone had you know, they listened to us on the radio and they actually came they called-in cause they want to visit with us. Cause they were getting ready to retire. They had an existing advisor, and that they really liked they’d had him for a long, long time. But the reason they were talking to us as you know, was that they were starting to wonder if maybe that advisor while being a really good person might not be the right person to help them get through retirement. They were looking more for a retirement expert if you will. 

Zach – Right. 

Michael – So when we reviewed their accounts you know, these people they had IRAs, they have Roth IRAs, they had after-tax like joint investment accounts. Zach, when we looked at those accounts, do you remember how they were allocated? Were they allocated any differently, or were they all allocated exactly the same way? 

Zach – They were all allocated pretty much the same way. 

Michael – Exactly, it was like, if you looked at one account, they had a series like they are joint. Their after-tax joint account, they had a series of funds. It was, they had a balanced portfolio. They had about 60% in stock funds, roughly 40% in bond funds you know, that kind of very typical thing. And they had about, well I think 10 or 12 different positions, but each position they had a certain percentage in each of those positions. And then if you looked at their IRA it was exactly the same, the exact same positions with the exact same percentages and their Roth IRA. Exactly the same exact same positions, exact same percentages. And you know, that’s something that we see all the time. Yet the challenge of course Zach, you know on the surface does that like, from your perspective you’re not, you’re not a Financial Planner, right? You do marketing here, from your perspective that seem normal to you? I do mean, what does that seem like to you? 

Zach – From my perspective that seems like a pretty standard arrangement. 

Michael – Yeah, and it is by the way, very, very standard. Yet this is a core difference between people who truly, truly specialize in retirement planning versus everybody else. Because while that seems normal Zach, and on the surface it seems normal. And from the average person’s perspective would be like, “yeah, what’s the big deal?” I mean, “yeah, why would I not have all my accounts set up the same way?” 

Zach – Right. 

Michael – There’s one little word that really directs us to not have them set up the same way. And it’s a simple five letter word. So do you know what that five letter word is? 

Zach – You’ll have to fill me in. 

Michael – Taxes. 

Zach – Taxes. 

Michael – It’s taxes, because here’s the problem. All these different types of investments are taxed differently. 

Zach – Right. 

Michael – And when you are working, it doesn’t matter as much because, let’s be honest how are you taxed when you are working pretty much in your income. Right, you get a W-2, you get a four at the end of the year and that drives the majority of your tax return. You don’t think about it much. But when you’re retired, that’s the first time in your life where you’re actually in control of where you’re getting your income from and the role of taxes that it plays. So let me give you an example. I’m gonna give you an example. 

Zach – Okay. 

Michael – Let’s say that you’ve decided to buy stock. You bought Amazon stock, right? Everybody, Amazon it’s everyone’s favorite stock these days because I think every single person deals with them on a daily basis. We’re all buying stuff from Amazon. My wife honestly gets packages I think every day from them. 

Zach – Right. 

Michael – In any event, let’s say you own Amazon stock. You own it in your joint or your after-tax account. The stock grows in value. Do you pay tax on that growth? I mean, each year it’s growing, do you pay tax on the growth? 

Zach – No. 

Michael – No. When do you pay tax on Amazon stock in an after-tax account? 

Zach – When you take that money out. 

Michael – Yeah, When you sell it. But here’s the key, what tax rate do you pay? See, there’s two rates of taxes in this country. There’s the income tax brackets, which is that what you pay on regular income. And then there are capital gains tax brackets which are lower rates. 

Zach – Right. 

Michael – So when you sell in an after-tax account, you are paying the lower capital gains tax rate. 

Zach – Right. 

Michael – Plus if there’s any dividends or income also you’re paying the lower long-term capital gains tax rate. So you’re getting a tax benefit, on top of that, what if you hold Amazon stock till you die? Your beneficiaries gets what’s called the step-up in basis meaning that all the gains in your stock they’re wiped away. This is though they never happened. And so your surviving spouse, your children, grandchildren, they get that stock as though you bought it the day you died. In essence, no tax, no capital gains tax on the growth either. Very tax advantaged. But what if you held that exact same stock inside of your IRA or your 401k? Now, as the stock grows Zach, do we pay tax on the growth? 

Zach – We do pay tax on the growth, no? 

Michael – No we don’t, we still don’t, still don’t pay tax on the growth, that’s the same. Here’s the problem. When you take money out, let’s say you’re taking out the dividends. Honestly, I don’t even think Amazon pays dividends but say they did. Let’s say you pull out the dividends. Are you taxed at the lower long-term capital tax rate or are you texts the higher-income tax rate?  

Zach – You’re taxed on the higher-income tax rate. 

Michael – The higher rate because it’s an IRA distribution. Further, when you own Amazon in your after-tax account you get to pick and choose when you want to sell it if ever. But if you hold it in an IRA, guess what? A lot of times, by the time you’re 72, you’ve got required minimum distributions that forces you to sell positions whether you want to or not, and take money out and pay what? 

Zach – Pay taxes. 

Michael – Pay more tax. And then when you die all the gains that you have an Amazon stock inside your IRA and it goes to your surviving spouse or your children or grandchildren, do they get a step-up in basis? Do they get that money tax-free? 

Zach – Absolutely not. 

Michael – No way, all fully taxable, a hundred percent taxable. So in other words, what this article is talking about and by the way, I kinda printed it out here. The articles what it’s really talking about is saying, “Hey, you need to recognize different types of accounts have different tax rules if you hold them outside of an IRA or inside of an IRA. And if you understand those different tax rules then you can optimize your accounts, you can hold the right types of assets in the right types of accounts.” We like to call this account location, account placement or I’m sorry, asset location, asset placement. And that’s really important. So, let me kind of lay out for you, the Cliff Note version of what assets should go in what accounts, right? So you ready for this Zach? 

Zach – Yup. 

Michael – IRAs, here’s the thing to understand, whenever you have IRAs, 401ks, 403bs, when you’re working, they’re great. But once you retire worst account, you can possibly own from a tax perspective. It’s as bad as it gets. Every dollar coming out is taxable. It’s taxed at your highest-tax rate. It’s the worst account to leave to a surviving spouse. The only account that forces you to pull money out whether you want to or not. They are by far from a tax perspective now, worst account to own in retirement. 

Zach – Right. 

Michael – So do you want those accounts to grow like crazy? It’s like ‘Hey, I’ve got 500,000 in the worst account I can own from a tax perspective, I got a great idea, let’s grow it, let’s double it. Let’s grow it to a million dollars.” Do you want to grow aggressively, the worst possible tax account you can have? 

Zach – Absolutely not. 

Michael – No! You might wanna grow when you’re working. But not when you’re retired. 

Zach – Right. 

Michael – Also, and this is key, growth types of investments are normally stock oriented. When you hold stock accounts or stock investments inside of an IRA or a 401k, you are giving up all the tax benefits. Which you don’t wanna do, instead what you wanna hold in retirement in your 401ks and IRAs, you want to hold all of your safe investments, to the degree that you can. So that means that’s where you hold your bonds and your fixed income. That’s where you hold your fixed annuities or your fixed indexed annuities. That’s where you hold your CDs and cash. It’s like here, because, why? All the growth in those accounts they’re taxed the same way as your IRA. 

Zach – Right. 

Michael – So what you’re doing is you’re matching inside of IRAs and 401ks, you’re matching investments that are taxed the same way and that are lower growth investments because you want those accounts to grow more slowly. Otherwise you’re gonna have incredible tax nightmares in your retirement. 

Zach – Right. 

Michael – Now what about a Roth IRA? Let’s look at a Roth, for most people a Roth IRA is the last money that they ever touch. So that’s the longest time horizon. So Zach, if we have a long time horizon what does that tell us about money… about the investments we can hold within that account? 

Zach – They need to be safe. 

Michael – Other way around. 

Zach – They need to be aggressive? 

Michael – Yeah, see, this is great because I love asking you these questions because you’re answering like most people answer. The reality is when we have a long time horizon, that’s where we can invest more aggressively. That’s where like think about it, you’re 26. You have a long time horizon to retirement. You can invest more aggressively than someone who is 66 right? 

Zach – Right. 

Michael – So in a Roth IRA, if we have a long time-frame before we’re likely to touch money that’s where we can invest more aggressively. That’s where we put our stocks. And here’s the best part. That’s a tax-free account which means it’s tax-free forever. It’s tax-free to you. It’s tax free to your surviving spouse. It’s tax-free to your children and grandchildren. So, hey, we want if we’ve got a tax-free account do we want the most growth there possible or the smallest growth possible? 

Zach – Lot of growth. 

Michael – We want the most. 

Zach – Right. 

Michael – That’s where our most aggressive investments go. Then in our after tax accounts, like that’s a joint investment account or a personal investment account. That’s where you’re gonna hold your individual stocks as well. It’s a good place for individual stocks. If you’re going to hold fixed income there, that’s a great place for municipal bonds, because they’re tax-free you know, things of that nature. So IRAs 401ks, to the best of your ability, cause here’s the problem we don’t live in a perfect world. So, you know, you might have all your money in IRA and so there’s nothing you can really do about it. But if you have IRA dollars, Roth dollars and after-tax dollars to the degree that you can, you put your safer investments in the IRAs you put your riskiest investments in the Roth IRAs and then in the after-tax accounts, it’s kind of in between, but that’s where you put individual stocks, your index funds and municipal bonds. That’s how you break it up. And that’s what this whole article is talking about. So key point, if you look at your investments, or you look at your different accounts and every account is set up pretty much exactly the same way, that might be okay but odds are you could use a little bit better asset placement or asset location than what you have now. 

Zach – Right Mike, let me ask you this question. If I’m somebody who really is looking to improve my asset location, especially if retirement’s on the horizon, you know, the next two to three years what should I do immediately? What should my first step be? 

Michael – The first step is you’ve gotta talk to a Retirement Planning Specialist someone that understands this stuff. For those of you who are clients who are watching we already do this for you. Or if you’re listening in, for those of you who are not clients if this is something that’s you want looked at, you wanna, you know maybe have someone just kind of look over your shoulder make sure that you’re doing the right thing. You can always give us a call. I mean, our number here, 512-265-5000 pretty easy to remember. You can email us, Zach. Email Zach. He’s the one that’s best, he takes and you know everybody that sends in their emails and they want to talk to an advisor he kind of you know, helps you identify the right person in the office to talk to. Zach, what’s your email? Z-A, spell it out. 

Zach – Z-A-C-H@cen. That’s C-E-N 

Michael – There you go, send Zach an email. You know why I keep messing this up Zach? It’s because we have a dog as you know, named Zac and his name is spelled Z-A-C. So I keep, you are an H at the end. I’ll eventually get there. I apologize that I can’t seem to get that straight. You can whack me over the head with I don’t know. 

Zach – You finally remembered my age though. 

Michael – At least I got that, you know, remember when we were kids, we’d whack each other over the head with the empty Christmas tree you know, the Christmas… the present rappers. 

Zach – Yup. 

Michael – The Christmas wrapper tube, right there. 

Zach – I remember. 

Michael – Next time you can whack me over the head neck as we come into the Christmas season. So anyway, listen, great discussion today. We’re going to wrap this thing up. Hopefully you enjoyed this, if this is informative, you like it. You can always forward this to your friends and relatives and neighbors and you know, all that kind of stuff. But give us a shout if we can be helpful and or send Zach an email. But I think that kind of wraps us up today, doesn’t it? 

Zach – Absolutely, just one more point I wanna make before we hop off Mike we often say on our radio show and on TV and on these podcasts an investment plan is not a retirement plan. And I think that was very clear today in this discussion. 

Michael – Yup, great, great conversation, yeah that’s a very good perspective. All right, hope you all have great rest your day. We’ll talk to you again next week. 

Zach – Thanks everyone. 

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