A Review of Asset Location Strategy

Asset location (different from asset allocation but inclusive of those concepts) involves determining which assets (growth, income, taxable, tax-free, tax efficient, tax-inefficient, etc.) should be applied to which account types (taxable, pre-tax, and tax-free) to maximize the risk-adjusted, final after-tax benefit based on the time horizon associated with each account.

Time horizon, or the time to which that investment would have to be sold to fund spending needs, is generally the most central part of building an effective asset location strategy. 

In the accumulation phase, this is simple: focus on growth across all account types (assuming the appropriate emergency fund is in place and other short-term goals are covered elsewhere). Generally, you would want tax-efficient (growth) investments in taxable accounts and non-tax-efficient growth investments in tax-sheltered accounts.  

The time at which asset location becomes more challenging to manage is as you approach and enter the spend-down phase. As you approach retirement (the spend-down phase), it can be meaningful to acknowledge that not all of your accounts have the same time horizon. It can be advantageous to spend from certain account types first and delay drawing from other account types until later. A commonly accepted order of distribution would be to pull from the following account types in the following order:

1. Taxable Account
2. Pre-Tax 
3. Roth 

By starting with the taxable account(s) first, you accomplish two things:

1. It allows your pre-tax and Roth dollars to continue growing tax-deferred. The lack of a tax drag year after year adds to compounding growth in both pre-tax and Roth retirement dollars.  
2. It allows you to pay less in taxes now (capital gains versus ordinary income). Simple time-value-of-money concepts illustrate that saving more or spending less earlier is always better, supporting this spending pattern. 

After determining your spending pattern by account, you can build a strategy around asset location. If you have all three account types, it might be good to start with the taxable account and determine what you need to allocate to bonds to cover the first few years of the draw on the account in the event of a prolonged downturn in the equity market. There are different philosophies regarding whether it is best to draw from both asset classes on a pro-rata basis according to the target objective or whether it’s better to pull down from bonds first and allow the equity allocation unencumbered appreciation (i.e., rising equity glide path). This is a topic for another day. For this conversation, we will assume periodic liquidations of both asset classes as long as they’re doing reasonably well.  

The goal of allocating enough to bonds to cover 4-5 years of withdrawals is not to maximize returns but to position yourself to be resilient to unexpected market events. You are creating a risk/return barbell to avoid extreme losses through a poorly timed market downturn (happening concurrently with a portfolio drawdown) while also maintaining enough growth (through the stock allocation) to support a 20-30-year retirement time horizon.

Once the taxable account has been structured with the appropriate risk-return profile to preserve near-term assets and support sustained long-term withdrawal, you can move to the opposite end of the spectrum: the Roth IRA. Following the simplistic approach outlined in this article, this would be the last “bucket’ of money that would be drawn on to support retirement living expenses. Therefore, it has the most extended time horizon and can be structured to achieve the highest levels of growth.   The Roth account would be funded with tax-inefficient growth investments.  

At this point, you would reevaluate and review what you have done: the taxable account is structured appropriately to cover the initial withdrawal, the Roth IRA is invested to maximize returns, and you are left with the traditional or pre-tax dollars. At this point, you would use the pre-tax account to select whatever allocation that would balance the global portfolio to the overall allocation you are aiming for within your risk tolerance (also, if possible, planning for required minimum distributions (RMDs) with an allocation to money market or bonds depending on the time horizon to the required beginning date to lessen volatility on that near-term liquidity event.  

To provide an example, we can assume the following:  You are 65 years old and retiring with $3 million spread across taxable accounts ($900,000), pre-tax/traditional ($1.5 million), and Roth ($600,000). You will have some pension and social security income, but will need to draw about $100,000 per year from investments to live on (roughly 3.5% of the total portfolio).  

• Taxable Account: You could invest in the taxable account 20/80 (stocks/bonds), which would give you enough of an allocation to bonds ($720,000) to cover about seven years of distributions at $100,000 (not considering returns or inflation).  
• Roth: The Roth ($600,000) could be allocated 100% of the stock since you would have to completely deplete the other two account types before needing liquidity from the Roth.  

• Pre-Tax/Traditional: Finally, to achieve the overall asset allocation that you are comfortable with from a risk standpoint, you could invest the pre-tax or traditional account 70/30 (stocks/bonds) to attain the 60/40 portfolio-level allocation. This 70/30 approach also provides some exposure (30%) to bonds in anticipation of required minimum distributions (RMDs).