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From Our Blog

The Mathematics of Asset Location

Our recommendation on asset location is to prefer holding tax-inefficient assets in tax-advantaged accounts. In our view, the expected return of an asset is close to irrelevant when determining where to locate it. This guidance applies to Roth as well as to traditional IRAs. For many, this can seem counterintuitive, given that much of what investors find in the financial media generally discusses locating the highest-expected-return asset classes in the Roth account.

This article is broken into two sections. First, we will discuss how a security’s expected return and risk characteristics can change based on where the asset is located. Second, we will walk through a Roth-versus-taxable-account asset location decision using after-tax asset allocation.

Section One: Asset Location’s Effect on Expected Return and Risk

The following table indicates the principal effectively owned by, return received by, and risk borne by individual investors in each savings vehicle. As shown, in contrast to bonds and stocks held in a Roth IRA, for bonds and stocks held in a tax-deferred account, the investor effectively owns each dollar of principal multiplied by one minus the tax rate on it but receives 100 percent of the returns and bears 100 percent of the risk.

Savings Vehicle Principal Return Risk
Roth IRA 100% 100% 100%
Tax-deferred account 1 – tax rate 100% 100%
Taxable account
 Bonds 100% 1 – tax rate 1 – tax rate
 Stocks 100% 1 – tax drag 1 – tax drag

To illustrate the risk and return sharing of bonds held in taxable accounts, we assume bonds have a 3 percent expected return and a 4 percent standard deviation (a measure of risk), as well as that the investor is in the 25 percent tax bracket. We also assume bonds earn returns of -1 percent, 3 percent and 7 percent in three years; that is, they earn the mean return and one standard deviation below and above it. The standard deviation of these returns is 4 percent. Assuming the 1 percent loss is used to offset that year’s taxable income, the investor’s after-tax returns are -0.75 percent, 2.25 percent and 5.25 percent for a standard deviation of 3 percent. In this case, the investor receives each dollar of pretax return minus the tax rate on it and bears each unit of pretax risk less the tax rate.

When stocks are held in taxable accounts (with cost bases equal to market values), the investor owns 100 percent of the principal, but their after-tax return and risk is reduced by a tax drag, specifically the taxes due on dividends and realized capital gains. The tax drag number depends upon how actively the stocks are managed, but for purposes of this example, we will assume that 15 percent of the return on stocks is lost to taxes each year. (This effectively assumes that all capital gains are realized 366 days after the stocks are purchased.)

To once more illustrate risk and return sharing properties of taxable accounts, we assume stocks have a 7 percent expected return and a 19 percent standard deviation. Stocks, we further assume, earn pretax returns of -12 percent, 7 percent and 26 percent in three years; that is, they earn the mean return and one standard deviation below and above it. The standard deviation of these returns is 19 percent. If the loss is used that year to offset long-term capital gains, the after-tax returns are -10.2 percent, 5.95 percent and 22.1 percent for a standard deviation of 16.15 percent (or 85 percent of the pretax standard deviation).

The key message from these examples is that the same underlying asset can have different expected return and risk characteristics depending upon the type of savings vehicle in which it is located.

Section Two: Asset Location and Roth IRAs

Using the framework from the first section, we can evaluate asset location decisions when it comes to Roth IRAs versus taxable accounts. This section assumes the investor will use all assets in his or her lifetime and is not designating Roth accounts for future heirs. If the investor is designating the Roth for heirs, then this account is effectively being managed for a purpose other than retirement and should have its own Investment Policy Statement.

The following are our capital market and tax assumptions:

Expected return on stocks  7.0%
Expected return on bonds  3.0%
Standard deviation on stocks 19.0%
Standard deviation on bonds  4.0%
Tax rate on stocks 15.0%
Tax rate on bonds 35.0%

Assume that our hypothetical investor has $200 split evenly between a taxable account and a Roth. Let us also express the investor’s risk tolerance in terms of acceptable volatility, and, in this case, the client is comfortable with a portfolio after-tax standard deviation about 9.7 percent.

One way to accomplish this would be to locate $100 of bonds in the taxable account and $100 of stocks in the Roth account.* The following table has the results:

Scenario 1: Incorrect Location
After-Tax Expected Return After-Tax Expected SD Start $ End $    Pre Tax End $ After Tax
Taxable account Stock 6.0% 16.2% $0.00 $0.00 $0.00
Bond 2.0% 2.6% $100.00 $103.00 $101.95
Roth IRA Stock 7.0% 19.0% $100.00 $107.00 $107.00
Bond 3.0% 4.0% $0.00 $0.00 $0.00
Total   4.5% 9.6% $200.00 $210.00 $208.95

The portfolio has an after-tax expected return of 4.5 percent and an after-tax standard deviation of 9.6 percent. At the end of the one-year period, the investor wound up with $208.95.

An alternative way to get to the 9.7 percent after-tax standard deviation would be to locate the assets in the optimal manner, with $100 of stocks in the taxable account and a 15/85 mix in the Roth account.*

Scenario 2: Correct Location
After-Tax Expected Return After-Tax Expected SD Start $ End $    Pre Tax End $ After Tax
Taxable account Stock 6.0% 16.2% $100.00 $107.00 $105.95
Bond 2.0% 2.6% $0.00 $0.00 $0.00
Roth IRA Stock 7.0% 19.0% $15.00 $16.05 $16.05
Bond 3.0% 4.0% $85.00 $87.55 $87.55
Total   4.8% 9.7% $200.00 $210.60 $209.55

The after-tax standard deviation of Scenario 2 is roughly the same as Scenario 1, even though the portfolio contains a higher allocation to stocks. The reason for this is that the government shares in the volatility of the stocks held in the taxable account. The after-tax expected return is higher in Scenario 2 than in Scenario 1, and the investor winds up with $209.55 at the end of a year.

The key insight from Robert Dammon, Chester Spatt and Harold Zhang’s 2004 Journal of Finance paper, “Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing,” is that Scenario 2 will have a higher after-tax expected return than Scenario 1, regardless of what the stock and bond returns are, as long as the following two conditions are met:

1. The tax rate on bond interest is greater than the tax rate on stock gains and dividends.

2. The interest rate on bonds is positive.

This is true even if we assume all stocks are taxed every year. In reality, some of the stock returns are tax-deferred even if the stock holding is in a taxable account. The size of the improvement in after-tax returns is exactly equal to the interest rate on bonds multiplied by the difference in tax rates.

Let’s look at one more scenario where the investor’s risk tolerance is expressed in terms of actual dollars allocated to stocks and bonds. In this scenario, we will say our investor wants a 50/50 asset allocation.

Scenario 1 still applies, but Scenario 2 has too much invested in equities. Scenario 3, then, locates $100 of stocks in the taxable account and $100 of bonds in the Roth.*

Scenario 3: Correct Location
After-Tax Expected Return After-Tax Expected SD Start $ End $    Pre Tax End $ After Tax
Taxable account Stock 6.0% 16.2% $100.00 $107.00 $105.95
Bond 2.0% 2.6% $0.00 $0.00 $0.00
Roth IRA Stock 7.0% 19.0% $0.00 $0.00 $0.00
Bond 3.0% 4.0% $100.00 $103.00 $103.00
Total   4.5% 8.3% $200.00 $210.00 $208.95

Scenario 3 provides exactly the same after-tax expected return as Scenario 1, but with less volatility. The reason for this is that the government is partaking in the volatility of the portfolio’s stocks.

It is important to recognize that the government shares in the risk and return of assets located in taxable retirement savings vehicles. Therefore, a bond or a bond fund held inside a Roth is effectively a different asset than the same bond or bond fund held in a taxable account. Using the assumptions from our last example, the return and risk for a bond held in a Roth IRA are 3 percent and 4 percent, but only 2 percent and 2.6 percent for the same bond held in a taxable account.

By employing this framework, we learn that the best assets to hold in the taxable account are those that make the best use of the preferential long-term capital gains treatment. This will typically be stocks, as long as the investor is willing to avoid short-term capital gains.

* This scenario is hypothetical and being presented for illustrative purposes only. It relies on the capital market assumptions cited in this article.

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of The BAM ALLIANCE®. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2018, The BAM ALLIANCE®

The Basics of a Spend-Down Strategy

Almost every client we talk with emphasizes one primary, overriding goal: having enough money in retirement. Most do not know how much money they need to save, or the planning process to get there. To provide the answers, we work collaboratively with clients to develop an overarching spend-down strategy designed to minimize taxes in their retirement and legacy plans.

By dividing their financial life into four timeframes, we can focus on the present but explain to clients the plan’s future benefits. Those timeframes are accumulation, blackout, spend-down and legacy. The overarching constant of these four stages is taxes. Our goal is not to help clients structure their affairs simply to pay the least amount of taxes each year. Rather, it is to create a framework that helps a family lose the least amount to taxes over a lifetime. Let’s look at these timeframes and, for each, provide examples of what strategies can be most beneficial.

Accumulation: This period begins with the first day of a career and ends when earning years cease. Some of the most common accumulation strategies are these:

  • Begin saving as early, and as much, as possible.
  • Take advantage of any employer match offered in a 401(k) plan.
  • Choose between Roth and traditional retirement accounts based on both current and future expected income tax brackets.
  • Build a globally diversified portfolio using an evidence-based approach.
  • Choose an allocation between stocks and bonds that matches your need, willingness and ability to take risk.
  • Choose the right location, that is, type of account, for holding stocks and bonds. Specifically, match ordinary-income-producing assets (bonds) with ordinary-income-tax accounts (401(k)s and IRAs). Match dividend- and capital gain-producing assets (stocks) with accounts that take advantage of preferential tax rates on those dividends and capital gains, and that allow a tax-free step-up in basis at death (joint or individual brokerage accounts).
  • Manage the financial hardship of a premature death by securing adequate and appropriate life insurance.
  • Plan for disability or premature death with powers of attorney and a will.
  • During the final earning years, when your marginal tax bracket generally is highest, fund a donor advised fund with appreciated stock worth several years of charitable contributions.

It may seem like the majority of the time and effort required to construct a comprehensive financial plan goes into formulating and executing these strategies, perhaps because they tend to get the most front-end attention or because the accumulation period is one of the longest. However, the way clients maintain and distribute the nest egg they’ve spent decades building can be just as important as the way they accumulate it, and can have a lasting impact on a family’s wealth.

Blackout: This period begins at the end of employment and ends at age 70½. It can be several years or nonexistent. Strategies useful during this time can be counterintuitive, because recommendations to pay more income taxes than necessary now can seem difficult. However, it is important to take the long-term view and avoid the common objective of always paying the least amount in taxes in the current year, focusing rather on taxes that can be saved in the future by taking advantage of potentially lower tax brackets during this timeframe.

Estimate what the marginal tax bracket after age 70½ will be if no planning is done, and consider converting a traditional IRA to a Roth IRA, thus shifting income into a lower tax bracket. Determine the optimal Social Security claiming strategy while efficiently transitioning from an employment paycheck to a paycheck from savings. Review the purpose and/or need for life insurance, and, finally, analyze supplemental Medicare policies and choose one best suited for your individual circumstances.

Spend-down: This period begins in the year you turn age 70½ and continues for the rest of your life. This is the age when the government mandates that investors begin taking required minimum distributions from their retirement accounts. The goal in this period is to use the funds you’ve accumulated to maintain your lifestyle.

Strategies during these years usually focus on after-tax, risk-adjusted returns. Review your choice of allocation between stocks and bonds to ensure it continues to match your need, willingness and ability to take risk. Start each year with an understanding of where funds will come from to support your income needs and lifestyle. Project adjusted gross income to control the impact on future Medicare premiums. In addition, consider donating to charity directly from an IRA and use the standard deduction to minimize taxable income. Sell equities with a high cost basis when necessary to fund your lifestyle, and take advantage of market downturns to harvest losses to lower taxes. Perhaps name a charity as your IRA’s beneficiary. It’s also vital to review estate-planning documents periodically and change them to adapt to your changing circumstances.

Legacy: Ultimately, this period occurs after your death, but the choices to make during your lifetime involve how much you will give to heirs, charity or the government at your death. Most of the strategies to limit the amount that goes to the government in taxes are put into place years before the end of life. Examples include equalizing the ownership of equities between spouses to take advantage of the step-up in basis on the first spouse’s death (this allows a surviving spouse to reduce equity risk, if desired, without income tax), revising beneficiary designations after the death of a spouse, selecting the best assets to give to charity, choosing the best assets to give to heirs, and preparing heirs for the transfer of wealth through lifetime gifts and/or family meetings.

Developing a spend-down plan is personal and unique to each individual, couple or family. An advisor in this arena must be comfortable and proficient in the worlds of investments, income tax, estate tax, insurance and charitable planning, to name but a few. The savings and peace of mind realized with a well-constructed and regularly reviewed plan are difficult to measure in dollars and cents. Clearly, those without a plan can suffer hardships they may not overcome. Why would anyone allow the latter to occur when proper planning, if it’s begun soon enough, can help avoid this outcome entirely?

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of The BAM ALLIANCE®. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2018, The BAM ALLIANCE®

Important To-Do’s Before Sending Your Child Off to College

The day has come. Your little baby has grown up and is now ready to leave the nest. He or she has graduated high school and the next big step is awaiting. Whether it’s college, a gap year, a year abroad or any other life adventure lies ahead, this time can be filled with much emotion for you and your child.

As departure day gets closer, you’re probably focusing on last-minute shopping lists and feeling overwhelmed with trying to get everything done in time. Of course, you have already visited Walmart, Target and IKEA for the dorm room basics, purchased the new computer (yes, that is a 529 College Savings Plan qualified expense), figured out the move-in logistics, and coordinated with the roommate about who will bring what.

Congratulations, you are well on your way. However, you might not be finished just yet. The following are six important tasks you may have overlooked.

  1. Make an appointment with your attorney to create a durable power of attorney document for financial matters and a health-care proxy.

Without them, in most states, you, as a parent, don’t have authority to make health-care decisions or manage money for your children once they turn 18. That’s true even if you are paying the tuition, have your child on your health insurance plans, or claim your child as a dependent on your tax returns. Without such documents in place, if your child is in an accident and/or becomes disabled, even if only temporarily, you might need court approval to act on your child’s behalf.

  1. Establish a monthly budget for your child.

The precise amount agreed upon in said budget is a personal discussion. However, it is especially important to set clear expectations about who will pay for what expense. Maybe you agree to pay for all school-related expenses and it’s your child’s responsibility to pay for all or some of the social expenses. Don’t spring this conversation on your child as you arrive on campus. Discuss it early enough to allow your student time to find a good summer job to earn and save money for the upcoming year.

  1. Determine whether your child will receive a credit or debit card and set rules around when to use each.

Educate your child on the difference between the two and, based upon your child, decide which is the better option. There are advantages and disadvantages with each. If your child is just starting to learn how to budget and balance a checkbook, beginning with a debit card may be best, especially for general daily expenses. Leave the credit card for larger expenses, such as travel arrangements, and emergencies.

Two important benefits of using a credit card are the ability to create a credit history and its better security. Building a credit history can work two ways – you can create a positive credit record or a negative one – so it’s imperative you educate your child on the proper way to use a credit card. Pay off the balance every month, don’t overspend, don’t assume mom and/or dad will bail you out every time, and understand how interest charges and late fees add up and are cumulative. Frank Abagnale, of “Catch Me If You Can” fame, explains that consumer protection law treats debit and credit cards very differently. Under federal law, your personal liability for fraudulent charges on a credit card might not exceed $50. But, if a fraudster uses your debit card, a direct line to your bank account, you could be liable for $500 or more, depending on how quickly you report it.

Some simple steps you, as a parent, can take:

  • Co-sign on the card.
  • Start with a low credit limit.
  • Ensure you have online access to the card.

Get ahead of the onslaught of credit card solicitations your student will receive. Advise your child simply to ignore and discard them.

In just a few years, your child will begin life fully on his or her own. Your child will need to sign an apartment lease and perhaps buy a car. While you can and will probably need to co-sign, how much better will your child feel if he or she already has established some positive credit history?

  1. Once on campus, make sure you and your child know where the closest hospital, urgent care and 24-hour pharmacy are located.

Ask your regular doctor or a trusted family member or friend familiar with the school or town if they know a good physician in case your child needs medical attention above what the college health center can provide. Make sure your child carries his or her health insurance card and you have reached an agreed-upon way to pay for any medical expenses. Does your child know when to use the credit card versus the flexible spending or health savings account (HSA) card? Remember to pack your child a simple medical kit with the essentials (bandages, anti-bacterial cream, cold and flu medicine, etc.).

  1. Have your child write down all passwords to any digital profiles, including financial and social media accounts.

Keep this in a safe place at home. Your child may not like this, but explain that you are not doing it to invade privacy, but to protect it in case of an emergency. I recommend you review this list with your child before each new school year in case any passwords have changed. On a related but separate note, have you and your spouse shared this information between yourselves? You probably should.

  1. Talk to your insurance agent and ask about covering your child’s belonging while they are living on or off campus.

The premiums associated with a dorm insurance policy or a renter’s insurance policy vary, but affordable options generally are available. Make sure the coverage amount and deductible of any policy you consider are appropriate for your and your child’s specific circumstances.

While my list of must-do items can help ensure you meet certain financial and other important needs before the first day of new student orientation, don’t let prioritizing the emotional aspect of dropping off your child at college for the first time get lost in the commotion. Indeed, this event can be a special opportunity to connect with your child.

Marshall Duke, a professor at Emory University, offers some wonderful advice on this topic. He writes: “It is a moment that comes along once in a lifetime. Each child only starts college once.… Such moments are rare. They have power. They give us as parents one-time opportunities to say things to our children that will stick with them not only because of what is said, but because of when it is said.

“Here is what I tell the parents: think of what you want to tell your children when you finally take leave of them and they go off to their dorm and the beginning of their new chapter in life and you set out for the slightly emptier house that you will now live in. What thoughts, feelings and advice do you want to stick? ‘Always make your bed!‘? ‘Don’t wear your hair that way!‘? Surely not. This is a moment to tell them the big things. Things you feel about them as children, as people. Wise things. Things that have guided you in your life. Ways that you hope they will live. Ways that you hope they will be. Big things. Life-level things.”

Duke suggests writing your child a special note, starting it with something like, “When I left you at the campus today, I could not tell you what I wanted to say, so I’ve written it all down.” Mail it, the old-fashioned way. He writes: “It will not be deleted; it will not be tossed away; it will be kept. Its message will stick. Always.”

It may take time for you and your child to adjust to this new stage of life. At the beginning, it may help to think of your child as a high school student now in college. Your child will need to learn how to become a college student – how to study, how to eat, how to handle money – and thrive amid the greater independence. So don’t be too hard on your student. This is a time to experience new things, and remember that your child will learn many of the most important lessons to prepare for life ahead outside of the classroom.

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of The BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2018, The BAM ALLIANCE®