The Importance of Asset Location

Transcript

Hi, I’m Brent Sullivan. Let’s talk about the importance of asset location.

While asset allocation decisions may explain most of a client’s pre-tax returns, asset location strongly influences what remains after taxes.

Asset location is the process of choosing which accounts to place investments in based on tax treatment and wrapper.

Assigning investments to the right account type is a simple, powerful lever for improving after-tax outcomes.

In this image, each account mirrors a client’s overall asset allocation. While straightforward, this approach overlooks the opportunity to align asset location with tax efficiency in mind.

On the other hand, in this image, assets classes are thoughtfully placed in the most appropriate account types to improve tax efficiency. The client’s exposure to each individual asset class remains the same at the aggregate level.

To reiterate, both approaches have the same total aggregated asset allocation, but the second approach considers the features of the asset classes and assigns them appropriately.

Let’s explore how the intersection of investment features, vehicles, and account types can help shape after-tax outcomes.

Let’s start with investment features on a spectrum of least tax efficient to most tax efficient. At the less efficient end, we have investments producing tax-inefficient distributions, including ordinary income, short-term capital gains, and non-qualified dividends, as well as those with high levels of turnover.

At the middle of the spectrum are investments which generate long-term capital gains and qualified dividends, benefiting from lower, preferential tax rates. These features are more tax-efficient yet still trigger annual tax exposure in taxable accounts.

At the most efficient end, we have investments which distribute tax-exempt income or a return of capital, and investments which realize long and short-term losses through tax-loss harvesting. These losses can offset capital gains to help defer taxation, depending on the investment vehicle where they’re held.

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Now let’s look at investment vehicle selection, again from least to most efficient.

Mutual funds are generally less tax efficient. They distribute capital gains annually and have less control over capital gains realization than exchange-traded funds. As mutual funds are commingled vehicles, distributed capital gains can be the result of other shareholders behavior. If number of shareholders are redeeming from a mutual fund, the portfolio manager will need to sell underlying assets to create liquidity, which could create a tax bill for the remaining shareholders. Although not listed, I would include most alternative investments at the inefficient end of the spectrum.

Exchange-traded funds improve upon these inefficiencies. As is indicated in their name, ETFs trade on an exchange. You do not redeem from an ETF, you divest by selling it in the open market. Additionally, rebalancing of the underlying exposure can be done through an in-kind redemption process to help defer capital gains and minimize the passthrough of surprises come tax time.

While investment managers of ETFs and mutual funds may utilize tax-loss harvesting, losses generated are not portable to the end client and remain inside the vehicle.

Separately-managed accounts are the most flexible. Clients own each position directly, allowing for in-kind funding, tax-efficient cash raises and customization around exposure or values-based goals. Due to their structure, tax-loss harvesting activity within an SMA allows for portable losses to be used to help offset gains across a client’s portfolio.

You’ll notice here that we’ve flipped the scale to evaluate from most tax-efficient to least tax-efficient.

Tax-exempt accounts, such as Roth IRAs, are the most tax-efficient as they can grow and distribute tax-free, making them ideal for sheltering inefficient income or turnover-heavy strategies.

Tax-deferred accounts, like traditional IRAs, delay taxes until withdrawal. At that point, the distributions are usually taxed as ordinary income.

Taxable accounts are technically the least tax-efficient because they expose investments to current-year taxation; however, taxable accounts open the door to tax management techniques such as loss harvesting.

Let’s put it all together. To summarize, features, vehicles and account types all live on a spectrum of tax efficiency.

Advisors should consider aligning the least efficient features and vehicles into tax-exempt and tax-deferred accounts to minimize tax drag and shelter clients from tax inefficiencies.

On the other hand, the most tax-efficient features and vehicles should ideally be placed in taxable accounts where their benefits, such as losses passed through from ongoing tax management, can be fully realized.

The views expressed, which may include forward-looking statements, are those of the speakers and are as of the date of this event only and may not necessarily come to pass. These views are subject to change at any time based upon market or other conditions, and the investment adviser disclaims any responsibility to update such views.

This material is a general communication, which is not impartial and all information provided has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.

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Eaton Vance and Morgan Stanley Investment Management (MSIM) do not provide tax advice. The tax information contained herein is general and is not exhaustive by nature.

Eaton Vance and Parametric are part of Morgan Stanley Investment Management. Morgan Stanley Investment Management is the asset management division of Morgan Stanley.

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