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Last week I discussed how time affects your portfolio allocation. Once we’ve agreed on the overall allocation, we consider the next step…location. There are three factors we need to consider…taxation of gains; potential and known cash needs; and restrictions.

 The easy way…

I worked for a firm many years ago who basically mirrored the same allocation in each account. In other words, if they believed a 50% stock allocation was best; they invested the Roth IRA, the Traditional IRA and the taxable brokerage account with the same allocation and often similar sub asset classes. The reason they invested this way was interesting.

They got sick of explaining why the Roth IRA performed better (or worse) than the taxable account or Traditional IRA. Even if they believed there was value in locating certain asset classes into specific accounts; they felt the time spent explaining why didn’t offset the value.

Building a similar portfolio in each of the accounts is also easier for those who use models. They plug the account value into a program and it recommends trades. With today’s technology, it likely uploads the trades directly. A tell-tale sign of a computer-generated solution is the account that bought one or two shares of many positions.

The examples create simple execution and perhaps less challenging conversations, but your portfolio won’t look like this.

 Accounts are taxed differently

After deciding on the overall allocation, we consider which asset class should be placed in which account…the location. For our example today, let’s assume all three taxable options are available. You have a taxable account, a traditional IRA and a Roth IRA. Your example might include a 401k (or similar plan), with traditional or Roth options. But, for now, let’s focus on the three so we can keep this post simple.

When considering your taxable account, your initial contribution is after-tax. In other words, you have already paid income taxes on the contribution. Taxation on your gains will be based on whether the gains are capital gains or income. When considering capital gains, we can control whether they are long term (held more than one year) or short term. Current tax code rewards you (taxes at a lesser rate) for long term gains over short term. Income is for the most part, taxed at the higher ordinary income tax rate (there are exceptions, but again…keeping it simple).

You do not pay taxes on your contributions when considering a traditional IRA (or 401k). The contributions are considered pre-tax which means taxes will be collected later. In other words, your gains (and taxation of contributions) are tax-deferred. They will be taxed as ordinary income based on your situation when you withdraw. The idea makes the most sense when your tax obligation is higher today than when you withdraw.

Finally, let’s consider the newest option. With a Roth IRA (or 401k), your contributions (or conversions) are taxed today at your current tax rate. I reviewed time and potential changes a couple of weeks back, so I will ignore today. The benefit of being taxed today…paying a known cost…is that the growth of the portfolio is tax free. This is different than tax deferred. When you withdraw funds (assumed followed rules), you are not taxed on the gains (or the original contribution). You can withdraw contributions at any time (you already paid taxes). You must follow the restrictions when withdrawing gains.

 Taxation matters

Different taxation creates opportunities as we consider location. We need to review your plan before making a recommendation. But, there are a few simple starting points that will apply to many situations.

Certain asset classes tend to pay a good portion of their gains in the form of dividends or interest (usually bonds). In most cases, the distributions will be taxed at your current tax rate. Other asset classes typically provide return through appreciation in price. In this case, you will be taxed based on the amount of gain and the time held.

You may quickly realize that without additional constraints, the asset classes that pay income and dividends may be best located in your tax-deferred and tax free accounts. The positions that don’t, may be better located in your taxable account where you can control when taxes are taken and determine if held long term versus short term. Losses can also be used in taxable accounts. Losses add no tax value in tax deferred or tax free accounts.

 Potential and known cash needs matter

After considering taxation, you may think this is easy. Put the “non-tax-friendly” asset classes in the tax deferred and tax free accounts and put the “tax-friendly” asset classes in the taxable account.

Simple…let’s move on…but hold up. Before we determine location, we need to consider cash needs.

Cash needs come in two varieties. First is the known need. This often takes the form of retirement funding, college funding or a large purchase. We can prepare for these. The other expense is unknown. Common examples include losing income or an unexpected expense. We consider but can’t necessarily prepare for them.

 Known cash needs

The most common example is the funding of retirement. For that reason, I will begin with this example. One of the most common questions is “from where will I pay my expenses once I give up my paycheck?” The answer to the question leads to asset location.

As you prepare to enter retirement, we’ll discuss your likely cash needs. After measuring your needs, we’ll determine from which account you will likely take withdraws first. Most planning programs assume you withdraw from your taxable account first, your tax-deferred second and finally your tax-free account. This is a good starting point when all else is equal. Let’s start with the assumption that all else is equal…in other words, we’ll ignore constraints and taxation for a few minutes.

Without other consideration, your account could be invested in the order of risk. If we assume you spend all your taxable assets first, followed by tax-deferred and finally tax-free, we could simply put the least “risky” asset class in the taxable account (spent first). If after filling that “bucket”, we had additional cash, we would invest in the next “risky” asset class. We would continue until all the taxable money was invested.

Then, we would follow the same process for the tax-deferred account and finally place the “riskiest” asset classes in the tax-free account. But, we can’t and won’t assume all else is equal.

We need to consider taxation of the asset classes. Less “risky” asset classes are often not tax friendly. In today’s low interest rate environment, this is a lesser concern, but it remains a consideration. If we placed all the low risk/tax unfriendly assets in your taxable account (based on cash need model), you might have a higher than desired tax obligation.

 Buckets have become a common theme

I believe this idea gained attention with the publication of a book authored by Raymond Lucia. When considering cash flow needs, especially when considered as part of retirement funding the idea of separating investments into “buckets” can be appealing.

In this scenario, investments are matched with specific needs. As an example, your short-term expenses would likely be matched with short term bonds (low volatility). Your furthest cash needs might be funded with commodities or emerging market stocks (high volatility). The theory is the risky asset class has plenty of time to fluctuate (and hopefully grow) before it is called on to fund a goal. This is a simplified version, but I expect most reading this post have heard of the bucket concept.

As we consider your cash flow needs, we will consider the bucket concept. We’ll attach your near-term goal with a low volatile asset class and place it in the account from which we expect you will withdraw the funds.

In most cases, we earmark a certain amount of funding to specific investments. The reason we do this is to provide a plan from where we would fund goals if the market was flat or equities suffered. I find that emotions (mainly fear) decrease when you can see where you will fund your near-term goals…even if we enter a bear equity market.

 Unknown cash needs

You may think cash flow considerations are only for retirees, but that isn’t true. There are the obvious examples which include college funding and a large purchase (usually a home), but when building your plan, it is beneficial to consider unknown cash needs as well.

Given their unknown nature, they are unable to plan for. We often begin with an emergency fund. This fund provides cash needs in the case of unexpected needs. A second consideration might be a Roth IRA. This recommendation might be controversial because most wouldn’t want to remove contributions from a tax-free account. I agree, but what if you wanted to split an emergency fund between cash and a Roth? Remember, you can withdraw the contributions without penalty. While this strategy may not add much in the way of returns in the near term (should still be invested conservatively with this goal), it funds an account that may be difficult to fund later.

Unknown cash needs are one of the reasons I rarely recommend a 100% stock portfolio. When considering a common unknown cash flow need…loss of job, layoffs and market declines are often correlated. As markets fall, employers look to cut costs. If you have a 100% stock portfolio, you might be forced to sell into a bear market…adding to the current stress of the situation.

 Restrictions create a challenge

At this point, we recognize the potential conflict between taxes and the timing of cash needs. Finally, we consider account restrictions. When considering restrictions, we are often looking at tax-deferred and tax-free accounts. We might want to withdraw from the 401k or IRA account based on balance, investment choice and cash need, but these accounts often restrict access based on age or time.

You are likely aware of the restrictions, so I won’t go into detail here. Instead, I’ll simply ask you to consider whether you might need access to the funds before the restrictions are lifted. This becomes a great discussion point as we build your plan.

Too vague? Maybe, so let me share a quick example. What if you are building your plan and recognize you are vulnerable to a near-term unexpected cash need? Let’s also assume you have almost all your investments in your 401k (based on current taxation, this might be your best choice). You may not have access to this account in the short term without significant tax and penalties. In this case, should we consider funding a Roth (maybe backdoor)? Should we add to savings (even if it forces a lower 401k contribution for a year)? There is no perfect answer that fits everyone. Remember, personal financial planning is personal.

The other typical constraint is the limitation of investment choices in accounts like 401ks. This used to big a bigger concern than it is today. Most 401k plans have increased their number of choices and are providing better choices.

 Finally, don’t forget the requirement for distributions from traditional IRA accounts at age 70 ½. This constraint can affect your asset location.

Sometimes location is just dumb luck

Patty (Stephanie's mom) was talked into taking dance lessons many years back. She’ll tell you she didn’t want to go but she had already told the person she didn’t have plans. She went. She has been dancing ever since.

Little did she know she was walking into the studio owned by Jim and Jenelle Maranto. They are two-time U.S. Professional American Smooth Champions. The luck of the location meant being taught by some of the best.

Stephanie is learning the art of ballroom dance which should be no surprise to regular readers given her love of theater and dance. This past week was the studio’s Spring Showcase. She also served as Master of Ceremonies (second year) …multi-talented.

By the way, I should mention that if you want to learn ballroom dance or know of someone needing to learn to dance for a wedding or other event, I recommend visiting their studio…the Academy of Ballroom Dance in Phoenix AZ. Tell them Stephanie Burger sent you….www.academyofballroomdance.com

Looking Forward

This is already a long post, so I will wrap up. As you can see, there are many factors to consider when addressing the location of asset classes. Simply duplicating the same allocation across each account neglects the potential costs and opportunities that can be gained when thinking about location AND allocation.

The week ahead

We could have an interesting week. There is a threat of a government shutdown next Saturday. This hasn’t made headlines like it did in the past. Probably because we assume the politicians will address the need before the government is forced to shut down. We’ll see. We didn’t think it would get to that point in 2013, but we know it did. Saturday also ends Trump’s first 100 days in office. Could get interesting.

Until next week…

 P.S. You may have guessed, but I will confirm…I don’t know how to dance...