The Mathematics of Asset Location

The Mathematics of Asset Location

By Kevin Grogan 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...