Thomas Walsh

	If your tax bracket is high enough, invest in tax-free municipal bond funds instead.

Asset allocation comes first, then comes asset 

It’s the often overlooked strategy of placing investments in the right accounts to minimize taxes. And while the anticipated new tax law may affect the strategy somewhat, don’t wait for passage to act.

Most asset-location strategies that work today will work just as well in 2018 under almost any scenario, though you may need to make some adjustments.

Asset location means you hold, or locate,

 investments in tax-deferred or tax-free accounts. While the concept is simple, execution can be complex.

It starts with viewing your assets as one integrated investment portfolio, instead of as separate accounts. By considering all of your accounts together, you can make good decisions about which accounts will hold which types of assets.

To make it work, you need significant assets in both taxable and tax-deferred accounts. The more types of retirement accounts you have — such as an IRA, Roth IRA, SEP IRA, profit-sharing plan, 401(k) or 403(b) — the more opportunities you have for effective asset location.

There are clear rules about where you should hold tax-inefficient investments. REITs, for instance, are tax-inefficient because they produce relatively large amounts of ordinary taxable income. REIT funds should be held in retirement plans whenever possible.

Taxable bonds are also tax-inefficient, but since they’re valuable for meeting medium-term needs, they can be spread among both taxable and retirement accounts to better manage cash withdrawals.

If your tax bracket is high enough, invest in tax-free municipal bond funds instead. That way, you can get tax efficiency while meeting your allocation to low-risk investments. Municipal bonds belong only in taxable accounts.

Stocks, in contrast, are tax-efficient for two reasons. First, they often produce more gains through capital appreciation than via dividends over the long term. If you hold onto them for at least a year, you’ll get the lower long-term capital gains rate when you sell them. Additionally, qualified dividends are taxed at a lower federal rate — in 2017, anywhere from 0 to 23.8%. 

Today, those in the 15% tax bracket, for example, pay 15% federal income tax on bond and bank interest but absolutely nothing on qualified stock dividends. The bills in Congress wouldn’t end the tax break for qualified dividends.

Equities should yield larger capital gains than bonds in the long run, but you ultimately don’t get the lower capital gains rate in tax-deferred accounts. All withdrawals from such accounts are subject to ordinary income tax. This is another reason to place some stock funds in taxable accounts.

Be smart about which stock funds go into which accounts. Most international stocks and funds withhold foreign taxes on dividends paid. They should be held in a taxable account so you can recoup the foreign taxes you paid by claiming a foreign tax credit on your return.

Index funds are highly tax-efficient and work well in taxable accounts because they pay small distributions and have low turnover.

Actively managed stock mutual funds with high turnover often pay big taxable distributions at the end of the year. They should be held in tax-deferred or tax-free accounts. If you own a fund with high turnover, place it in a tax-deferred or tax-free account if possible.

The tax-free Roth IRA is ideal for equities, and because Roth assets grow tax-free, you should place high-growth investments in a Roth IRA.

With most other retirement plans, you or your heirs will ultimately pay ordinary income taxes on

every penny that’s in them. Withdrawals from a Roth IRA are tax-free, which makes it a good place for the most aggressive component of your portfolio.

Asset location is not a one-size-fits-all decision, and there are complex variables to consider when deciding how to accomplish it. Variables such as future tax rate assumptions, the types and sizes of accounts owned, availability of investments, state income taxes, and estate-planning needs all need to be considered.

It’s as much an art as it is a science, and sometimes you have to make compromises with what’s ideal versus what’s practical.

While asset location may not save you a large amount of taxes in any one year, it should produce small increases in your after-tax return every year. Over decades, these small amounts compound and can really add up. There’s no need to pay more federal and state income taxes than you have to.

Unique factors can really add to the complexity of the asset location decision. It’s often a good idea to consult a financial planner to make sure you’re doing it right.

I spend significant time implementing asset allocation and asset location strategies for my clients. When the new tax law passes, I’ll reexamine my clients’ asset location strategies to see if we need to make any changes.

Thomas Walsh, Certified Financial Planner (CFP©) is a client service and portfolio manager with Palisades Hudson Financial Group in Atlanta.

 is a fee-only financial planning firm and investment manager based Fort Lauderdale, Florida, with more than $1.3 billion under management. It offers financial planning, wealth management, and tax services. Its Entertainment and Sports Team serves entertainers and professional athletes. Branch offices are in Stamford, Connecticut; Atlanta, Georgia; Portland, Oregon; and Austin, Texas. The firm’s monthly newsletter covering financial planning, taxes and investing is online at 

www.palisadeshudson.com/insights/sentinel

Articles

New tax law may call for tweaking strategy but probably not big changes.

Asset Location, Strategy to Cut Taxes, Is Often Overlooked

Money market funds are low-risk but pay little. Junk bonds and long-term bonds yield more but they’re risky. So how can you ramp up yield without taking on too much risk?

With strategic diversification, you can safely boost your portfolio’s yield. It’s the only strategy that can both decrease risk and increase yield. True diversification is about building a portfolio of uncorrelated investments that aren’t all affected by the same economic factors.

Some risks aren’t worth taking. Long-term rates are very low. If they rise significantly, you can lose a lot of money in a long-term bond fund. In the current environment, the higher yield is typically not worth the increase in risk.

Where can you get more yield without too much risk? Consider REITs and floating-rate funds.

Due to real estate’s low correlation with other investments, REIT funds can provide a hedge against a lengthy period of poor performance in the stock and bond markets. The investment’s low correlation to other assets may provide an opportunity to reduce risk and increase portfolio yield.

A diversified REIT fund produces reliable income from properties such as shopping malls, apartment buildings, office buildings and hotels. Since these properties are generally located across the U.S., and sometimes in other countries, geographic risk is minimized.

But don’t go overboard. While REIT funds offer good yields, like all other equities, they’re volatile. So limit your REIT investments to 7.5 percent of your equity allocation. Even that modest allocation offers yield and diversification.

I recommend actively managed and index REIT funds that invest in the U.S and abroad. Avoid private and obscure REITS to keep risk down.

FLOATING-RATE FUNDS OFFER BULWARK AGAINST RISING RATES 

Floating rate or bank-loan funds buy loans made by banks to companies with below-investment-grade credit ratings. Their higher yields and floating rate make them attractive.

Because the underlying loans’ yields can rise along with broader market rates, share prices may hold steady when rates rise, thus protecting you from interest-rate risk.

Unlike other high-yield bonds, floating-rate loans have safeguards built in, including collateral requirements, performance-based covenants and a senior position within a company’s capital structure. Senior debt is more likely than other debt to be repaid in case of bankruptcy. Many loans have floor provisions so that interest payments cannot go lower than a set minimum should market rates decline.

These funds are attractive when rising interest rates are a greater concern than the creditworthiness of the underlying investments.

A skilled fund manager controls risk by choosing more-secure loans. Look for a conservatively managed floating-rate fund instead of trying to find the highest yield.

You can safely invest up to 15 percent of your fixed-income portfolio in a floating-rate fund.

STASH HIGH-YIELDERS IN RETIREMENT ACCOUNTS

Investments that produce large amounts of ordinary income, such as floating-rate funds and REITS, should usually be held in tax-deferred accounts like IRAs and 401(k)s. The tax bite on your portfolio is reduced, allowing for greater long-term growth and higher total returns.

Some investments do not benefit from being held in a tax-deferred account — for example, international investments that withhold foreign taxes on dividends.

It’s better to hold these in a taxable brokerage account so that you can recover some of the foreign taxes paid via the foreign tax credit on your tax return.

KEEP YOUR CORE BOND INVESTMENTS SHORT-TERM

With interest rates still near record lows, the only direction to go is up. You don’t want to be caught holding long-term bonds when the music stops. A 1 percent increase in interest rates should trigger about a 10 percent loss on a 10-year bond.

High-quality short-term bond funds are far less volatile. They should form the core of your fixed-income portfolio. They provide competitive yields — better than money market funds — for a minimal increase in risk.

Don’t focus too much on the risks of each potential investment in isolation. Instead, consider how a new investment will interact with the rest of your portfolio. Would adding it increase or decrease your overall risk, or have no impact? Take a holistic view when working to boost your yield while minimizing risk.

Thomas Walsh, Certified Financial Planner and portfolio manager with Palisades Hudson Financial Group, practices in the firm’s Atlanta office. 

 is a fee-only financial planning firm and investment manager based Fort Lauderdale, Florida, with more than $1.2 billion under management. It offers financial planning, wealth management, and tax services. Its Entertainment and Sports Team serves entertainers and professional athletes. Branch offices are in Stamford, Connecticut; Atlanta, Georgia; Portland, Oregon; and Austin, Texas. 

Sure, you make the bulk of your investments in money market funds to minimize risk. But what are you getting in return? You can boost your portfolio's yield safely with a dollop of REITs and floating-rate funds, in addition to some tax savvy.

Diversification Lets You Increase Portfolio Yield without More Risk

Rising interest rates would cause the value of long- and intermediate-term bond funds to plummet. Since these funds are too risky today, what’s the best way to get decent income today?

With most of your fixed-income portfolio: KISS (Keep It Short and Simple).

Put at least 60% in short-term certificates of deposits, money market funds, and high-quality short-term bond funds with an average maturity of about two years or less. (If your tax bracket is high enough, use short-term tax-free funds.)

But also invest in alternatives to basic short-term funds. They generally pay higher yields and are well positioned to keep their value when rates rise, which is bound to happen in the near future.  

Non-Vanilla Funds Boost Income, Buffer Rate Hikes

If you can take just a bit more risk, invest up to 40% of your fixed-income portfolio in non-vanilla income funds. That allocation can be split among three buckets.

Up to 10% can go into a merger-arbitrage mutual fund, a specialized type of stock fund with nearly bond-like performance. The fund buys shares of merger acquisition targets at a slight discount to the expected value upon completion of the deal. This price difference is known as the arbitrage spread and is captured as long as the deal is completed. The manager buys protection in case the deal falls through.

It’s a concept with a solid long-term record.

 Consider investing 10-15% in them. These hybrid funds include inflation swaps along with short-term fixed-income holdings. An inflation swap involves one party paying a fixed rate on the swap amount in exchange for a floating-rate payment based on actual inflation.

These funds are an effective way to mitigate the effects of inflation while keeping interest-rate risk low. 

Floating-rate bond funds—also known as bank-loan funds. 

Another 10-15% out of the 40% can go into them. These funds purchase loans made by banks to companies with below-investment-grade credit ratings. The underlying loans’ yields float, generally rising with broader market rates, protecting investors from most interest-rate risk.

Unlike high-yield junk bonds (which are generally too risky), floating-rate loans have safeguards built in, including collateral, performance-based covenants and a senior debt position. Senior debt is more likely than other debt to be repaid in case of a bankruptcy.  

Look for a conservatively managed floating-rate fund instead of trying to find the highest yield.

There is no one-size-fits-all strategy for fixed-income investing. The techniques described here are not the only options, and any plan should be tailored to an individual portfolio based on your risk tolerance, liquidity needs, investment horizon and personal goals.

Fixed-income investments should be conservative, used for reducing volatility of the total portfolio and preserving wealth, not risking it.

Thomas Walsh is an investment analyst in Palisades Hudson Financial Group’s Atlanta office.

 is a fee-only financial planning firm and investment adviser based in Scarsdale, NY, with $1.3 billion under management. It offers investment management, estate planning, insurance consulting, retirement planning, cross-border planning, business valuation and appraisal, family-office and business management, tax preparation and executive financial planning. Branch offices are in Atlanta, Fort Lauderdale, FL, and Portland, OR. 

The firm’s recent book, “Looking Ahead: Life, Family, Wealth and Business After 55,” is a paperback and Kindle e-book available on Amazon at 

. Read Palisades Hudson’s daily column on personal finance, economics, and other topics at 

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The Federal Reserve has made its intention to raise rates clear, though they've been slowed by outside economic forces. However, with more increases likely soon, what's the best way to boost your investment income?