Asset Location

Today’s post takes a look at asset location, which is not to be confused with asset allocation.

Location, Location, Location

Asset allocation is one of the fundamental strands of investing.

• Basically, it’s the assets that you put your money into and will be the largest factor in your returns.

Asset location is a US term for the process of mapping your assets to the various types of accounts that you might hold:

1. taxable accounts
2. tax-exempt accounts
3. tax-deferred accounts

The repetition of the word tax might tip you off to the purpose of having an asset location strategy – which is to limit the amount of tax that you pay.

• It’s not about which country your assets are domiciled in.

Vanilla and other flavours

The typical asset location problem is that you have a lot of money in a taxable account, and you can only move a small portion of this into a tax-sheltered account during each tax year.

• Since the transfer process will take several/many years, you would like to minimise the potentially taxable gains in the taxable account, and maximising your gains in the tax-sheltered account(s).

As we will see below, some quirks of the UK tax system introduce the similar problem of capping your growth in two accounts and maximising it in a third.

Lost in translation

Most of the freely available material on asset location is from the US, and some things are lost in translation.

First up is account names:

1. US tax-deferred accounts are (traditional) IRAs and 401(k)s
   • The UK equivalent is the SIPP
2. US tax-exempt accounts are Roth IRAs and Roth 401(ks)
   • The UK equivalent is the ISA
3. We’ll refer to taxable accounts in both countries as GIAs
   • Shares in unlisted companies would usually end up here, too, though control of the company would add some tax planning options not available in a regular GIA

The second quirk is the US treatment of capital gains:

• short-term gains are taxed more highly than long-term gains
• long-term gains from taxable accounts can be more efficient than short-term gains from tax-deferred accounts

There are also qualified and unqualified dividends, with the former qualifying for the long-term capital gains treatment.

• So qualified dividends from taxable accounts are better than unqualified dividends from shelters.

Here in the UK, gains are gains (though property sales attract higher rates).

• There is, however, a tiny (£2K pa) dividend allowance which means that at least some dividends from GIAs could be taxed (the UK dividend yield is normally 3% to 4% pa)
• The CGT allowance is £12.3K pa, which allows for a GIA of around £100K

The third quirk is the UK cap on tax-deferred accounts.

• Above £1.073M, your SIPP will attract an additional tax of 25%
• This tax is not fungible with other taxes and can’t be offset by capital losses or investments into VCTs or EISs.

The fourth quirk is the restrictions on assets that can be held in UK tax shelters.

• US shelters allow things like options, which can be very useful for tax strategies
• UK shelters are restricted to vanilla stocks, bonds, funds, trusts and ETFs, with options reserved for GIAs

The fifth quirk is the existence in the US of municipal (state and town) bonds

• These are tax-exempt for most US investors, and so swapping them in for taxable bonds can lead to higher-post-tax returns
• The nearest UK equivalent is probably premium bonds, which are limited to £50K per person

A sixth quirk is the existence of minimum withdrawal rates (RMDs) in US pensions.

• In practice, things are not so different in the UK, since in retirement you would want to make use of your tax allowances (the zero and 20% bands) each year.
• Assuming your pot will not be rapidly exhausted, you might take £50K each year from your SIPP, perhaps re-allocating some of this to ISAs.

In summary, the US system is much more complicated (hence the available literature) and leads to some non-intuitive heuristics.

• The LTA and the dividend allowance are the main issues in the UK, but the relative simplicity of the system means that few tax-mitigation strategies are available.

Unfortunately, this means that most of the asset location articles on the internet won’t be of any use to UK investors.

Efficient frontiers

One approach that can be taken is to work out the post-tax returns and volatility for each asset class.

• We’ll need to assume marginal tax rates, so the details of the calculation will vary from individual to individual.

The net effect will be to bring the returns and volatility of stocks closer to that of bonds, which means that the stock allocation in an optimized portfolio would increase.

• Calculations I’ve seen (using US rules) would boost stock allocations by 10%, converting a 50/50 portfolio into 60/40.

The size of the over-allocation to stocks would depend on the relative size of your taxable and tax-sheltered accounts (since returns and volatility within the shelter are not impacted by tax).

I’m already falling short of my stock allocation (because of property and DB pension constraints), so this isn’t directly applicable to me.

Assets by location

The simplest approach to asset location is to stick high return assets (stocks) into the tax shelters.

• US dividend and capital gains rules sometimes complicate this, but we can ignore those.

High yielding assets should also be in sheltered accounts.

There are three issues with this approach for me:

1. 40% of my portfolio is pre-allocated to property (medium returns) and DB pensions (low returns)
   • The other 60% is split roughly 50% to high-return assets and 10% to low-return assets (including insurance assets and cash).
2. My tax-deferred accounts are at the LTA limit and so holding high return assets in them is not ideal.
3. I don’t really hold any high-yielding (> 4% pa) assets.

It seems that the best I can do is make sure that the tax-exempt accounts (ISAs) hold only high-return assets.

Withdrawal sequencing

The simple approach is to run down taxable accounts first, in order to preserve compounding in the tax shelters.

• If you have very different allocations in your accounts, this could have implications for your overall allocation.

In the UK, the LTA complication on SIPPs can make it better to take money from the SIPP. (( This excludes inheritance considerations – under current rules, SIPPs are useful tools for avoiding IHT ))

There are also rules around the order in which asset classes should be consumed, with low return assets first in line.

• I have no control over when DB pensions are consumed and will be filling the rest of the basic rate tax band with cash from SIPPs, but these will hold few low-return assets.

Conclusions

In some ways, it’s surprising that it’s taken me seven years of the blog’s existence to get around to looking at asset location.

• In other ways, it’s not, since my personal situation doesn’t leave me with many options in this area.

What I need is a “money pump” to reduce the value of capped accounts (SIPPs) and boost the unlimited accounts (ISAs).

• If I come up with anything, I’ll be back with another article.

I hope your own situation is more open to optimisation.

• Until next time.