Fans of The Motley Fool can't help but be aware that it's practically impossible for Wall Street pundits and writers to communicate without some obscure patois slipping into the mix. It's not their fault, of course. The purpose of specialized argot in any arena is to provide folks with shorthand so they don't have to keep repeating long phrases to describe things like "employer-sponsored, tax-advantaged investment accounts whose funds are intended only to be withdrawn in retirement." So much easier just to say "401(k)."
But if you want to play the game, you have to comprehend the conversation, so in this week's Rule Breaker Investing podcast, Motley Fool co-founder David Gardner is bringing in a trio of special Foolish guests to explain six terms that investors might not know as well as they think they do or as well as they'd like to. In this segment, Robert Brokamp kicks off the more advanced section of the podcast by defining asset location -- and no, that's not a typo. We're talking about what type of accounts you use to hold specific assets.
A full transcript follows the video.
This video was recorded on Feb. 21, 2018.
David Gardner: Robert, what is term No. 4?
Robert Brokamp: It's "asset location." So, not asset allocation, but asset location.
Gardner: I feel like you're either being cute with the planned words, here, or this is a hardcore phrase.
Brokamp: This is a real thing.
Gardner: OK. I think a lot of us would say we know asset allocation. Where you're putting your dollars. How you're doling them out, some to this stock, or some to bonds and not stocks. Or whatever it is, it's how you're allocating your assets. Let's talk about location, then.
Brokamp: So, you've decided how much to have in various assets. Which investments you're going to buy. The next decision you have to make is in which accounts. You might have a taxable brokerage account. You might have a traditional IRA. You might have a Roth IRA. You might even have a Coverdell or some other type of account. Each different account has different tax characteristics, and each of your investments has tax characteristics.
Gardner: I see where you're headed here.
Brokamp: So, determining which investment should go in which accounts is the art of asset location.
Gardner: So, Robert, this immediately begs the question. How many accounts, either, do you have or do you think we should have? Or, what is the average number of accounts held by an American, if you know something like that answer?
Brokamp: The last I heard, the average person has between four and eight accounts. And that depends on, first of all, whether you're single, or if you're married, and if you have kids because, as we discussed, if you have kids then you probably have some other accounts. But you probably have your 401(k) at work. You probably have an IRA. You might have a 401(k) at a previous job. Then you have your spouse's account. So, we have multiple accounts that you have to make these decisions about, and which investments they should go in.
Gardner: Robert, what would be a typical example of an awesome asset location, and then what would be a typical mistake made by people who don't listen to this podcast and learn important concepts like asset location.
Brokamp: There are a few key principles of it, and one is basically to rank your investments and investment strategies according to tax inefficiency, and then you take the investments or strategies that really would cost you a lot in taxes and make sure those go in your IRAs and 401(k)s.
As an example, let's say you own an actively managed mutual fund that has a lot of turnover. In other words, the fund manager is doing a lot of buying and selling generating a lot of taxes. It happens.
Gardner: I probably don't want to own that fund, but it does happen.
Brokamp: Right, so if you have one of those, you should put it in your IRA or your 401(k). Compare that to a stock that you plan to hold for decades, and it doesn't pay a dividend. You can own that stock for 30 years and you'll never pay a penny of taxes on that until you sell. And then when you sell, you'll pay long-term capital gains, which is a lower rate than what you'd pay if you were taking that stock out of your traditional IRA. That's one example of how you would take a look at your investments and decide in which type of account they should go in.
Since you asked for a mistake, one mistake people make is they think OK, I'm just making the decision between the taxable account and the IRA, but they then don't compare whether what they should put into the traditional IRA and the Roth, assuming they have that. What you should do is take a look at your investments and think which investments have the highest potential return. Of course, you never really know, but generally speaking you might think that this collection of stocks is probably going to outearn this other collection of stocks.
Gardner: Maybe, for example, five stocks the world really needs right now.
Brokamp: A perfect example, David! A perfect example.
Gardner: All right, good. I'm with you now.
Brokamp: You would put the ones that you think have the highest potential in the Roth, because the Roth is the account that when you take the money out in retirement, it's tax-free. That's the best account, so that's the account you want to grow the most, and you'd use your traditional 401(k) IRA for investments that still will be growing, but that you don't expect to grow as much. It might be just your standard index fund, or it might be your bond fund, or something like that.