By Mike Gertsema, CEO & Wealth Advisor
There is a lot of talk about investing: the stock market, DOW Industrial Average, S&P 500, NASDAQ. Most people shake their heads and ask what it all means and if they should care.
The quick answer is yes because it may have an impact on your portfolio in terms of measuring what’s going on in the market on a day-to-day basis.
Sometimes we’ll have clients call and ask why their portfolio didn’t go down nearly as much as the overall market did – and while they’re grateful, they wonder why. The answer is their asset allocation.
With the use of asset allocation, we attempt to balance our client’s portfolios between different asset classes based on the client’s risk tolerance, financial goals and the timeframe of when they may need to use the money from the portfolio – which is determined within their financial plan and is updated at least annually.
The next question that comes up is asset diversification, which can mean a lot of things – but, in general, we look at how each portfolio is invested among different categories or sectors.
For example, we see portfolios that have a lot of different holdings, so you’d assume diversification, right? This is not always the case. Just because you may have a lot of different holdings, that does not mean you’re diversified because all the holdings could be in the same industry or sector.
We sometimes see portfolios that are over-weighted in technology, energy, financials or healthcare – which is great when those sectors go up, but it’s devastating when the sectors or industries go down.
This is especially apparent as we look back on some of the major market drops that we’ve witnessed over the last 30 years, think of the Dotcom Bubble in 2000 and the 2008 Market Crash.
Major market drops have minimal impact on young investors because they have a lot of life to live and have time to recover from major market downturns in their retirement investments. But, older investors look at market drops much differently and tend to shy away from high risk and volatile investments because time is not on their side.
We also see portfolios that hold a lot of different mutual funds and closed-end mutual funds only to find many of them are invested similarly in the same sectors. This also does not give the investor diversification which increases risk and possibly, total rate of return.
This also pertains to investing in bonds or bond mutual funds.
The consumers need to understand that the bond holdings are normally rated by different rating agencies for quality:
This is the best rating available and indicates a high degree of creditworthiness of the issuer and has the lowest risk of default.
- AAA to BBB-
These are called investment-grade bonds and the higher the grade the better the quality.
D rating is the lowest rating. So bonds rated BB+ to D fall below the investment grade standard and sometimes get referred to as junk bonds because the bond issuer has a lower degree of creditworthiness and a higher risk of default.
The higher the letter grade the better the bond and the lower the grade indicates lower creditworthiness. Feels like going back to school, doesn’t it? This means that if the bond or bond fund is paying a high income it could mean that there is a considerable amount of risk associated with it.
The subject that is overlooked the most is asset location. Asset location is a tax-minimization strategy that takes advantage of different types of investments getting different tax treatments.
Using this strategy, an investor determines which securities should be held in tax-deferred accounts and which in taxable accounts to maximize the client’s after-tax returns. It can also mean having types of tax-treated investment accounts: The taxable accounts, the tax-deferred accounts, and the tax-free accounts.
A taxable account is checking, savings and any investment made with after-tax money.
The tax-deferred accounts consist of IRA’s, 401(k)s, 403(b)s – generally, most tax-deferred retirement plans, which are deferring the taxation of the money until retirement, age 59½ or when taken out of the account.
The post-tax/tax-free investment occurs in a Roth IRA and Roth 401(k), in which you are paying the income taxes now, investing the money for retirement or after age 59½ where the money is growing tax-free and withdrawals are income tax-free.
So, it comes down to two complex questions: When do you want to pay income taxes on the money you save and what are you saving the money for, short term or long term?
This is where financial planning is very critical to your success. Asset allocation, asset diversification and asset location is about investing – and more importantly, it’s about advising.
The Tax Cuts and Job Act in 2017 made favorable changes to the income tax code which are currently set to expire in 2025.
The change is giving investors opportunities to decide when they want to pay taxes on tax-deferred investments, whether currently retired or not anywhere near retirement age.
An example for younger investors is looking at today’s tax brackets, compared to what is set to revert to in 2026, maybe saving money in a tax-free Roth makes much more sense than tax-deferred accounts.
Think of it this way: If you’re married with children and find yourself with an average income tax rate of 10%, 12% or lower, it might make more sense to invest in the Roth option. If income taxes go up or your income goes up and you find yourself in a higher income bracket, start using the tax-deferred IRA or 401(k) for an income tax deduction.
For the currently retired persons, the same question comes into play: What is your average income tax bracket and where will it be in 2026 when The Tax Cuts and Job Act in 2017 is set to expire?
Should you consider taking more money from your post-tax accounts now with favorable income tax treatment or try your luck on what it will be in 2026?
If you take the money out of the tax-deferred investment (IRA), what’s the plan for it? The first place we can put it is your after-tax account or cash reserve.
The next is a Roth IRA, where you can let it grow tax-free and access it income tax-free down the road if you need it. It’s also a great investment to be left as a legacy to your children because your children have the option of letting it grow tax-free.
Making the Complex Simple
Income taxes are confusing to most, but with the use of our technology, we are able to make the complex simple by:
- Illustrating different strategies within the income tax brackets
- Integrating the strategy into your financial plan to illustrate short-term and long-term options and benefits.
Financial planning allows us to illustrate the benefits of knowing what you need for an average rate of return on your investments for a comfortable retirement. We do this by understanding and taking into consideration the aspects of asset allocation, asset diversification and asset location.
If you’d like to learn more or you’re interested in a complimentary consultation, get in touch today!
Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. A diversified portfolio does not assure a profit or protect against loss in a declining market.