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Plan Well, Retire Well

Saving and investing your money

A Real Life Example of Rebalancing + Asset Location

It's that time of year for me – time to review what investments or savings my husband and I have and what types of accounts they are in. I have three goals:

  • Rebalance, meaning I'll bring our asset allocation back to where it should be.
  • Check our asset location. That may be a new term for you. It refers to placing assets in the types of accounts (taxable, tax-deferred, Roth) that will make my portfolio as tax efficient as possible. See my previous post for more.
  • Reduce duplication and the number of investments we own. For example, I have money in at least three different small or mid cap US stock mutual funds in three different retirement accounts. I want to choose one of those and use it as the sole or main investment vehicle for that asset class.

This becomes a bit like putting a puzzle together. (If at any time this puzzle starts to feel like it's too much for you, skip to the end for a short-cut.) It gets complicated because there are a lot of constraints and considerations. For example:

  • We have several different kinds of accounts: employer plans, a Roth IRA, and two small traditional IRAs. Since I generally can't move money between these, it makes it harder to figure out how to carry out the rebalancing to get the asset allocation we want.
  • Not all types of investments that I want are available in each account. For example, my employer plan offers only mutual funds from Company A. Company A offers some index funds, but not in every asset class. My husband's employer plan offers about 10 funds, one from each major asset class – but no target date retirement funds.
  • In our taxable account, I will have capital gains income if I sell investments in order to rebalance.
  • The concept of asset location basically says you'll come out ahead if you own more tax-efficient assets (such as index mutual funds, stocks that you expect to hold long term, and municipal bonds) in your taxable accounts and less tax-efficient investments (bonds, real estate investment trusts, CDs) in tax-deferred accounts.
  • We need to have a certain amount of liquid funds for possible emergencies, planned expenses like home repair and improvements, and a down payment (or more) on a new car sometime in the next couple of years. Those monies have to be accessible, so they can't be in any kind of retirement account even though that means I'll pay taxes each year on that interest.

So how do you combine all these factors to arrive at a do-able plan of what to own and in what account? Here's how I tackled the task for a situation where mutual funds are the main investment vehicle:

Determine your target asset allocation.

Decide how much you will keep in an emergency fund and any other earmarked savings, like for a new kitchen floor. Subtract that from the amount that you want to have in short term bonds or cash. The remainder would ideally be in a tax-deferred account, following the principle of asset location.

For each account you have, make a list of 1) your current investments, 2) the value of each one, and 3) the total value of the account.

Look at the available investments in each account. You want to identify investments that are the best choices for each asset class. Consider such factors as:

  • Whether the fund is an index mutual fund or an actively managed fund. This is one of the main drivers of the fund's turnover rate. Higher turnover results in more gains being declared to fund owners as taxable income each year.
  • Fees, including loads, 12(b)1 fees, redemption fees, or annual fees for small account.
  • Expense ratio.
  • Minimum initial investment.
  • Performance and risk exposure: for an index fund, how well it matched the return of its benchmark, For active funds, how the return compares to an appropriate benchmark. How did a stock fund perform during bear markets? For bond funds, what is the duration – a measure of interest rate risk?
  • Availability of a lower-cost class of shares for large investors, if you will have a large amount in this asset class. Some employer plans give you access to super low-cost institutional shares no matter how little you invest.

If you have good candidates for the same asset class in more than one account, make a prioritized list of your first choice, second, etc. for each asset class. For very comparable investments, rank may be based strictly on costs or on what type of account (taxable, tax-deferred, Roth) will produce the best tax efficiency. For example, I have access to index funds tracking the Standard & Poor's 500 in most of our accounts. These are tax-efficient funds and are best located in taxable accounts. Therefore, the XYZ S&P Index Fund in my taxable account with an expense ratio of just .20% takes first place. A close second might be BBB S&P Index Fund because through my employer plan, I have access to BBB's super-low-cost institutional shares with an expense ratio of just .12%.

Now the fun begins – moving money around. Do it on paper before you move any real money.

First, identify investments that cannot be changed or are difficult to change. For example, I don't want to sell my $6000 in ABC Foreign Stock Fund that I own in a taxable account, because I would have to pay tax on the gains. I'm not dissatisfied with ABC Stock Fund, and it's a good thing to own in a taxable account.

Start working your way through your prioritized investments for each class, filling up each asset class "bucket" as you go along. Say my goal was $40,000 in my large cap stock "bucket." In my taxable account, I only have $15,000 available to invest after setting aside money for my emergency fund. So I put $15,000 in XYZ S&P Index Fund – my first choice . Then I finish filling this bucket by putting $25,000 into my second investment choice for large cap stocks, BBB S&P Index Fund, in my employer plan.

For bonds, I also have two good candidates: All Bonds Fund in my IRA and Complete Bonds Fund in my husband's 401(k).

If the amount I want to invest in bonds is more than the amount I have in my IRA, I'll invest all my IRA money in All Bond Fund. Then, I'll invest the remainder that I need to fill up my bond bucket in my 2nd choice, Complete Bonds Fund.

I continue working my way through my prioritized list of investments for each asset class. Sometimes, I have to make adjustments. For example, I discover that the only account through which I have access to an emerging markets stock fund is my IRA. I might decide to devote my small IRA to that emerging markets fund instead of All Bond Fund A. Then, I'll need to put more money into my 2nd choice for bonds, More Bonds Fund B, in my husband's 401(k).

Are you feeling overwhelmed? It can be a big task. But you don't have to get it perfect – just get close to your targets. There will always be next year to tweak things again.

Short Cut: If you just know you'll never be able to deal with all this, you can take a short cut. Target date retirement funds are a way to achieve asset allocation appropriate for your life stage. Or, you can get help from a professional who does this week in and week out.

Congratulations if you stayed with me to the end of this lengthy post. I'd be interested in your thoughts and your experiences with rebalancing and asset location. Please click on my name below and let me hear from you.

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