Asset location is the practice of allocating investments among taxable, tax-deferred and tax-exempt accounts to achieve greater tax efficiency. Different types of assets – like bonds, stocks and real estate – generate varying levels of taxable income, and the way they are allocated can impact the amount of taxes you pay over time. By placing certain types of investments in accounts that best align with their tax characteristics, you can potentially reduce your overall tax liability, allowing for better after-tax returns.
If you need help determining how to strategically spread your assets for tax efficiency, connect with a financial advisor today.
What Is Asset Location?
Asset location is a tax-optimization strategy that involves allocating different types of investments to specific accounts based on their tax treatment.
Unlike asset allocation, which focuses on how to distribute investments across various asset classes, asset location is about determining which account type – taxable, tax-deferred or tax-exempt – is best suited for particular assets. For instance, investments like bonds, which generate regular interest income, are often better suited for tax-deferred accounts, as this income can accumulate without immediate tax consequences. In contrast, stocks that primarily grow through capital appreciation might be placed in taxable accounts where long-term gains benefit from lower tax rates.
By assigning investments to appropriate accounts, you can maximize the overall tax efficiency of a portfolio. This approach can help reduce the annual drag of taxes on returns, ultimately allowing your investments to grow more effectively over time.
Asset location is particularly useful for individuals who have multiple account types and wish to optimize the tax implications of their investment returns across the entire portfolio. It requires understanding how different investments are taxed and aligning that knowledge with account types to enhance after-tax performance. In other words, asset location focuses on where to invest with an eye toward the tax implications, rather than how to invest.
Tax-Advantaged vs. Taxable Accounts
To understand asset location, it is important to know the difference between various investment account types.
Generally, you’ve got three options for investing and saving:
- Tax-deferred accounts
- Tax-free accounts
- Taxable accounts
Tax-deferred accounts are ones that allow you to invest money without paying taxes on growth right away. So that includes traditional 401(k) plans, solo 401(k)s, traditional IRAs, SEP and SIMPLE IRAs (which follow traditional IRA tax rules for withdrawals) and 403(b) plans. With each of these accounts, you pay regular income tax on qualified withdrawals. Early withdrawal penalties can apply for taking money from a tax-deferred account before age 59.5.
Tax-free accounts allow you to save using after-tax dollars. That means that technically, you don’t escape taxation entirely since you’re contributing money you’ve already paid taxes on. But when you make qualified withdrawals you pay no additional income tax. Examples of tax-free accounts include Roth IRAs, Roth 401(k)s and Roth 403(b) plans.
Taxable accounts offer no tax breaks in the form of a deduction for contributions, which you could get with a 401(k) or a traditional IRA. And you don’t get to skip out on paying taxes when you withdraw money like you could with a Roth. Instead, taxable accounts require you to pay capital gains tax on the earnings from your investments when you sell them.
Capital gains can be applied using a short-term or long-term rate, depending on how long you hold the assets. Between the two, the long-term capital gains tax rate is more favorable. But to take advantage of it, you have to hold on to investments for at least one year before selling.
You can invest in both tax-advantaged and taxable accounts at the same time and that’s part of a good asset location strategy. Just keep in mind that you may not be able to have all of these accounts at once. For example, you can’t max out contributions to a traditional IRA and a Roth IRA for the same tax year under IRS rules.
Why Asset Location Matters
Asset location is important for a few different reasons. First, it’s part of creating a diversified portfolio. Diversification is a way to manage risk by spreading your investment dollars across different assets. Asset location also plays into the diversification formula when you place money in tax-advantaged and taxable accounts strategically.
For instance, say you’re worried about having to draw down your retirement accounts early because a recession deals a blow to your income. Having money in a taxable account, such as a brokerage account or even a taxable money market savings account, gives you other options for getting the cash you need without having to drain your 401(k) or IRA.
Asset location is also important from a tax perspective. Some investments are naturally more tax-efficient than others. Exchange-traded funds, for example, tend to have a lower holdings turnover ratio compared to other types of funds.
Keeping tax-efficient investments in a taxable brokerage account could make more sense for limiting your tax liability. At the same time, you could funnel less tax-efficient investments into a tax-advantaged 401(k), IRA or even a Health Savings Account if you have access to one of those through a high deductible health plan.
Minimizing your tax liability is a good thing once you’re ready to start drawing down assets in retirement. The less you can pay in taxes on retirement income, the more of that income you can keep to cover your living expenses in your later years. That’s especially helpful if you anticipate higher health care costs or needing long-term care and you don’t have long-term care insurance.
Asset Location in Action
Consider a hypothetical investor named Sarah, who has both a tax-deferred retirement account, a taxable brokerage account and a Roth IRA. Sarah decides to allocate her bond investments to her tax-deferred retirement account, allowing the interest income to grow without being taxed each year. She places her stock investments, which she expects to appreciate over time, in her taxable account to take advantage of lower long-term capital gains tax rates.
Meanwhile, Sarah allocates assets with high growth potential, such as small-cap stocks or certain ETFs, to her Roth IRA. Since the Roth IRA allows for tax-free growth and withdrawals in retirement, Sarah can maximize the benefit of this account by placing investments with the highest expected returns there.
By strategically placing her investments across these different accounts, Sarah effectively reduces her tax burden and enhances her portfolio’s after-tax growth. This approach helps her take full advantage of the unique tax benefits offered by each account type, ultimately boosting her overall investment efficiency.
How to Create a Tax-Efficient Investment Strategy
Making your investments tax efficient starts with knowing what accounts you have to invest in and what your goals are. If you have a 401(k) at work, for example, it might make sense to maximize your annual contributions as much as possible using less tax-efficient mutual funds first. Then you could move on to your IRA contributions, rounding things out with ETFs or low-cost index funds in a taxable brokerage account.
One thing to keep in mind is that this isn’t necessarily a set-it-and-forget-it strategy. As your income changes and you get closer to retirement, it may be necessary to shift both your asset allocation and your asset location to keep your portfolio aligned with your goals.
It’s also important to consider how things like tax-loss harvesting can help you better manage the investments in your taxable accounts. Tax loss harvesting involves selling off stocks at a loss to help offset capital gains. If you’re investing with a robo-advisor, tax loss harvesting may be included as part of your investment strategy. But if not, it’s something your financial advisor can guide you through to help minimize taxes on your investments.
Bottom Line
Structuring investments across account types with an eye on tax implications can enhance the efficiency of a portfolio. By aligning assets with their most tax-beneficial accounts, investors may see better after-tax returns and a more flexible approach to withdrawals. Incorporating strategies like tax-loss harvesting and reassessing allocation over time adds another layer to this approach, keeping portfolios adaptive as circumstances change. In this way, careful asset location can support long-term financial goals, making the most of each account’s tax advantages to boost overall growth.
Tips for Investing
- A financial advisor with tax experience can help you create or improve a strategic plan for both asset location and asset allocation. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- When considering tax-efficient investments like ETFs, don’t overlook the fees. Mutual funds and ETFs may offer tax benefits but come with high expense ratios, which can also eat away at returns. Also, if you’d like help with asset allocation, an easy-to-use calculator can point you in the right direction.
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