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Tax consultant working with clientsAs you build an investment portfolio, you probably make a point of considering your asset allocation and how that squares with your risk tolerance. But don’t confuse asset allocation with asset location, which is a distinct part of your investment strategy that helps to minimize your tax burden. Below, you’ll discover the ins and outs of what asset location means, but if you’re in need of further guidance to spread out your assets for tax efficiency, consider enlisting the services of an expert financial advisor.

Asset Location, Definition

Asset location refers to where you strategically keep the money you’re investing — between tax-advantaged, tax-free and taxable accounts — in order to maximize after-tax returns.

That’s not the same as asset allocation, which deals more with what types of investments you put your money into. For example, if you have 60% of your portfolio invested in stocks, 30% invested in bonds and 10% invested in cash, that’s asset allocation at work. Asset allocation is about balancing risk while still investing in a way that’s designed to help you achieve your investment goals for the short- and long-term.

When you’re talking about asset location you might be talking about how much to contribute to your employer’s 401(k) or what you should add to your online brokerage account. In other words, the focus is 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

Charts and graphsAsset 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.

How to Create a Tax-Efficient Investment Strategy

Tax efficiency "dial"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.

The Bottom Line

Getting asset location right is just as important as managing asset allocation. Over time, it can make a significant difference in how much you pay in taxes on your investments and how much of your returns you get to keep. Periodically checking in with your investment portfolio can help ensure that you’re investing your money in the right places.

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. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s financial advisor matching tool can help you find an advisor in your area. If you’re ready, 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.

Photo credit: ©iStock.com/FG Trade, ©iStock.com/triloks, ©iStock.com/AlexLMX

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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