Much is written about asset allocation, the allocation of your investments among various asset classes based upon your financial goals and risk tolerance. Asset location takes planning a step further. Asset location is about which types of investments are held in various types of investment accounts.
Typically the three main types of investment accounts are:
- Taxable investment account.
- Tax-deferred investment accounts such as traditional IRAs, traditional 401(k)s and other traditional retirement accounts.
- Roth IRAs, Roth 401(k)s and Roth retirement accounts in other types of employer sponsored retirement plans such as a 401(k) and others.
Why is asset location important?
Asset location is a strategy to help investors minimize taxes on their investment portfolio. An asset location strategy is about holding certain investments in specific types of accounts to maximize tax efficiency.
While investment returns are of course very important, it’s also important that investors are able to keep as much of their investment gains as possible on an after-tax basis. While it is generally not possible to hold every investment in the most optimal account, it does make sense to focus on asset location to the extent possible for your situation.
Holding investments in the most favorable tax accounts can yield significant tax savings on an overall basis.
Match investments with the best type of account
A key part of asset location is to determine the best type of account from a tax perspective for various types of investments.
Taxable accounts
Taxable accounts are funded with after-tax dollars, there is no tax deferral for contributions. Interest income, realized gains from investments held less than one year and non-qualified dividends are taxed at ordinary income tax rates. Long-term capital gains and qualified dividends are taxed at preferential long-term capital gains rates.
Assets held in the account can be left to heirs with a step-up in cost basis upon the owner’s death, which can be helpful in estate planning. Some assets that can make sense for taxable accounts include:
- Municipal bonds and muni bond funds. Interest is federally tax exempt and may also be exempt from state taxes in some cases.
- Index mutual funds and ETFs. These funds often throw off a limited amount of annual income and will be taxed at preferential long-term capital gains rates if sold at a gain after a year.
- Tax managed mutual funds. These are funds where the manager explicitly tried to limit dividends and aims for long-term capital gains in the fund.
- Stock generating qualified dividends. These dividends are taxed at a more favorable rate for investors.
- Investments of various types that you are likely to hold longer than one year.
Tax-deferred accounts
Tax-deferred retirement accounts include a traditional IRA, 401(k), 457, 403(b) and others. These accounts generally allow pre-tax contributions, they allow money in the account to grow tax-deferred and then withdrawals are taxed as ordinary income.
There are no taxes on capital gains, interest, or dividends while assets are held in the account.
Solid holdings for these accounts and Roth accounts discussed below can include:
- Core bonds and bond funds that issue regular interest payments during the year.
- High-yield bonds and funds that yield higher interest payments during the year.
- Real estate investment trusts (REITs) which are required to issue 90% of their income to shareholders.
- Actively managed stock mutual funds or ETFs which usually generate more frequent and higher taxable distributions than average.
Tax-exempt Roth accounts
These include Roth IRAs, 401(k)s, 403(b)s, 457 accounts and some others.
Contributions to Roth accounts are made with after-tax dollars. Qualified withdrawals of contributions can be made tax-free. Likewise qualified account distributions (typically post age 59.5) are tax-free as well.
Typically the same holdings that are solid for traditional retirement accounts will be solid ones for a Roth account as well.
Who benefits from proper asset location?
While the answer to this question is most people to at least some extent, there are some specific situations where proper asset location can be very beneficial tax-wise.
- You are currently in a high marginal tax bracket.
- You expect to be in a higher marginal tax bracket in the future.
- You are investing for the long term.
- You find that your taxable accounts are very tax-inefficient based on your holdings.
- You are looking to pass on investments to heirs and hope to be able to take advantage of the step-up in basis.
It is generally close to impossible to have all accounts perfectly aligned from an asset location perspective. But paying attention to this over time when investing new money, realizing gains and losses and making charitable contributions with appreciated holdings can help you to reduce your taxes from investment gains and keep more of your assets.
