Asset location isn’t just about what you invest in—it’s about where you place those investments. Deciding which assets belong in your taxable accounts, tax-deferred accounts, or tax-exempt accounts is an incredibly powerful, yet often overlooked investment strategy. Why does this seemingly small detail matter so much?
- Tax Impact: Different types of investments are taxed differently, and different account types have their own tax rules. By strategically placing your investments, you could significantly lower your tax bill year after year.
- Maximized Returns: Taxes take a bite out of your investment profits. Minimizing those taxes with smart asset location means more money stays invested and has the potential to compound over time.
Types of Investment Accounts
Before we dive into asset location strategies, let’s outline the three primary types of investment accounts:
- Taxable Accounts: These are your regular brokerage accounts. Any interest, dividends, or capital gains generated within these accounts are subject to taxes in the year they occur.
- Tax-Deferred Accounts: Traditional IRAs, 401(k)s, and similar accounts offer a major perk — your investments grow tax-deferred. You won’t pay taxes until you make withdrawals, typically in retirement.
- Tax-Exempt Accounts: Roth IRAs, Roth 401(k)s, and similar accounts are fueled by after-tax contributions. In return, your investments grow tax-free and qualified withdrawals in retirement are entirely tax-free.
Key Point: Understanding the tax implications of each account type is crucial for effective asset location strategies.
Which Assets Should Go Where?
While there are some nuances, here’s a general guideline to kickstart your asset location strategy:
Taxable Accounts
- Stocks: Especially individual stocks that you plan to hold for the long term and aim for significant growth. Long-term capital gains are taxed at a lower rate than ordinary income.
- Tax-Efficient Index Funds and ETFs: These low-cost investment options generally have less turnover, meaning fewer taxable events within the fund itself.
- Municipal Bonds: Interest from these bonds is usually tax-exempt at the federal level, and sometimes at the state level, making them a good fit for taxable accounts.
Tax-Deferred Accounts
- Bonds and Bond Funds: Interest from bonds is taxed as ordinary income, making it ideal to delay that tax hit using tax-deferred accounts.
- High-Turnover or High-Dividend Stocks: These generate more frequent taxable events, so tax-deferral provides a significant advantage.
- Real Estate Investment Trusts (REITs): REITs often distribute high dividends, making them best housed in tax-sheltered accounts.
Tax-Exempt Accounts
- Assets with High Growth Potential: Think stocks and stock funds that you expect to experience substantial appreciation over the long term. You’ll maximize your returns by never paying taxes on those gains.
Important: These are starting points! Your optimal asset location will depend on individual circumstances.
Asset Location Strategies for Different Investors
Let’s look at how individual circumstances shape asset location decisions:
- Young Investors: If you have decades until retirement, maximizing growth in tax-exempt accounts like a Roth IRA can be incredibly powerful. You might favor more aggressive allocations in these accounts.
- Near Retirement: As you approach retirement, you may begin shifting towards income-generating assets. Housing a portion of your bond holdings in tax-deferred accounts can provide regular income while deferring taxes.
- Income level: High earners face higher tax rates. Maximizing the use of tax-advantaged accounts becomes even more crucial.
Important Resources:
IRS: Tax Topics – Topic 409 Capital Gains and Losses
Additional Considerations for Asset Location
Asset location is a dynamic process. Here’s what else you need to keep in mind:
- Rebalancing: As your investments grow (or if market swings happen), your initial asset allocation across accounts might get out of whack. Rebalancing means selling and buying in different account types to bring things back in line with your targets. Consider how rebalancing might generate taxable events.
- Tax-Loss Harvesting: This is the strategic practice of selling investments at a loss to offset capital gains and lower your tax bill. While typically done in taxable accounts, it can play a role in how you approach asset location over time.
- Risk Tolerance: Asset location should not override your overall investment risk profile. Ensure your allocation between stocks and bonds across all accounts still matches your comfort with risk.
Asset Location Examples
Let’s make this concrete with a simplified example. Imagine an investor with the following accounts:
- Taxable Brokerage Account
- Traditional IRA
- Roth IRA
A possible asset location strategy might look like this:
- Taxable: Primarily individual stocks and index funds
- Traditional IRA: A mix of bonds, bond funds, and high-dividend stocks
- Roth IRA: Aggressive stock funds with high expected growth
Important: This is illustrative! Your ideal breakdown might differ based on your time horizon, income, and specific investments.
Advanced Asset Location Strategies
For those with more complex financial situations, here are some advanced maneuvers to consider (always consult a tax professional first):
- Employing multiple taxable accounts: Strategically spread out assets with different cost bases to take advantage of specific tax-loss harvesting opportunities.
- Roth IRA conversions: In certain years, it might be beneficial to convert some assets from a Traditional IRA to a Roth IRA, paying taxes now to unlock future tax-free growth.
Conclusion
Asset location might seem like a small detail in the grand scheme of investing, but its impact can be massive over time. By strategically considering where you place your investments, you could save thousands of dollars in taxes and significantly boost your long-term returns.
Key Takeaways
- Asset location is just as important as your choice of investments.
- Match your investments to the account type that offers the most favorable tax treatment.
- Individual circumstances like your age and tax bracket influence optimal asset location.
Important Note: Asset location can be complex. It’s always wise to consult with a financial advisor to create a personalized strategy that works best for your unique situation.
Call to Action:
Have you considered asset location as part of your investment strategy? If not, now is the perfect time to start! Here are some action steps:
- Inventory your accounts: List out your taxable, tax-deferred, and tax-exempt accounts.
- Review your holdings: Note the specific types of investments held within each account.
- Seek Guidance: Consider scheduling a consultation with a financial advisor or tax professional to evaluate your current setup and discuss potential optimizations.