September 18, 2023

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Asset Location, Definition

Asset location refers to strategically keeping the money you are investing across tax-advantaged, tax-free, and taxable accounts to maximize after-tax returns.

When looking at asset location, you might be considering how much to contribute to your employer’s 401(k) or the amount to contribute to your Roth or taxable investment account. The focus is on where to invest while considering the tax implications.

Tax-Advantaged vs. Taxable Accounts

To understand asset location, it is important to know the difference between various investment account types.

In my last article I mentioned the 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. This includes traditional 401(k) plans, 403(b) plans, traditional IRAs, Simplified Employee Plans (SEP), and Simple IRAs (which follow traditional IRA tax rules for withdrawals). 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 ½. Tax-free accounts allow you to save using after-tax dollars. When you make qualified withdrawals, you pay no additional income tax. Examples of tax-free accounts include Roth IRAs and Roth 401(k)s.

Taxable accounts offer no tax breaks in the form of a deduction for contributions, as found with tax-deferred accounts. In addition, taxable accounts do not provide the benefit of not paying taxes when you withdraw money like you do with a tax-free account. Instead, taxable accounts require payment of capital gains tax on the earnings from the investments when you sell them.

Capital gains can be subject to 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. To take advantage of this, you must hold on to investment for at least one year before selling.

Investing in both tax-advantage and taxable accounts at the same time is an example of a good asset location strategy. Keep in mind that you may not be able to contribute to all accounts in the same year. For example, you cannot max out contributions to a traditional IRA and a Roth IRA for the same tax year per IRS rules.

Why Asset Location Matters

Asset location helps create a diversified portfolio. Diversification is a way to manage risk by spreading your investment dollars across different asset types and paying attention to tax-efficient investing by placing money strategically in both tax-advantaged and taxable accounts. Asset location is also important from a tax perspective. Some investments are naturally more tax-efficient than others. Exchange-traded funds (ETFs), for example, tend to have a lower holdings turnover ratio (which refers to how often the underlying assets in a specific fund are bought and sold) compared to mutual funds. As a result, ETFs generate little to zero capital gains distributions versus mutual funds which generate much higher capital distributions. Some bonds generate income which is taxed as ordinary income at your marginal tax rate. Municipal bonds, however, generate income that is tax-free. Therefore, keeping tax-efficient investments in a taxable investment account could make sense for limiting your tax liability. At the same time, you could funnel less tax-efficient investments into a tax-advantaged account such as an IRA or 401(k).

One thing to keep in mind is this is not 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 is 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.

The Bottom Line

Proper asset location 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.

As always, it is best to consult a tax or investment professional before making these important decisions.

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Important Disclosures:

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