When it comes to investing, most people focus on what to buy—stocks, bonds, mutual funds. However, where you place those investments can be just as important as what you buy. This is the concept of asset location, and it’s a key strategy for minimizing taxes and keeping more of your investment returns.
What Is Asset Location?
Asset location involves strategically dividing your investments among taxable, tax-deferred, and tax-free accounts to help optimize tax efficiency.
The IRS treats each type of account differently, so understanding how taxes apply to your investments can help you maximize after-tax returns.
For example:
Taxable accounts (like a brokerage account): You pay taxes annually on interest, dividends, and capital gains. Most dividends from stocks as well as long-term capital gains are usually taxed at more favorable capital gains tax rates.
Tax-deferred accounts (like 401(k)s and traditional IRAs): Taxes are deferred until you withdraw the money, typically in retirement, at which point withdrawals are taxed at ordinary income rates.
Tax-free accounts (like Roth IRAs): You pay taxes upfront. Investments grow tax-free, and withdrawals in retirement are also tax-free.
The goal of asset location is to place investments in the accounts where they will receive the most favorable tax treatment.
Why Asset Location Matters
Taxes can erode your investment returns over time. By making deliberate choices about where to hold different assets, you can lower your tax burden and potentially increase your retirement savings.
Here’s a simple example: Imagine you hold high-dividend stocks in a taxable account. Those dividends are taxed annually at your ordinary income tax rate or the qualified dividend rate. If you instead had them in a tax-deferred or tax-free account, you could defer or eliminate those taxes.
Similarly, if you hold municipal bonds—which generate tax-free interest—in a tax-deferred account like an IRA, you lose the benefit of their tax-free status. Municipal bonds are generally better suited to taxable accounts, and especially if you are a high earner and situated in a higher federal tax bracket.
Which Assets Go Where?
While individual circumstances vary, these general guidelines can help:
Tax-efficient investments in taxable accounts: Tax-efficient investments, such as index funds and municipal bonds, generate relatively low taxable income. These are good candidates for taxable accounts, as they’re less likely to create a large tax bill.
Tax-inefficient investments in tax-deferred accounts: Investments that generate ordinary income, like high-yield bonds and actively managed funds with frequent trading, can be placed in tax-deferred accounts like a 401(k) or traditional IRA. The tax deferral can help shield you from annual tax hits.
High-growth assets in tax-free accounts: Assets with the potential for significant appreciation, like stocks, can be ideal for tax-free accounts such as a Roth IRA. Because withdrawals are tax-free, you won’t owe taxes on the gains.
Considerations for Retirees
If you’re in retirement, you may need to adjust your strategy:
Manage required minimum distributions (RMDs): Once you reach RMD age, the IRS requires you to take annual withdrawals from traditional IRAs and 401(k)s. RMDs are taxed as ordinary income, so consider balancing withdrawals with other tax-efficient income sources to avoid jumping into a higher tax bracket.
Prioritize withdrawal order: Generally, it’s tax-efficient to withdraw from taxable accounts first, then tax-deferred accounts, and save tax-free accounts like Roth IRAs for last. This approach allows tax-advantaged accounts to continue growing longer.
Harvest losses or gains: In taxable accounts, you can use tax-loss harvesting to offset gains and reduce your tax bill. Retirees may also strategically realize capital gains when their tax rate is lower.
When Asset Location Gets Complicated
While these principles are straightforward, applying them can get complex depending on your investment mix, tax bracket, and financial goals. Life changes, such as retiring, downsizing, or selling a business, can also shift the optimal strategy.
Additionally, tax laws frequently change, affecting the advantages of certain asset placements. For instance, recent changes to inherited IRA rules require beneficiaries to withdraw the full balance within 10 years, making strategic asset location even more important for estate planning.
The Case for Professional Guidance
Tax-efficient investing requires more than just understanding asset location—it requires a holistic view of your financial picture. Working with a fiduciary financial advisor with expertise in tax-efficient strategies can help ensure your investments align with your goals while minimizing unnecessary tax burdens.
An advisor can analyze your specific situation, recommend strategies tailored to your goals, and adapt your plan as tax laws and your circumstances evolve. They can save you time and stress by handling the details so you can focus on enjoying your life and retirement.
Final Thoughts
Optimizing asset location is a powerful way to enhance your after-tax investment returns, but it’s not a one-size-fits-all strategy. By understanding which assets belong in which accounts and adapting your approach over time, you can reduce taxes and make the most of your hard-earned savings.
If you’re unsure how to begin, consider working with a fiduciary financial advisor to help you feel confident your investments are structured to achieve your financial goals in the most tax-efficient way possible. After all, every dollar saved on taxes is a dollar you can use to enjoy your retirement.
Schedule a complimentary 30-minute discovery call with a fiduciary wealth advisor.