Minimize Taxes With Asset Location

What is Asset Location?

Asset location is a tax-minimization strategy that helps investors optimize their portfolio by considering the tax treatment of different types of investments. Investors can maximize their after-tax returns by placing specific securities in either tax-deferred or taxable accounts. But how does asset location minimize taxes, and how can you apply this strategy to your own investments?

Key Takeaways

• Balanced portfolios that include both equity and fixed-income investments stand to benefit most from asset location.
• Older investors or those nearing retirement can realize greater tax benefits from asset location, particularly if they plan to start withdrawing funds soon.
• Stocks and equity funds are best held in taxable accounts to take advantage of lower capital gains taxes.
• The benefits may be less pronounced for younger investors, but proper asset location can still enhance long-term returns.

Achieving Optimal Asset Location

While asset location is a powerful tax strategy, it should be seen as complementary to asset allocation— the process of spreading investments (equities, funds, other holdings) across different sectors to reduce risk. Only after determining the proper asset allocation for your portfolio should you consider the tax advantages of where to place each investment.

The best location for an investor’s assets depends on factors like your financial profile, tax laws, investment holding periods, and the tax characteristics of the individual securities.

Tax-friendly stocks should be held in taxable accounts because of their lower capital gains, dividend tax rates and the ability to defer gains. Riskier and more volatile investments belong in taxable accounts both because of the ability to defer taxes, and the ability to capture tax losses on poorly performing investments sold at a recognized loss.

Index funds and exchange-traded funds (ETFs), are valued for their tax efficiency and should also be held in taxable accounts, as should tax-free or tax-deferred bonds. Taxable bonds, real estate investment trusts (REITs) and related mutual funds should be held in tax-deferred accounts, to avoid the higher ordinary income tax rates on interest payments and dividends.

Who Benefits From Asset Location?

You need investments in taxable and tax-deferred accounts to take full advantage of asset location. Typically, investors with a balanced investment strategy consisting of both equity (stocks) and fixed-income (bonds) investments can reap the most benefits. While investors with only equities or fixed-income investments can still benefit, the advantages are more pronounced in a balanced strategy.

A typical investor with a balanced portfolio (e.g., 60% stocks and 40% bonds) might hold different types of assets in taxable and tax-deferred accounts. For example, stocks or equity funds would be best placed in taxable accounts, while fixed-income investments should be placed in tax-deferred accounts like an IRA or 401(k).

Asset Location for a Balanced Portfolio

Let’s consider an investor with a portfolio mix of 60% equities and 40% fixed income. The goal is to position the assets to minimize taxes while maintaining the same overall asset allocation:

• Tax-deferred accounts (such as an IRA or 401(k)): Hold 40% fixed-income investments (e.g., bonds) in these accounts since bond interest is taxed at ordinary income rates.
• Taxable accounts: Hold 60% equities (e.g., stocks, equity mutual funds) here, as long-term capital gains and qualified dividends are taxed at favorable rates (0%, 15%, or 20%).

This strategy ensures that taxable income from bonds is deferred and taxed at a lower rate while more tax-efficient equity returns are taxed at preferential rates.

If an investor is withdrawing funds from tax-deferred accounts or will be doing so soon, the benefit of asset location is greater than for younger investors with many years left before they start withdrawing funds.

Assume an investor has accumulated $20,000 in capital gains and dividends in a traditional individual retirement account (IRA). The investor takes the total amount as a distribution, which is then treated as ordinary income. If the taxpayer falls in the 35% tax bracket, the investor would be left with $13,000. If the investor made $20,000 in long-term capital gains and qualified dividends in a taxable account, the tax would have been only 15%, leaving $17,000.

Important

How a security is taxed will determine where it should be located.

How Asset Location Minimizes Taxes

How a security is taxed will determine where it should be located. Long-term capital gains and qualified dividends are given favorable rates of 0%, 15%, or 20%, depending on your income level. Meanwhile, taxable interest is reported on Form 1040 and is subject to ordinary income rates, which range between 10% and 37%.

Since most equity investments generate returns from both dividends and capital gains, investors realize lower tax bills when holding stocks or equity mutual funds within a taxable account. Those same capital gains and dividends, however, would be taxed at the ordinary rate (up to 37%) if withdrawn from a traditional IRA, 401(k), 403(b), or another type of retirement account where taxes are paid on the withdrawal of funds.

Fixed-income investments such as bonds generate a regular cash flow. These interest payments are subject to the same ordinary income tax rates of up to 37%.

What Is the Difference Between Asset Allocation and Asset Location?

Asset allocation refers to how you divide your investments across various asset classes (stocks, bonds, real estate, etc.) to balance risk and return. Asset location is the strategy of placing these investments in the right types of accounts (taxable vs. tax-deferred) to minimize taxes. While asset allocation focuses on diversification and risk management, asset location is a tax-efficient strategy that helps you keep more of your returns by reducing your tax burden.

How Can I Determine Which Investments Are Best Suited for Taxable vs. Tax-Deferred Accounts?

Tax-efficient investments like stocks (especially those with qualified dividends) and index funds should be placed in taxable accounts, where they benefit from lower capital gains and dividend tax rates. Bonds, taxable mutual funds, and REITs (which often generate high taxable income) are better suited for tax-deferred accounts, such as IRAs or 401(k)s, where the tax burden is postponed until withdrawal.

How Does Asset Location Affect My Retirement Planning?

Asset location plays a crucial role in retirement planning because it helps minimize the taxes you’ll pay on your investment returns over the long term. For example, you can maximize the tax benefits of tax-deferred accounts like IRAs and 401(k)s by holding investments that generate taxable income (e.g., bonds) in those accounts. This allows you to preserve more wealth for retirement. Additionally, strategically placing tax-efficient assets in taxable accounts means you can take advantage of lower tax rates on long-term gains and dividends in retirement.

The Bottom Line

Asset location is a strategy that aims to maximize after-tax returns by placing investments in the accounts that provide the most favorable tax treatment. The key to effective asset location is understanding your financial profile, tax situation, and investment time horizon. By carefully considering where to place your taxable and tax-deferred investments, you can potentially reduce your overall tax liability and enhance your portfolio’s long-term growth.