Most investors know the importance of diversifying their portfolios across different asset classes like stocks and bonds. However, there’s another type of diversification that many people overlook, and it could be costing you thousands of dollars in unnecessary taxes every year. It’s called asset location, and it’s not about which investments you own but where you choose to hold them.
Asset location is the strategic placement of investments in the right type of account to minimize your tax burden. Just like putting winter clothes in your bedroom closet and summer clothes in the attic, different investments work better in different account types. The difference is that making smart asset location decisions can boost your after-tax returns and help you keep more of your hard-earned money over time.
What Is Asset Location?
Asset location is the strategy of placing specific investments in the most tax-efficient account types. Unlike asset allocation, which focuses on how much you invest in stocks versus bonds and cash, asset location is about choosing the right “home” for each investment based on how it gets taxed.
You likely have three main types of investment accounts: taxable brokerage accounts, tax-deferred accounts like traditional IRAs and 401(k)s, and tax-free accounts like Roth IRAs. Each type has different tax rules that can work for or against you depending on what investments you hold in them.
The Three Account Types Explained
Taxable Accounts
These are your regular brokerage accounts where you invest money that’s already been taxed. You’ll pay taxes on dividends, interest, and capital gains as they occur. However, you get favorable tax treatment on qualified dividends and long-term capital gains, which are taxed at lower rates than ordinary income.
Tax-Deferred Accounts
Traditional IRAs and 401(k)s fall into this category. You get a tax deduction when you contribute, but you’ll pay ordinary income tax rates on everything you withdraw. This means even your investment gains get taxed at your regular income tax rate, not the lower capital gains rate.
Tax-Free Accounts
Roth IRAs and Roth 401(k)s are funded with money you’ve already paid taxes on, but the growth and withdrawals are completely tax-free if you follow the rules. This makes them incredibly powerful for long-term wealth building.
The Smart Asset Location Strategy
The key to successful asset location is matching investments with the account types that minimize their tax burden. Research shows that following asset location principles can boost net returns up to 0.30% per year, which can add up to significant savings over decades of investing.
Tax-Inefficient Investments
Some investments generate a lot of taxable income that gets hit with high ordinary income tax rates. These belong in tax-deferred or tax-free accounts where they can grow without creating annual tax bills.
Tax-Efficient Investments
Other investments are naturally more tax-friendly and can work well in taxable accounts. These include index funds that rarely distribute capital gains, individual stocks that you plan to hold for years, and municipal bonds that generate tax-free income.
Where to Place Bonds
Bonds are typically tax-inefficient because they generate regular interest payments that get taxed at ordinary income rates. This makes them ideal candidates for tax-deferred accounts where the interest can compound without creating annual tax bills.
High-yield bonds are especially tax-inefficient because they generate even more taxable income. Keep these in your traditional IRA or 401(k) where the income can grow tax-deferred until you retire and potentially face lower tax rates.
Where to Place Stocks
Individual stocks and stock index funds often work better in taxable accounts because they’re more tax-efficient. Qualified dividends get taxed at favorable rates, and you can control when you realize capital gains by choosing when to sell.
However, if you’re investing in Roth accounts, consider putting your highest-growth potential stocks there. Since Roth accounts never get taxed, you want the investments with the biggest upside potential growing in that tax-free environment.
Real Estate Investment Trusts (REITs)
REITs are required to distribute at least 90% of their income to shareholders, making them tax-inefficient investments. The distributions are often taxed as ordinary income rather than qualified dividends, so they may be best suited inside of tax-deferred accounts.
Municipal Bonds Exception
Municipal bonds generate tax-free income at the federal level and sometimes at the state level too. This makes them one of the few bond investments that work well in taxable accounts, especially for high-income investors in upper tax brackets.
Common Asset Location Mistakes
Holding Bonds in Taxable Accounts
This is one of the most expensive mistakes investors make. Taxable bond interest gets hit with ordinary income tax rates, which can be as high as 37% for high earners. Moving bonds to tax-deferred accounts may save thousands in taxes annually.
Putting Tax-Efficient Investments in Tax-Deferred Accounts
Some investors put index funds and individual stocks in their 401(k)s when they could work better in taxable accounts. This wastes the tax-deferral benefit on investments and lessens the opportunity to take advantage of lower capital gains tax rates..
Who Benefits Most from Asset Location
Asset location strategies work best for certain types of investors. Research indicates that following an asset location strategy can boost annual after-tax returns by 0.14 to 0.41 percentage points for conservative investors in mid to high income tax brackets.
High-Income Investors
The higher your tax bracket, the more you can save through smart asset location. If you’re paying 32%, 35% or 37% in federal income taxes, these benefits become substantial over time.
Balanced Portfolio Owners
Investors with both stocks and bonds in their portfolios have more opportunities to optimize their asset location. If you only own one type of investment, there’s less room for optimization.
Getting Started with Asset Location
Start by listing all your investment accounts and their current holdings. Look for obvious mismatches like taxable bonds in brokerage accounts or tax-efficient index funds in traditional IRAs.
Make changes gradually to avoid triggering unnecessary taxes. You can implement asset location strategies when you’re rebalancing your portfolio or making new contributions to your accounts.
Work With Us
Asset location represents one of the most overlooked opportunities for improving your investment returns without taking additional risk. By strategically placing your investments in the right account types, you can potentially add meaningful value to your portfolio over time while keeping more of your money out of the IRS’s hands. The key is understanding how different investments are taxed and matching them with account types that minimize their tax burden. At Brogan Financial, we help clients implement sophisticated tax-efficient strategies like asset location as part of comprehensive financial planning. Our team understands the nuances of tax-efficient investing and can help you optimize your portfolio across all your account types. Contact us today to learn how proper asset location strategies can help you keep more of your investment returns and accelerate your path to financial independence.
