Asset Location Strategies: A Framework for Reducing Investment Taxes

By Michael Fishman, CFP®

What’s Included: 

When it comes to managing your investments, minimizing taxes is just as important as maximizing returns. While it’s common for investors to focus on strategies like tax-loss harvesting, income timing, and charitable giving to reduce their tax burden, asset location is another powerful, yet often overlooked tool for increasing after-tax returns.

Asset location refers to the strategic placement of investments across different account types — taxable, tax-deferred, and tax-exempt — to take advantage of each account type’s unique tax treatment. Since different types of investments generate income that is taxed in different ways, optimizing which bucket holds various assets can reduce tax drag and improve overall portfolio efficiency.

Understanding and implementing asset location strategies can lead to significant tax savings over time, making it an essential component of a well-structured investment plan.

What Is Asset Location?

Asset location is the practice of strategically placing investments in different types of accounts based on their tax efficiency. The goal is to maximize after-tax returns by aligning assets with the most favorable tax treatment for each type of investment.
 

For example, some mutual funds can distribute high capital gains annually, even if a position isn’t sold. Similarly, taxable bond funds routinely generate high levels of bond interest. These income distributing investments may be best suited for tax-advantaged accounts like IRAs or 401(k)s, where they will be allowed to grow tax-deferred.

Meanwhile, tax-efficient assets, such as index funds or municipal bonds, can be held in taxable accounts without incurring excessive tax liability.

By carefully considering where to place various assets, investors can reduce tax drag, allowing their portfolios to grow more efficiently over time.

What Is the Difference Between Asset Allocation and Asset Location?

While asset location and asset allocation are related concepts, they serve distinct purposes in an investment strategy.

• Asset allocation refers to how a portfolio is divided among different asset classes—such as stocks, bonds, and cash. When determining a client’s asset allocation, we review their risk tolerance, time horizon, and financial goals. The goal of asset allocation is to balance risk and return to work toward achieving long-term investment objectives.
• Asset location focuses on where assets are held to optimize tax efficiency. It determines whether an investment should be placed in a taxable, tax-deferred, or tax-exempt account to minimize the tax impact on returns.

Both strategies work together to enhance portfolio performance. Asset allocation ensures diversification and risk management, while asset location optimizes tax efficiency, helping investors retain more of their returns.

 

Understanding Different Investment Account Types

To implement an effective asset location strategy, it is essential to understand the three primary types of investment accounts and their tax implications.

Taxable Accounts

Taxable accounts, such as individual brokerage accounts, are funded with after-tax dollars (i.e., your paycheck). Taxes are assessed annually on investment income including dividends and interest, or when investments are sold and have capital gains at the time of the sale. Taxable dollars provide flexibility because there are no penalties for accessing your money.

Tax-Deferred Accounts

Tax-deferred accounts, such as an Individual Retirement Account (IRA) or an employee-sponsored retirement plan (such as a 401(k) plan) are funded with before-tax dollars and are allowed to grow tax-deferred. Funds are taxed as ordinary income when they are withdrawn. Dollars contributed to a tax-deferred account receive an immediate tax benefit on the investor’s current year tax return, by reducing their taxable income.  

 

Tax-Exempt Accounts

Roth IRAs and Roth 401(k)s fall into the tax-exempt category. Contributions are made with after-tax dollars, but qualified withdrawals are tax-free. These accounts are excellent for high-growth investments that can benefit from tax-free compounding. Once the account owner turns age 59.5 (and assuming the account has been open for at least five years), any growth on these funds can be withdrawn tax-free. Additionally, contributions can be withdrawn at any time tax and penalty free. 

Understanding these distinctions is key to determining where different investments should be placed for maximum tax efficiency. 

How Asset Location Works

To illustrate how asset location can improve after-tax returns, consider the following example:

Investor A has a $1 million portfolio split evenly across a taxable brokerage account, a traditional IRA, and a Roth IRA.

They invest in three asset classes: 
   o Bonds, which generate taxable interest income 
   o Dividend-paying stocks, which provide qualified dividends – dividends that are taxed at a lower rate 
   o Growth stocks, which primarily generate capital appreciation 

Scenario 1: Poor Asset Location Strategy
Investor A holds the following:
   o Taxable Account – Bonds
   o Traditional IRA – Growth stocks
   o Roth IRA – Dividend stocks

As a result, they pay high taxes on the bond interest, while the growth stocks, the investment projected to have the highest return over time, are in an account where withdrawals will be taxed as ordinary income.

Scenario 2: Optimized Asset Location Strategy
Investor A instead holds the following:

   o Taxable Account – Dividend stocks (taking advantage of lower tax rates on qualified dividends)
   o Traditional IRA – Bonds (benefiting from tax-deferred interest income)
   o Roth IRA – Growth stocks (where future gains will be tax-free)

By restructuring their asset location, Investor A significantly reduces their tax burden, leading to higher after-tax returns over time.

How Asset Location Can Help Reduce Taxes

A well-implemented asset location strategy can provide several tax benefits, including:

• Reducing current tax liabilities – place highly-taxed investments in tax-advantaged accounts.
• Minimizing tax drag – allow investments to compound more efficiently over time.
• Optimizing withdrawal strategies in retirement – ensure that distributions are taken from the most tax-efficient sources.

By strategically managing where assets are held, investors can enhance their long-term wealth accumulation and reduce unnecessary tax costs.

Pros and Cons of Asset Location

Despite the many advantages to implementing an asset location strategy, there are some disadvantages, which should be considered.

Pros:
• Reduces tax drag on investment returns
• Enhances after-tax growth potential
• Optimizes tax-efficient withdrawal strategies in retirement

Cons:
• Requires careful coordination with asset allocation
• Can be complex to implement and maintain
• Potential rebalancing challenges, especially if assets are spread across different account types

Asset Location in Practice: Where to Hold Different Investments

A general guideline for asset location is:

• Tax-Advantaged Accounts (Traditional IRAs, 401(k)s):
  o Bonds
  o Actively managed funds with high turnover
• Taxable Accounts:
  o Index funds
  o Municipal bonds
• Tax-Exempt Accounts (Roth IRAs, Roth 401(k)s):
  o High-growth stocks
  o Small-cap or emerging market funds

By aligning investments with the appropriate accounts, investors can maximize tax efficiency and improve overall returns.

Key Considerations When Implementing an Asset Location Strategy

• Maintain asset allocation consistency while optimizing location.
• Understand personal risk tolerance and financial goals to ensure alignment.
• Consider liquidity needs and potential rebalancing challenges before making changes.
• Regularly review and adjust asset location to reflect changes in tax laws and personal circumstances.

When to Consider Professional Guidance on Asset Location

When implementing an asset location strategy, it’s important to have a clear understanding of your entire financial picture. Any tax-saving strategy should not come at a cost to your long-term financial goals.

It is equally important to remain disciplined to your asset allocation and keep risk tolerance and time horizon at the forefront of your investment strategy. Because of this, it may be beneficial to work with a professional financial planner or advisor if you are interested in implementing an asset location strategy.

Key Takeaways

• Asset location optimizes tax efficiency by strategically placing investments in the most favorable accounts.
• Proper asset location can significantly reduce tax drag and improve after-tax returns.
• Regular review and adjustments are essential to maintaining an effective asset location strategy.
• Working with a financial advisor can help ensure that asset location aligns with your broader financial goals.

By incorporating asset location into your investment strategy, you can maximize tax savings and enhance long-term wealth accumulation. 

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Content should not be viewed as legal or tax advice. You should always consult an attorney or tax professional regarding your specific legal or tax situation. 401(k), IRA, and tax rules are subject to change at any time. Affiance Financial does not serve as an accountant and does not prepare tax returns. There may be negative tax implications if your liquidity needs change.

All investments and strategies have the potential for profit or loss. Different types of investments involve higher and lower levels of risk. There is no guarantee that a specific investment or strategy will be suitable or profitable for an investor’s portfolio. There are no assurances that an investor’s portfolio will match or exceed any particular benchmark. Asset allocation, rebalancing, and diversification will not necessarily improve an investor’s returns and cannot eliminate the risk of investment losses.