When it comes to financial planning, most investors are familiar with asset allocation—the process of spreading investments across stocks, bonds, and other asset classes to manage risk. But there’s another, often overlooked strategy that can make a huge difference in your after-tax returns: asset location. This strategy is a cornerstone aspect of how Afton Advisors positions client portfolios to pay the least tax possible.
Asset location is about where you hold your investments—in taxable, tax-deferred, or tax-exempt accounts—to minimize taxes and maximize growth. This extra layer of planning can help you pay less in taxes overall, optimize Roth conversions, and reduce capital gains taxes. Yet, many financial planners don’t emphasize it enough.
What Is Asset Location?
Simply put, asset location is the strategic placement of different types of investments into the right types of accounts based on their tax characteristics:
- Taxable accounts: Investments here are subject to annual taxes on dividends, interest, and capital gains.
- Tax-deferred accounts (Traditional IRAs, 401(k)s): Taxes are deferred until withdrawal, and withdrawals are taxed as ordinary income.
- Tax-exempt accounts (Roth IRAs): Contributions are made with after-tax dollars, but qualified withdrawals are tax-free.
By aligning your investments with the account that offers the best tax treatment for that asset, you can reduce your overall tax bill and keep more of your money working for you.
Why Asset Location Matters: The Tax Benefits
Lower Your Overall Tax Bill
Different investments generate different types of income, taxed at different rates. For example, bond interest is taxed as ordinary income, often at a higher rate than long-term capital gains or qualified dividends from stocks.
By holding tax-inefficient investments like bonds and actively managed funds in tax-deferred accounts, you shelter that income from immediate taxation. Meanwhile, tax-efficient investments like broad-based stock index funds, which generate qualified dividends and long-term capital gains, can be held in taxable accounts where they benefit from lower tax rates and the ability to defer gains.
This strategic placement can reduce the annual tax drag on your portfolio by up to 0.4% or more, which can translate to thousands of dollars saved over time.
Enhance Roth Conversions
Asset location also supports smarter Roth IRA conversions. By holding growth-oriented assets in Roth accounts, you allow them to grow tax-free. When you convert traditional IRA assets to Roth IRAs, having the right assets in place can minimize the tax impact and maximize future tax-free withdrawals.
Reduce Capital Gains Taxes
Holding tax-efficient equity funds in taxable accounts helps minimize capital gains distributions and taxes. Conversely, tax-inefficient assets like REITs and actively managed funds, which tend to generate frequent taxable gains, are better suited for tax-advantaged accounts.
Practical Asset Location Tips
- Municipal bonds belong in taxable accounts because their interest is usually tax-exempt.
- Stock index funds and ETFs are ideal for taxable accounts due to their tax efficiency.
- Tax-inefficient assets like taxable bonds, REITs, and actively managed funds should be placed in tax-deferred accounts.
- Roth IRAs are best for growth-oriented, volatile assets that benefit most from tax-free compounding.
Final Thoughts: Don’t Overlook This Powerful Strategy
Asset location is a crucial, yet often neglected, part of comprehensive financial planning. By thoughtfully assigning your investments to the right accounts, you can significantly reduce taxes, improve your after-tax returns, and set yourself up for more flexible and tax-efficient withdrawals in retirement.
If your financial plan doesn’t include asset location strategies, now is the time to start. This simple but powerful step can help you keep more of your hard-earned money and enjoy a more comfortable retirement.