The Importance of Asset Location for Tax Efficiency
When people think about investing for retirement, they often focus on what they own: stocks, bonds, mutual funds, ETFs and other investments. But another question can be just as important: Where should those investments be held?
This is the concept of asset location.
Asset location is the strategy of placing different types of investments in different types of accounts—such as taxable brokerage accounts, traditional IRAs and Roth IRAs—with the goal of making the overall portfolio more tax-efficient.
Asset location is different from asset allocation. Asset allocation determines the mix of investments you own, such as stocks and bonds. Asset location considers which account is best suited to hold each investment.
For individuals approaching or living in retirement, this distinction can become particularly important. Taxes can affect how much of your investment returns you ultimately keep and how much income is available to support your lifestyle.
Why Asset Location Matters
Different investment accounts and investments can receive different tax treatment.
For example, interest income from certain investments may be taxed differently from qualified dividends or long-term capital gains. Traditional retirement accounts generally provide tax-deferred growth, while Roth accounts can offer tax-free qualified withdrawals. Taxable investment accounts may provide greater flexibility, but investment income and realized gains can create annual tax obligations.
Because of these differences, holding the same investments in different account types can produce different after-tax results.
Asset location attempts to take advantage of these differences.
The objective isn't necessarily to reduce taxes in every single year. Instead, the goal is to consider how taxes may affect the portfolio over time and coordinate investment placement with the rest of the financial plan.
How Different Accounts Are Taxed
Understanding the basic characteristics of each account can help illustrate why asset location matters.
Traditional IRAs and other tax-deferred accounts generally allow investments to grow without annual taxation on interest, dividends and capital gains. Withdrawals are generally taxable as ordinary income, and required minimum distributions may apply once an individual reaches the applicable age.
Roth IRAs are funded with after-tax dollars. Qualified withdrawals are generally tax-free, and Roth IRAs do not have required minimum distributions for the original owner under current federal rules.
Taxable brokerage accounts don't receive the same tax deferral as retirement accounts. However, they can offer flexibility and may provide favorable tax treatment for certain long-term capital gains and qualified dividends.
Because each account has different characteristics, the location of an investment can influence the amount and timing of taxes.
A Simple Example of Asset Location
Imagine an investor owns both bonds and stocks.
Bonds can generate interest income, while stocks may generate qualified dividends and long-term capital gains. Depending on the investor's circumstances, placing income-producing investments in a tax-deferred account and holding investments with more favorable tax characteristics in a taxable account may potentially improve tax efficiency.
This is only a general example. The most appropriate strategy depends on the specific investments, account types, tax bracket, income needs and financial goals involved.
The important concept is that the account holding an investment can matter almost as much as the investment itself when considering after-tax results.
Potential Benefits of Asset Location
One potential benefit is greater tax efficiency.
By thoughtfully coordinating investments with account types, investors may be able to reduce or defer certain taxes, depending on their circumstances.
Asset location can also help with cash-flow planning during retirement. Different accounts can provide different types of income, and coordinating withdrawals across accounts may help manage taxable income from year to year.
Another potential benefit is greater flexibility.
Having investments spread across taxable, tax-deferred and tax-free accounts can give retirees more options when deciding where to draw income. That flexibility can become particularly valuable when managing large expenses, changing tax circumstances or unexpected financial needs.
Asset Location and Retirement Withdrawals
Asset location becomes especially relevant once retirement begins.
During retirement, you may have income from several sources, including Social Security, pensions, investment accounts and other assets. Withdrawals from different account types can have different tax consequences.
For example, taking additional distributions from a traditional IRA could increase taxable income, while qualified Roth IRA withdrawals generally do not increase taxable income.
Taxable investment accounts can create capital gains or other taxable income when investments are sold or generate income.
As a result, retirement income planning isn't simply about determining how much money to withdraw. It can also involve determining which accounts to withdraw from and when.
The Role of Tax Diversification
Asset location works particularly well when considered alongside tax diversification.
Tax diversification means having assets spread among different types of accounts with different tax treatments.
For example, a retiree might have:
Taxable brokerage assets
Traditional IRA or 401(k) assets
Roth IRA assets
Having money in multiple account types can provide flexibility because future tax laws, income levels and personal circumstances are difficult to predict.
A retiree may be able to choose among different sources of income depending on the circumstances in a particular year.
This flexibility can be valuable, but it also means that account types need to be considered as part of the overall retirement strategy rather than managed independently.
Potential Risks and Considerations
Asset location isn't a strategy that automatically lowers everyone's taxes.
One consideration is that moving investments between accounts can itself have tax consequences. Selling an investment in a taxable account, for example, could create a capital gain.
There can also be tradeoffs between tax efficiency, investment diversification, liquidity and other financial objectives.
In addition, tax laws can change. A strategy that is beneficial under today's rules may need to be adjusted in the future.
Investors should also be careful not to let tax considerations override sound investment principles. Choosing an investment solely because of its tax treatment may not make sense if it doesn't fit the portfolio's overall objectives, risk profile or time horizon.
The Short-Term and Long-Term Impact
In the short term, thoughtful asset location may help reduce or defer certain tax costs and potentially increase the amount of investment income available after taxes.
Over a longer period, the impact can become more significant because money that isn't paid in taxes today may remain invested and potentially compound over time.
However, tax deferral is not necessarily the same as tax elimination. Traditional retirement account withdrawals are generally taxable, so the timing of taxes still matters.
This is why asset location should be viewed as part of a long-term strategy rather than simply a way to lower this year's tax bill.
Why Professional Guidance Can Help
Asset location involves more than simply putting bonds in an IRA and stocks in a brokerage account.
A knowledgeable financial advisor can help evaluate how asset location fits with your investment strategy, retirement income needs, tax situation and broader financial goals.
For example, an advisor may consider:
Your current and expected future tax brackets
The types of investments you own
Your taxable, tax-deferred and Roth account balances
Required minimum distributions
Social Security income
Retirement spending needs
Estate-planning goals
Potential changes in tax laws
Your investment time horizon and risk tolerance
Coordinating these factors can help ensure that tax efficiency doesn't come at the expense of other important financial priorities.
Actionable Takeaways
If you're approaching retirement or already retired, consider these steps:
1. Know where your investments are held. Create an inventory of your taxable, tax-deferred and Roth accounts.
2. Look beyond investment returns. Consider how much of those returns you ultimately keep after taxes.
3. Think about withdrawals before you need them. The account you withdraw from can affect your taxable income and overall tax bill.
4. Consider tax diversification. Having assets across different account types can provide flexibility when managing retirement income.
5. Don't make decisions based solely on taxes. Investment risk, diversification, liquidity and your overall financial goals should remain part of the decision.
6. Review your strategy periodically. Changes in income, tax laws, investments, retirement needs or estate-planning goals may affect whether your current asset-location strategy remains appropriate.
Making Your Retirement Plan More Tax-Efficient
Asset location is an often-overlooked part of investment and retirement planning. While choosing appropriate investments and maintaining a suitable asset allocation remain important, where those investments are held can also influence your after-tax results.
For retirees and those approaching retirement, coordinating taxable, tax-deferred and Roth accounts can provide additional flexibility and may help manage the tax impact of investment income and withdrawals over time.
Because everyone's financial circumstances are different, there is no universal asset-location strategy. The right approach should fit your investments, retirement income needs, tax situation and long-term goals.
If you have questions about asset location or how tax-efficient strategies could fit into your overall retirement plan, schedule a complimentary phone call with OpenAir Advisers:
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