Asset location is the strategy of placing investments in the most tax-efficient account type. While asset allocation determines what you own, asset location determines where you own it. Done right, asset location can add significant value to your portfolio without changing your investment strategy.
Asset Allocation vs. Asset Location
These two concepts are related but distinct:
- Asset allocation: Your overall mix of stocks, bonds, and other assets
- Asset location: Which account types hold each investment
Key Insight: You can have the same asset allocation with different asset locations. A portfolio of 60% stocks and 40% bonds can be arranged tax-efficiently or tax-inefficiently across your accounts.
Understanding Account Types
Different accounts have different tax characteristics:
Taxable Accounts (Brokerage)
- Interest and dividends taxed annually
- Capital gains taxed when realized
- Long-term gains receive preferential rates
- Tax-loss harvesting available
- Step-up in basis at death
Tax-Deferred Accounts (Traditional IRA, 401k)
- No taxes on growth during accumulation
- All withdrawals taxed as ordinary income
- No distinction between gains, dividends, or interest
- Required minimum distributions (RMDs)
Tax-Free Accounts (Roth IRA, Roth 401k)
- No taxes on growth or qualified withdrawals
- Contributions made with after-tax dollars
- No RMDs for Roth IRAs (Roth 401k has RMDs)
- Most valuable for high-growth investments
The Asset Location Framework
Place investments based on their tax efficiency:
Tax-Advantaged Accounts (Traditional/Roth)
Hold tax-inefficient investments:
- Taxable bonds (high interest income)
- REITs (dividends taxed as ordinary income)
- Actively managed funds (high turnover)
- High-yield investments
- Commodities and commodity funds
Taxable Accounts (Brokerage)
Hold tax-efficient investments:
- Index funds and ETFs (low turnover)
- Growth stocks (unrealized gains)
- Tax-managed funds
- Municipal bonds (tax-free interest)
- Stocks you plan to donate to charity
Roth vs. Traditional Location Decisions
Within tax-advantaged accounts, there is a secondary decision:
Place in Roth Accounts
- Highest expected growth assets
- Small-cap and emerging market stocks
- Aggressive growth funds
- Assets you will hold longest
Place in Traditional Accounts
- Bonds and fixed income
- REITs
- Lower growth assets
- Assets you may need before retirement
Roth Optimization: Since Roth withdrawals are tax-free, you want the most growth in Roth accounts. A stock that grows 10x in a Roth is worth far more than the same stock in a traditional IRA.
Practical Asset Location Example
Let us walk through a complete example:
Portfolio Setup
Target allocation: 60% stocks, 30% bonds, 10% REITs
Total portfolio: $500,000
Account breakdown:
- 401(k): $200,000
- Roth IRA: $100,000
- Taxable brokerage: $200,000
Tax-Efficient Location
Roth IRA ($100,000):
- 100% small-cap and international stocks
- Highest growth potential in tax-free account
401(k) ($200,000):
- $150,000 in bonds (30% of total)
- $50,000 in REITs (10% of total)
- Tax-inefficient assets sheltered from current tax
Taxable ($200,000):
- $200,000 in US large-cap index funds
- Tax-efficient, qualifies for LTCG rates
The Value of Asset Location
Research suggests asset location can add 0.25% to 0.75% annually to after-tax returns. Over decades, this compounds significantly.
Long-Term Impact
On a $500,000 portfolio over 30 years:
- 0.25% annual benefit: $95,000 extra
- 0.50% annual benefit: $200,000 extra
- 0.75% annual benefit: $320,000 extra
When Asset Location Matters Most
Asset location provides the most benefit when:
- You have significant assets: Larger portfolios benefit more in absolute terms
- You are in a high tax bracket: Higher rates mean bigger tax savings
- You have multiple account types: More flexibility to optimize
- You hold tax-inefficient investments: Like bonds, REITs, or active funds
- You have a long time horizon: Benefits compound over time
Common Asset Location Mistakes
1. Holding Bonds in Taxable Accounts
Bond interest is taxed at ordinary income rates. Unless you use municipal bonds, hold bonds in tax-advantaged accounts.
2. Holding Municipal Bonds in IRAs
Municipal bond interest is already tax-free. Putting them in an IRA wastes the tax benefit and converts tax-free income to taxable income at withdrawal.
3. Ignoring International Stock Taxes
International stocks in taxable accounts can receive foreign tax credits. In an IRA, you cannot claim this credit.
4. Not Considering Your Full Picture
Asset location should consider all your accounts together as one portfolio, including spouse's accounts.
Analyze Your Asset Location
Pro Trader Dashboard helps you visualize your asset location across all accounts and identifies optimization opportunities.
Rebalancing with Asset Location
When rebalancing a tax-efficiently located portfolio:
- Rebalance within tax-advantaged accounts first: No tax consequences
- Use new contributions: Direct new money to underweight assets
- Use dividends and interest: Redirect distributions to rebalance
- Sell in taxable only if necessary: And preferentially sell assets with losses or small gains
Special Situations
Employer Stock
If you have company stock in a 401(k), consider the Net Unrealized Appreciation (NUA) strategy. This allows transferring stock to a taxable account and paying only LTCG rates on appreciation.
Concentrated Positions
Large positions in a single stock are generally most tax-efficient in taxable accounts where you can use strategies like charitable giving or exchange funds.
Expected Tax Rate Changes
If you expect to be in a lower tax bracket in retirement, traditional accounts may be more valuable. If you expect higher rates, Roth accounts become more attractive.
Implementation Steps
- List all accounts: Include taxable, traditional, and Roth accounts
- Define your target allocation: Overall mix of asset classes
- Rank assets by tax efficiency: Most to least tax-efficient
- Fill Roth accounts: With highest-growth, least tax-efficient assets
- Fill traditional accounts: With remaining tax-inefficient assets
- Fill taxable accounts: With tax-efficient investments
- Review annually: Adjust as account balances change
Limitations to Consider
- 401(k) investment options: You may not have ideal funds available
- Contribution limits: Cannot always fully optimize due to limits
- Liquidity needs: May need accessible funds in taxable accounts
- Simplicity: Extreme optimization may not be worth the complexity
Summary
Asset location is a powerful but often overlooked strategy for improving after-tax returns. By placing tax-inefficient investments in tax-advantaged accounts and tax-efficient investments in taxable accounts, you can potentially add significant value over time without changing your investment strategy. The key is viewing all your accounts as one unified portfolio and making deliberate decisions about where each asset class belongs.
Learn more about optimizing your investments in our guides on tax-efficient investing and long-term capital gains rates.