Asset Location: Best Accounts for Different Investments

Asset Location is a tax-efficient investing strategy to help you minimize taxes and grow your investments faster by holding investments in the best-suited investment accounts. This strategy leverages the fact that investments in Roth IRA and 401(k) are tax-free, and investments in Traditional IRA and 401(k) are not taxed until the money is withdrawn. For example, bonds generate taxable income, and you’d have to pay ordinary income taxes each year on the interest. With asset location strategy, you would hold bonds in a tax-deferred account which eliminates the yearly taxes.

Asset Location vs. Asset Allocation

These are two different but related concepts. The overarching strategy is your Asset Allocation, which determines how much of each asset class you hold in your portfolio. Asset Location, on the other hand, determines what type of account you should use to hold each asset.

As a general rule, investments that provide predictable income, like interest and dividends, need to be in tax-deferred accounts to avoid taxes on the income. Investments held for long-term capital gains can be held in taxable accounts since the gains receive favorable tax treatment.

Asset Allocation takes priority over Asset Location. This means that you should not change your asset allocation to fit your asset location.

For example, if your asset allocation calls for 65% Stocks and 35% Bonds, and you have $50,000 in a 401(k) and another $50,000 in a taxable account. This doesn’t mean you should change your asset allocation to 50% and 50% because Bonds are better suited for the 401(k) and Stocks are better suited for the taxable account. In this case, you’d invest $35,000 in Bonds and $15,000 in Stocks inside your 401(k), and $50,000 in Stocks in your taxable account.

Three Types of Investment Accounts

Tax-Free Accounts

These are your Roth IRA and 401(k).

Your deposits are after-tax, i.e., you pay income taxes before making your contributions.
You do not have to pay any tax when you liquidate an asset, but you cannot claim a tax-loss either.
You do not have to pay any tax for dividends, or interest received.
You do not have to pay any tax when you withdraw the money.

Tax-Deferred Accounts

These are your Traditional IRA and 401(k).

Your deposits are pre-tax, i.e., your contributions are exempt from income taxes.
You do not have to pay any tax when you liquidate an asset, but you cannot claim a tax-loss either.
You do not have to pay any tax for dividends, or interest received.
You pay income taxes at your ordinary income tax rate when you withdraw the money.

Taxable Accounts

These are your regular brokerage and banking accounts.

Your deposits are after-tax, i.e., you pay income taxes before making your contributions.
You pay capital gains tax when you liquidate an asset, or you can claim a tax-loss (see below).
You pay income taxes at your ordinary income tax rate for dividends or interest received each year.
You do not have to pay any tax when you withdraw the money since you already paid.

Taxes

Capital Gains and Losses

Short-Term Capital Gains

Short-term capital gains are gains on the sale of assets held for one year or less. These must be reported as ordinary income and taxed at your ordinary income tax rates.

Long-Term Capital Gains

Long-term capital gains are gains on the sale of assets held for more than one year.

They have favorable tax treatment, which depends on your personal income tax rate. For most sales, capital gains are taxed at 0%, 15% or 20% depending on your income. Some exceptions apply to a few specific situations.

Capital Losses (Tax-Loss)

Capital losses are losses on the sale of assets regardless of the length of time held, and there are restrictions on how much of the loss you can deduct. You can deduct any losses to the extent that you have capital gains.

If your losses exceed your gains, you can deduct up to $3,000 against ordinary income in any one tax year. Any loss in excess of $3,000 can be carried forward and used to reduce your income in subsequent years.

For example, if you had a net capital loss of $10,000 in 2018, you can deduct $3,000 for that year, and carry the remaining loss of $7,000 forward to 2019. If you have $10,000 in gains in 2019, you can apply the entire $7,000 loss from 2018, reducing the 2019 taxable gain to just $3,000.

Interest and Dividend Income

Interest and dividend income are generally taxed as regular income. There are exceptions, such as municipal bond interest and qualified dividends.

Asset Location Map by Asset Classes

Because of the different ways, the IRS taxes investment income, some investments are better held in tax-sheltered accounts (i.e., tax-free and tax-deferred accounts) while other investments work better in taxable accounts.

Best for Tax-Free Accounts

Growth Stocks

Growth stocks, inclusive of ETFs and mutual funds investing in growth stocks are best-suited for Tax-Free accounts. Since your tax-free account is the best of the three tax-wise, it is the best place to invest your highest growth potential assets.

Since you are limited on how much you can add to these accounts each year, the next best place to invest your growth stocks and funds is in your Taxable account. If you can manage to stay in the lowest tax brackets, you could potentially pay zero income tax on capital gains.

Best for Tax-Deferred Accounts

Income Stocks

Dividend-paying stocks, inclusive of ETFs and mutual funds investing for income are best-suited for Tax-Deferred accounts. Dividend and interest income from these investments are not taxed until withdrawal.

On the other hand, Taxable Accounts are the worst place to keep these investments because you would have to pay income taxes on dividend and interest income each year.

Bonds

Bonds of all types, except tax-free municipal bonds, are best-suited for Tax-Deferred accounts. Earnings from these investments are not taxed until withdrawal. In a taxable account, you would have to pay income taxes on bonds income each year.

REITs

REITs are required to distribute at least 90% of their income to shareholders. The income is taxed at your ordinary income tax rate, so it is best to keep REITs in your Tax-Deferred accounts.

Since you are limited on how much you can add to these accounts each year, the next best place to invest your growth stocks and funds is in your taxable account.

Best for Taxable Accounts

Tax-Free Municipal Bonds

The income on these bonds is tax-exempt at both Federal and State levels, so there is no reason to hold them in a tax-sheltered plan.

Precious Metals

Some IRA plans advertise that you can hold gold bullion coins in them, but it is not a good use of your tax-sheltered money from a tax standpoint. Since precious metals pay no dividends, they are by default assets that are held for capital gains.

Other Considerations

In general, I believe long-term buy and hold using passively managed ETFs is the best way to invest your money. However, if you want to venture away from these best practices, here are things to consider.

Active Trading

If you’re an active stock trader, you will probably be better off trading in a tax-sheltered account. This way, you avoid paying short-term capital gains which are taxed as ordinary income, so the tax-deferred feature of sheltered plans will be an advantage.

The one main caveat is any loss cannot be used to offset capital gains.

High Turnover Funds

Mutual funds with high turnover ratios do a lot of trading during a typical year. This often results in a high percentage of short-term capital gains. These funds are better suited to tax-sheltered accounts to avoid tax liability.

Actively Managed Funds

Similar to high turnover funds, actively managed funds tend to generate more short-term capital gains, so these funds are better suited for tax-sheltered accounts.

High-Risk Investments

If you are planning to experiment with less proven investments or new investing strategy, it is best to do this on a limited basis in your taxable account. Since the risk of loss is higher, you want to be able to claim tax loss if things go bad. Secondly, you have limited ability to contribute to your tax-sheltered accounts, so you don’t want to take too much risk

Bottom Line

As your savings grow across the three account types, take asset location into serious consideration to help you minimize tax liabilities. The money you don’t have to pay in taxes can continue to work in your investment accounts and help them grow faster.