Curated by: Rubric Advisors
Tax Planning
Tax-Efficient Asset Location
Tax-efficient asset location involves placing investments in the most tax-advantaged account type, taxable, tax-deferred, or Roth, based on each asset's tax characteristics.
Tax-Efficient Asset Location
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What Is Asset Location?
- Asset location is distinct from asset allocation, it determines which account type holds each investment, not the overall mix.
- The goal is to minimize the total tax drag on a portfolio by matching each asset's tax profile to the most appropriate account.
- Three primary account types exist: taxable brokerage, tax-deferred (traditional IRA, 401(k)), and tax-exempt (Roth IRA, Roth 401(k)).
- The potential benefit of asset location generally increases with the size and diversity of accounts across all three types.
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Full Guide
What Is Asset Location?
- Asset location is distinct from asset allocation, it determines which account type holds each investment, not the overall mix.
- The goal is to minimize the total tax drag on a portfolio by matching each asset's tax profile to the most appropriate account.
- Three primary account types exist: taxable brokerage, tax-deferred (traditional IRA, 401(k)), and tax-exempt (Roth IRA, Roth 401(k)).
- The potential benefit of asset location generally increases with the size and diversity of accounts across all three types.
Tax Characteristics of Common Asset Types
- Bonds generate interest income typically taxed at ordinary income rates, which can be relatively high.
- U.S. equities held long-term may benefit from lower long-term capital gains rates and qualified dividend treatment.
- REITs generally distribute income taxed at ordinary rates, making them relatively tax-inefficient in taxable accounts.
- International equities may generate foreign tax credits that are only usable in taxable accounts.
Tax-Deferred Account Placement
- Tax-inefficient assets, such as taxable bonds, REITs, and actively traded funds, are often placed in tax-deferred accounts.
- High-turnover funds generating short-term capital gains may also benefit from tax-deferred placement.
- Withdrawals from tax-deferred accounts are taxed as ordinary income regardless of what the account holds.
- This placement shields the highest-taxed income from current taxation during the accumulation phase.
Taxable Account Placement
- Tax-efficient assets, such as broad equity index funds, ETFs, and tax-managed funds, are generally well-suited for taxable accounts.
- Municipal bonds may provide federal (and sometimes state) tax-exempt income in taxable accounts.
- Taxable accounts allow tax-loss harvesting, which is not available in retirement accounts.
- Assets held in taxable accounts may receive a stepped-up cost basis at death, potentially eliminating unrealized gains.
Roth Account Placement
- Roth accounts offer tax-free growth and tax-free qualified withdrawals, making them valuable for high-growth assets.
- Assets with the highest expected long-term growth, such as small-cap equities or emerging markets, may benefit most from Roth placement.
- Roth accounts have no required minimum distributions during the original owner's lifetime (under current law).
- The tax-free nature of Roth withdrawals may also provide flexibility in managing taxable income in retirement.
Municipal Bonds in Taxable Accounts
- Municipal bond interest is generally exempt from federal income tax and may also be exempt from state tax if issued in your state of residence.
- The tax-equivalent yield of a municipal bond depends on your marginal tax bracket, higher brackets generally increase the relative attractiveness.
- Municipal bonds are typically most beneficial in taxable accounts; placing them in tax-deferred accounts wastes their tax-exempt status.
- Consult a tax advisor to compare after-tax yields when choosing between municipal and taxable bonds.
Key Takeaways
- Asset location may add meaningful after-tax value over time, though the benefit varies by individual circumstances.
- Place tax-inefficient assets (bonds, REITs) in tax-deferred accounts and tax-efficient assets (index funds, municipal bonds) in taxable accounts when possible.
- Roth accounts may be best suited for assets with the highest expected long-term growth potential.
- A financial advisor can help model the potential benefit of asset location for your specific portfolio and tax situation.
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