Asset Location: Which Investments Belong in Taxable vs Tax-Advantaged Accounts

Asset allocation decides how much of your portfolio goes into stocks, bonds and cash. Asset location is the next step: deciding which of your accounts should hold each of those investments. Because different accounts are taxed in different ways, placing the right investment in the right account can reduce the taxes you pay every year without changing your overall level of risk.

Most investors have up to three types of accounts. Taxable brokerage accounts are funded with after-tax dollars and taxed each year on interest, dividends and realized gains. Tax-deferred accounts, such as a traditional 401(k) or IRA, grow without annual taxes but are taxed as ordinary income when you withdraw. Tax-free accounts, like a Roth IRA or Roth 401(k), are funded with after-tax money and allow qualified withdrawals with no tax at all.

Investments that suit taxable accounts

Broad stock index funds and exchange-traded funds tend to be tax efficient. They generate relatively little taxable income each year, and much of their dividend income may qualify for lower long-term capital gains rates. Individual stocks you plan to hold for many years also fit well, because you control when gains are realized. Municipal bonds, whose interest is generally free from federal income tax, are designed for taxable accounts and gain little from being sheltered.

Investments that suit tax-deferred accounts

Taxable bond funds, certificates of deposit and other investments that produce regular interest are often best held in tax-deferred accounts. Interest is taxed at ordinary income rates, which can be much higher than capital gains rates, so sheltering it can save meaningful money. Actively managed funds that trade frequently and pass along short-term gains are also good candidates for this kind of account.

Investments that suit Roth accounts

Since qualified Roth withdrawals are completely tax free, many planners reserve Roth space for the investments with the highest expected long-term growth, such as small-company or international stock funds. The bigger the growth, the more valuable it is to never pay tax on it. Roth accounts also have no required minimum distributions for the original owner, which makes them useful for money you may leave to heirs.

Real estate investment trusts, or REITs, are another example worth noting. Most REIT dividends are taxed as ordinary income rather than at the lower qualified dividend rate, so they are often a better fit for a tax-deferred or Roth account than for a taxable one.

Asset location does not change what you own. It changes how much of what you earn you get to keep.

Keep the whole portfolio in view

Asset location works best when you treat all of your accounts as one combined portfolio. Your target mix of stocks and bonds should hold across everything you own, even though individual accounts may look unbalanced on their own. Spreadsheet tracking or a planning tool can help you see the total picture and rebalance across accounts instead of within each one.

It is also important not to let tax savings override common sense. If your only account with room for bonds is a taxable one, owning bonds there is still better than skipping them. Required minimum distributions, expected future tax brackets and when you plan to tap each account all affect the ideal setup. Our Tax Advisory and Wealth and Investment Planning teams at Money Horizon Asset can review your accounts together and suggest a placement that fits your situation.