Asset Location: How to Increase Wealth by Matching Assets to Accounts

Bob Carlson

How much time do you spend on asset location?

(Notice, that’s asset location… NOT asset allocation.)

If you’re like most investors, and even financial advisers, you don’t give asset location much time or attention, or use some oversimplified rules of thumb.

Over time, that oversight reduces after-tax returns, which means your nest egg won’t last as long.

By asset location, I mean the type of account in which an asset is held.

Most people have three types of accounts.

  • Taxable accounts, which are standard brokerage or mutual fund accounts with no tax benefits.
  • Tax-deferred accounts, which are traditional IRAs and 401(k)s, annuities and even life insurance cash value accounts. Income and gains in these accounts compound tax-deferred, but are taxed when distributed.
  • Tax-free accounts, which are Roth IRAs and 529 college savings plans. Income and gains in these accounts compound free of tax, and are also usually tax-free when distributed.

Most of the investors who do consider asset location often follow the rules of thumb that stocks should be owned in taxable accounts, while bonds and other income investments should be in tax-advantaged accounts.

Those rules of thumb are true in many cases, but like the case with many rules of thumb, there is more to the story, and there are some key exceptions.

Many people will lose substantial after-tax wealth over their lifetimes by blindly following rules of thumb instead of considering their own situations.

It is important to realize the trade-offs of tax-deferred accounts.

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The good feature of these accounts is the tax deferral. Income and gains compound each year and isn’t reduced by taxes.

The downside of tax-deferred accounts is that distributions are taxed as ordinary income. The accounts can convert tax-advantaged income, such as long-term capital gains and qualified dividends, into ordinary income taxed at the highest individual rates.

When the asset location isn’t optimal, a tax-deferred account might deliver less after-tax money than the money received after those same assets compound in a taxable account.

Optimizing your asset location, or even improving it a bit, can boost your after-tax wealth.

Before we dive into the research results, I want to make clear that having the right asset allocation is more important than having the optimum asset location.

You want the right asset mix for you, even if that means holding some investments in the “wrong” accounts. Not everyone has money spread among different accounts in the right proportions to achieve optimum asset location.

Decide which assets you want to own first, and then match them as best you can to the accounts you have.

Let’s first look at some general rules for asset location.

Rule # 1:  Assets that have no tax advantages generally should be held in tax-deferred or tax-free accounts when possible.

Any asset that generates ordinary income falls into this category.

The income is taxed as ordinary income regardless of the account that holds it. But the income will compound in the tax-deferred account until distribution, and the compounded amount should give you more after-tax income than if you had paid taxes on the income each year.

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Of course, if the investments are held in a tax-free account such as a Roth IRA, the income is never taxed, and you have even more after-tax wealth.

Assets without tax advantages are those that pay taxable ordinary interest. Treasury bonds, money market funds, and high-yield bonds are the prime candidates.

Real estate investment trusts (REITs) usually fall into this category. Their dividends aren’t qualified dividends with the maximum 20% tax rate.

Instead, they are taxed the same as ordinary interest. This was more important in years past when REITs had yields of 4% and higher.

Now, REITs yields are much lower. If you plan to own them for the long-term and eventually sell for substantial long-term capital gains, it might be better to own them in taxable accounts.

Stocks and stock mutual funds you hold for one year or less are also best owned through tax-advantaged accounts.

Continue reading Part 2 of this article here , where I share Rule # 2, along with some “special situations” in which these general rules aren’t the best advice.

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