Where You Hold It Matters: The Overlooked Discipline of Asset Location

Most investors have heard of Asset Allocation: The mix of stocks, bonds, and cash that anchors a portfolio to a person's goals and tolerance for risk. Far fewer have heard of its quieter cousin, Asset Location, and that is a shame, because it is one of the few places in investing where a household can improve its after-tax outcome without taking on a shred of additional risk or sacrificing returns.

The idea is simple to state and easy to neglect. Asset Allocation looks at what you own. Asset Location asks where you own it. The core of this approach is the fact that different account structures are taxed in fundamentally different ways and each of these structures comes with its own set of strengths and weaknesses. By splitting an investor’s asset allocation in a way that seeks to optimize the strengths and minimizes the weaknesses provided by each account type, we can increase the “after-tax” return of a portfolio without increasing the risk.

Three Buckets, Three Tax Treatments

Broadly speaking, individual investors have access to three types of accounts:

The first is the taxable brokerage account. Here, dividends and interest are taxed in the year you receive them, and you owe capital gains tax when you sell at a profit. This downside is balanced by the fact that you can use realized losses to offset gains, long-term capital gains and qualified dividends enjoy preferential federal rates, and the fact that you can withdraw funds from these accounts without any penalty to tax consequences at any time.

The second is the tax-deferred account, which includes Traditional IRA, 401(k), 403(b) and other similar retirement account structures. These are funded with “pre-tax” dollars, meaning you’re your contributions are deducted from your taxable income in the year they are made. Nothing that happens inside the account is taxed along the way. Interest, dividends, and realized gains all compound untouched. However, the tax bill comes due only at withdrawal, when every dollar is taxed as ordinary income. Further adding to the downside is the fact that investors must begin pulling funds from these accounts at a certain age (currently 73) through Required Minimum Distributions (RMDs).

The third is the tax-exempt account, which are often referred to as “Roth Accounts” such as the Roth IRA or Roth 401(k). These accounts are funded with after-tax dollars, and in exchange, qualified withdrawals come out entirely free of tax. Just like tax-deferred accounts, nothing that happens “inside” the account is taxed, but these accounts also have the added benefit of offering tax-exempt withdrawals and being exempted from the required minimum distributions imposed on tax-deferred structures.

Three options, three very different sets of rules. Asset location is simply the practice of matching each investment to the bucket where it is treated most kindly.

Putting the Right Holdings in the Right Place

It is important to remember that all of this comes after establishing an asset allocation plan that makes sense for your unique situation. Investors cannot let the “tail wag the dog” by emphasizing tax efficiency at the cost of the asset allocation decisions that will ultimately determine most of their risk and return. However, once the asset allocation decision is made and you have identified “what” you should invest in, the next step calls for optimizing “where” these assets should be held.

The basis of asset location strategies revolve around placing investments that generate ongoing taxable income into accounts where this income is not taxed, while allocating investments that do not generate ongoing taxable income (or which are taxed more favorably in some way) to accounts that allow them to benefit from these features.

Investments that generate a lot of ordinary income: Taxable bonds, REITs, TIPS, high-turnover mutual funds, stocks with high dividend yields, etc… tend to be the least tax-efficient things you can own. Held in a taxable account, they throw off income that is taxed every single year at your highest rate, whether you actually withdraw the funds to use them or not. Sheltered inside a tax-deferred IRA, that same income compounds without an annual drag. As a general matter, this is where the tax-hungry holdings belong.

Investments with unique tax advantages like Municipal Bonds, which are already exempt from federal (and at times even state) income tax, or things like Limited Partnerships (which distribute their income in a tax-advantaged manner), also belong in taxable accounts where these benefits can be realized. Burying them inside an IRA is a genuine mistake, because you would be sheltering income that was already tax-free and converting it into ordinary income on the way out.

Broad stock index funds and ETFs, by contrast, are naturally tax efficient. They turn over slowly, most of their dividends are qualified, and you largely control when gains are realized. They benefit less from being sheltered and they enjoy preferential capital-gains tax rates anyway. This means they are often well-suited for a taxable account, where they also open the door to tax-loss harvesting and, ultimately, the step-up in cost basis that can pass appreciated shares to heirs with the embedded gain forgiven.

Your highest-growth assets, the holdings you expect to appreciate the most over decades, have a natural home in Roth accounts. If growth will never be taxed, and basic withdrawal strategy in retirement calls for tapping Roth accounts after all other options have been exhausted, it just makes sense to place these long-term compounders into this bucket.

The Quiet Edge

Research differs when it comes to quantifying the benefits of an optimal asset allocation strategy, with sources like Vanguard suggesting that this can increase after-tax returns by roughly 0.30% per year and others suggesting the benefits are even higher. In practice, the benefits are highly dependent on the individual in question: Those in higher tax brackets, higher tax states, and with higher levels of investment income, will see more benefits. The same is true for those starting from a less efficient asset location approach to begin with.

These numbers may seem small in any given year, but they add up significantly over time as these benefits compound. More importantly, these benefits snowball: Every dollar that isn’t sent to the IRS is a dollar that can be used to invest and generate compounding returns for you. There are also other benefits as well; Lower taxable income can mean staying in a lower tax bracket longer, qualifying for certain income-related tax benefits, lowering Medicare premiums, and avoiding things like the Net Investment Income Tax (NIIT). Over time, these benefits can equate to portfolio values that are meaningfully higher relative to a less efficient asset location approach.

This approach should be viewed as part of a wider strategy that epitomizes the old saying “it’s not way you make, it’s what you keep”. When Asset Location is combined with other tax-aware strategies such as tax loss harvesting, direct indexing, and taxable equivalent yield, research suggests that the total benefits can be as high as 1-2% in increased “after-tax” return per year. Over multiple decades, this can equate to portfolios that are 25-30% larger than they otherwise would have been. None of this requires predicting the market, chasing a hot manager, or taking on a single unit of additional risk. That is what makes asset location such an unusual opportunity: It is one of the few edges in investing that is entirely within your control and available regardless of what stocks and bonds happen to do in a given year. The catch is that it does not happen on its own. It takes a deliberate look at what you hold, where you hold it, and whether each dollar is sitting in the account that treats it most kindly. For most households, that review is worth having, because when the difference compounds quietly for two or three decades, "quiet" turns out to be exactly the point.

Robinson Crothers is Managing Partner at Great South Bay Advisors in Holbrook. This column is for general educational purposes and is not individualized investment, tax, or legal advice. Securities and investment advisory services offered through Osaic Wealth, Inc., Member FINRA/SIPC. Great South Bay Advisors and Osaic Wealth, Inc. are not affiliated.