The Role of Asset Location in Managing Retirement Taxes

Location, location, location. It’s not just for real estate.

Most investors are familiar with the concept of asset allocation, which describes how much of your overall portfolio is dedicated to stocks, bonds, cash, and alternative investments.¹ But fewer investors are familiar with the concept of asset location, which is all about where you should put those assets.²

Because different kinds of accounts—taxable brokerage accounts; tax-deferred accounts like 401(k)s and traditional IRAs; and tax-advantaged accounts like Roth IRAs—are taxed differently, being thoughtful about which assets you hold in which accounts can help you both minimize your tax payments and set your heirs up for success.

Let’s review the taxes

In standard brokerage accounts, gains realized from selling an investment are generally subject to taxes when they are realized. Interest and dividend payments are taxed when you receive them as well. If the investments on which you’ve realized capital gains have been in your portfolio for more than a year, then they’re taxed at either 0%, 15%, or 20%, depending on your taxable income and filing status. Short-term capital gains (investments you've held for less than one year) are taxed at your ordinary income tax rate, which is usually higher than your long-term capital gains tax rate.

With traditional tax-deferred retirement accounts such as a traditional IRA, 401(k), or 403(b), gains realized inside the account aren’t taxable when they’re realized. Rather, taxes are assessed on withdrawal of the funds. Withdrawals from traditional retirement accounts are generally taxed as ordinary income federally. In some states, distributions from retirement accounts may not be taxed at the state level. Additionally, if you’re under age 59 ½ when the withdrawal is made, then the distribution will be subject to a 10% early withdrawal penalty as well in most cases.

With tax-advantaged Roth accounts—which can be an IRA, 401(k), 403(b) or others—any realized gains or other income will also accumulate and potentially grow inside of the Roth account. As long as you’re at least age 59 ½, withdrawals will generally be made tax-free. Like tax-deferred accounts, if you’re under age 59 ½, distributions of earnings may be subject to taxes and/or a 10% penalty, although withdrawals of contributions are tax-free no matter your age.

It’s these differences in the tax treatment of withdrawals and assets that are the basis of asset location.

Asset location

While your overall asset allocation will be determined by your time horizon, your goals, and your risk tolerance, your optimal asset location will be based on the kinds of investments and your goals.

Note that, as a practical matter, it may not be possible or even desirable to have each kind of account and each type of investment asset perfectly aligned with each other. But paying attention to asset location as much as possible can yield significant tax savings, and potentially add to the long-term value of your accounts.

Taxable accounts

While taxable accounts can hold virtually any type of investment asset or asset class you might be interested in, certain types of holdings may be best suited to these accounts.

• Tax-exempt municipal bonds, as well as muni bond funds and ETFs, are generally tax-free, making them a solid choice for taxable accounts. In fact, there’s no real reason to hold these investments in either a traditional or Roth retirement account, because the benefit of tax-free income would be lost.
• Stocks, including stock-based mutual funds and ETFs, where the plan is to hold these assets and then pass them on to non-spousal heirs after your death. With the step-up in basis that your heirs receive on these inherited assets, they can save a substantial amount on capital gains taxes if these assets have experienced significant appreciation over time.
• Index ETFs and mutual funds can be a good choice, since they generally don’t generate high levels of taxable income during the course of a year. If they’re sold at a gain after at least a one year holding period, these gains would be taxed at preferential long-term capital gains rates instead of at ordinary income rates.

Tax-deferred retirement accounts

Part of the logic behind tax-deferred retirement accounts—such as traditional IRAs, 401(k)s, and 403(b)s—is that, by the time you start taking withdrawals, you may well be in a lower tax bracket than you were in when the gains were realized. However, those withdrawals are still taxed at ordinary income rates.

Investments that can be a good fit in a traditional retirement account include:

• Taxable bonds, including taxable bond mutual funds and ETFs. Interest isn’t taxed in the year it’s received, and can instead be invested inside the account and allowed to grow tax-free over time.
• Stocks, including stock mutual funds and ETFs, that throw off substantial dividends, or stock funds and ETFs that are actively managed can be good candidates for a tax-deferred account, because those gains can themselves appreciate tax-deferred.

Tax-advantaged Roth accounts

Roth accounts offer the opportunity for tax-free growth, as long as withdrawals from the account adhere to the five-year rule on Roth accounts and the account holder is at least age 59 ½.

The types of holdings outlined in the section for tax-deferred accounts are also solid holdings for a Roth account, because taxes were already assessed on the contributions, allowing investments that might have a higher upside to grow without tax penalty.

One way to differentiate might be to put investments you think have higher upside potential in Roth accounts, so you get the benefit of higher growth without taxes.

Asset location in practice

Now, you probably already have investment accounts, and you probably already have investments in those accounts. Should you try to sell less-optimal investments in each account to buy more-optimal investments in that account? 

Probably not.

The goal of asset location is to minimize taxes over time; unless taking a tax hit now (when you might be in a higher tax bracket) is going to be substantially less than any taxes down the road (which you can’t really predict because growth is uneven), it’s better to leave things as they are and make different choices over time in the future.

• Focus on asset location when rebalancing accounts. Buy and sell assets with your overall asset location in mind.
• Use new money to implement asset location. Whether you make contributions to a 401(k) or other accounts, use these new contributions to help manage your overall asset location.
• When you leave an employer and rollover an account, make decisions based on both overall asset location and asset allocation.

Incorporating asset location into your decision-making can help you ensure you get to enjoy more of your hard-earned money in retirement.