What Is Asset Location?
Asset location strategically places your investments to minimize your tax burden.
This involves placing taxable and tax-advantaged investments into different accounts to take advantage of tax breaks and minimize your taxable income.
There are two main types of accounts: tax-advantaged and taxable. Tax-advantaged accounts include 401(k)s, IRAs, and 529 plans and offer tax breaks on contributions and investment earnings.
Taxable accounts include regular brokerage accounts and bank accounts and are subject to income taxes on investment earnings.
Tax-Advantage and Taxable Accounts
The first step in asset location is understanding the difference between tax-advantaged and taxable accounts.
Tax-advantaged accounts offer tax breaks on contributions and investment earnings. The money you contribute to a 401(k) or IRA, for example, is not subject to income taxes. And the money you earn from investing in those funds is also tax-free.
On the other hand, taxable accounts are subject to income taxes on investment earnings. Your money from investing in a regular brokerage account is taxed at your ordinary-income tax rate.
How Does Asset Location Work?
There are three main asset location strategies: asset class, fund family, and country.
Asset class means grouping investments by type, such as stocks, bonds, or real estate. You can then place these asset classes in different accounts depending on their tax treatment.
Fund family means placing funds from the same company in different accounts. For example, you could put all stock funds in a taxable account and all bond funds in a tax-advantaged account.
Country asset location means investing in stocks and bonds from different countries and placing them in separate accounts. This is the most complex asset location strategy, but it can be the most effective if you have holdings in multiple countries.
There are also three basic types of investment accounts: A standard brokerage account, a tax-deferred account, and a tax-exempt account.
A standard brokerage account is the simplest type of investment account and is subject to income taxes on investment earnings.
A tax-deferred account is an account such as a 401(k) or IRA. These accounts allow you to defer paying income taxes on contributions and investment earnings until you withdraw money from the account.
A tax-exempt account is an account such as a 529 plan or Roth IRA. These accounts allow you to avoid paying income taxes on investment earnings altogether.
Why Does Asset Location Matter?
Asset location is important because it can help you save on taxes. The goal is to move investments into accounts that will be taxed less, which can reduce your overall tax bill and improve your investment returns.
For example, if you have a large taxable account, you could move some of your investments into a tax-advantaged account, reducing your taxable income and saving you money on taxes.
Does An Active Asset Location Strategy Benefits You?
You can use these criteria to decide if an active asset location strategy is right for you.
- If you are currently paying a high marginal income tax rate.
- If you expect to be in a higher tax bracket in the future.
- If you have a large amount of money invested in taxable accounts.
- If you are investing in funds with high turnover rates.
- High marginal income tax rates indicate that you could benefit from an active asset location strategy.
- If you expect to be in a higher tax bracket in the future, you should also consider using an active asset location strategy.
- If you have a large amount of money invested in taxable accounts, you could benefit from moving some investments into tax-advantaged accounts. This would reduce your taxable income and save you money on taxes.
- Investing in funds with high turnover rates can also increase your tax
- If you are expecting to pay a lower marginal income tax rate soon.
- If you have significant assets in a tax-inefficient investment held in a taxable account.
- If you expect to be invest for more than ten years.
Reasons to Use Asset Location
There are a few reasons you might want to use asset location:
- To reduce your tax bill.
- To improve your investment returns.
- To simplify your investment planning.
How to Create a Tax-Efficient Investment Strategy
There are a few things you can do to create a tax-efficient investment strategy:
- Minimize your taxable income.
- Move investments into accounts where they will be taxed less.
- Use tax-efficient investment strategies.
- Maximize your use of tax-advantaged accounts.
- Investing in stocks and mutual funds rather than individual bonds.
- Place investments in the proper accounts.
- Use asset location.
- Use tax-advantaged accounts when possible.
- Avoid investing in tax-inefficient investments.
The Bottom Line
Asset location is an important part of a tax-efficient investment strategy. By placing investments in the correct accounts, you can save on taxes and improve your investment returns.
An active asset location strategy can be especially beneficial if you expect to pay a lower marginal income tax rate shortly or have significant assets in tax-inefficient investments.
FAQs
1. Does asset location apply to all types of assets?
Asset location applies to all types of assets, including stocks, bonds, and mutual funds.
2. Can you benefit from an active asset location strategy if you only invest in tax-advantaged accounts?
You need to have investments in both taxable and tax-advantaged accounts to benefit from an active asset location strategy.
3. Can I do a DIY asset location?
You can do a DIY asset location, but be aware of the tax implications of each investment and place them in the correct account.
4. Who can help me with asset location?
If you're not comfortable doing asset location on your own, you can seek help from a financial advisor. They will be able to recommend the best strategy for your specific situation.
5. Can I avoid tax-inefficient investments?
You can avoid tax-inefficient investments by investing in stocks and mutual funds instead of individual bonds.
