Asset location is the strategy of matching the type of investment with the best type of account for the purpose of minimizing taxes.
What Is Asset Location?
Asset location may sound like asset allocation, but these two terms are not the same.
Asset location means placement of an investment in a taxable or tax-advantaged account in the manner that receives the best tax treatment. Asset allocation refers to the way assets are mixed and portioned in a given account.
The choice of investment placement can have a major impact on an investor's taxes and net return after taxes.
How Asset Location Works
There are three basic types of investment accounts:
- A standard brokerage account that can be individual or joint
- A tax-deferred account, such as an IRA or 401(k)
- A tax-exempt account, such as Roth IRAs, Roth 401(k)s
Investments held in a brokerage account are taxed on capital gains and on interest income, or money you earn from dividends. For example, if you sell a mutual fund at a price higher than the price you purchased it, you will have a capital gain for which you will owe a tax. This is a tax on the fund's net asset value. Also, any interest income earned on investments in a brokerage account is taxed as income, just as when you receive payment from an employer.
The way tax-deferred accounts are taxed differs greatly from the way brokerage accounts are taxed. Selling mutual funds in a tax-deferred account, such as an IRA or 401(k), will not result in capital gains taxes.
In fact, selling funds in a tax-deferred account results in no immediate taxes at all. Other mutual fund fees may apply though. Also, income from dividends is not taxed in IRAs or 401(k)s until you withdraw money at a later time, such as after you retire.
In a tax-exempt account, investments are made with after-tax income. This means that you pay taxes on income before you invest it into the account, so it won't be taxed again after. Any money you earn within this type of account grows tax-free, so long as it stays in the account for a given length of time. The IRS places limits on how much you can invest in a tax-exempt or tax-deferred account. For instance, for the tax year 2021, Roth IRA phase-out begins at $125,000 in earnings for people filing single, and for married filers it goes up to $208,000 in certain cases.
So one way to think about asset location is simply choosing where to invest so you get the best tax deal.
Funds that generate little to no taxes are best held in brokerage accounts. Mutual funds that may generate taxes are best held in tax-deferred accounts.
Types of Funds for Asset Location Strategy
In a brokerage account, it makes sense to use the most tax-efficient funds. These might include municipal bond funds or funds that create little or no dividend income, such as certain Exchange Traded Funds (ETF), index funds, or growth stock funds.
If the fund objective is "Income" or "Value," the holdings of the mutual fund are most often stocks that produce income. For "income" or "value" based funds you'll have a tax bill if the fund is held in your brokerage account.
A growth mutual fund most often holds stocks with growth objectives, which means the companies use their profits to reinvest in the company itself, rather than paying dividends to their investors.
Reasons to Use Asset Location
The main reason to use asset location is clear: Why lose money to taxes if you don't need to? To keep taxes low on mutual funds, it helps to be smart about where you hold your assets. Taxes paid on gains can also be one of the biggest drags on how well a fund performs for its investors.
To review, keep funds that produce income (such as most bond funds and stock funds with an income goal) in a tax-deferred account. An IRA or 401(k) will work well. Keep tax-efficient funds in a taxable account, such an individual or joint brokerage account. Also, watch out for capital gains. If you expect to buy, sell, or exchange funds many times per year, try to do this more in your IRA or 401(k) where no capital gains taxes will result.
- Asset location is the strategy of matching the type of investment with the best type of account for the purpose of minimizing taxes.
- It should not be confused with asset allocation, but both can be used hand in hand to produce the best chance at long-term earnings.
- Investments that are likely to produce income should go into tax-deferred accounts such as IRAs and 401(k)s.
- Tax-efficient funds are best suited to a standard brokerage portfolio.