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 sounds like asset allocation, but it is different.
Asset location means placement of an investment in a taxable or tax-advantaged account. Asset allocation is the mix of investments.
The choice of investment placement has a significant impact on an investor's taxes and net return after taxes.
How Asset Location Works
There are three basic types of investment accounts:
- A regular 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 (dividends). For example, if you sell a mutual fund at a price (net asset value) higher than the price you purchased it, you will have a capital gain for which you will owe a tax. Also, any interest income (dividend) earned on investments in a brokerage account is taxed as ordinary income, just as when you receive payment from an employer.
Taxation is significantly different in tax-deferred accounts than in brokerage accounts. Selling mutual funds in a tax-deferred account, such as an IRA or 401(k), will not generate capital gains taxes.
In fact, selling funds in a tax-deferred account generates no immediate taxes—although other mutual fund fees may apply. Also, income from dividends is not taxed in IRAs or 401(k)s until withdrawn at a later time, such as retirement.
In a tax-exempt account, investments are made with after-tax income, meaning whatever is earned in the account grows tax-free, if money is kept invested for the required length of time. For the tax year 2021, Roth IRA phase-out begins at $125,000 in earnings for single taxpayers and for married taxpayers it goes up to $208,000 in certain circumstances.
So asset location is simply determining where to invest to get the best tax advantage. The Internal Revenue Service (IRS) limits how much can be invested in tax-exempt and tax-deferred accounts. Income limits for participation also apply.
Funds that generate little to no taxes should be held in brokerage accounts and mutual funds that may generate taxes should be held in tax-deferred accounts.
Types of Funds for Asset Location Strategy
In a brokerage account, you might consider using tax-efficient funds, such as municipal bond funds or funds that generate 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 usually stocks that generate income, so you'll have a tax bill if the fund is held in your brokerage account.
A growth mutual fund will typically hold stocks with growth objectives, which means the companies use their profits to reinvest in the company rather than paying dividends to investors.
Reason to Use Asset Location
Why lose money unnecessarily to taxes? To keep taxes low on mutual funds, be smart about asset location.
The place where you hold your mutual funds can make a big difference in taxes, which are one of the biggest drags on performance for investors.
Once again, keep funds that produce income—most bond funds, most stock funds with an income objective—in a tax-deferred account, such as an IRA or 401(k). Keep tax-efficient funds in a taxable account, such as individual and joint brokerage accounts. Also, watch out for capital gains in brokerage accounts. If you anticipate buying, selling, or exchanging funds several times per year, try to do this more in your IRA or 401(k) where no capital gains taxes are generated.
- 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 is equally important for long-term earnings.
- Investments that are likely to generate income should go into tax-deferred accounts such as IRAs and 401(k)s.
- Tax-efficient funds are suitable for a regular brokerage portfolio.