In the world of investing, asset allocation is a commonly known concept that involves choosing the right mix of stocks and bonds to balance risk and return. However, many investors overlook the critical aspect of asset location, which refers to the types of accounts in which these assets are held. According to financial advisors, asset location is just as crucial as asset allocation, especially for wealthier investors who are looking to maximize their after-tax returns.
When an investor’s income places them in the 24% federal marginal income tax bracket, typically around $100,000 for single individuals and $201,000 for married couples, adopting an asset location strategy becomes increasingly beneficial. This strategy leverages the differences in tax treatment among various investment accounts to minimize taxes and enhance overall returns.
One of the fundamental principles of asset location is recognizing that not all investment accounts are taxed equally. There are three main types of accounts: tax-deferred accounts like traditional IRAs and 401(k) plans, tax-exempt accounts such as Roth IRAs, and taxable accounts like traditional brokerage accounts. Each account type has distinct tax implications, influencing the overall tax efficiency of an investor’s portfolio.
Investment income is also taxed differently based on the asset type. While interest income is taxed at an investor’s ordinary income tax rates, profits from long-term investments like stocks are taxed at lower federal rates. By strategically placing high-tax or tax-inefficient investments in tax-preferred retirement accounts and vice versa, investors can minimize their tax burden and optimize their after-tax returns.
To effectively implement asset location, investors should align this strategy within the framework of their overall asset allocation plan. For instance, bonds and bond funds, which typically generate interest income taxed at ordinary rates, are better suited for tax-deferred or tax-exempt accounts. On the other hand, high-growth investments and stock funds with frequent trading activity should be held in taxable accounts to leverage favorable tax rates.
One key consideration is the tax implications of each account type. While traditional retirement accounts may offer tax-deferral benefits, withdrawals are subject to ordinary income tax rates. In contrast, Roth accounts provide tax-free distributions, offering more flexibility in retirement planning. Diversifying across different account types not only optimizes tax efficiency but also prepares investors for potential changes in tax laws and rates in the future.
According to a 2022 Vanguard analysis, employing an asset location strategy can boost after-tax returns by 0.05% to 0.3% annually, depending on the investor’s circumstances. For example, an investor with a $1 million portfolio evenly split between stocks and bonds across different account types could potentially save $74,000 over 30 years by incorporating asset location.
Wealthier investors stand to benefit significantly from prioritizing tax allocation alongside asset allocation in their investment strategies. By strategically placing assets in tax-efficient accounts and considering the long-term implications of tax treatment, investors can enhance their after-tax returns and build a more resilient financial future.