Wealth management
Why asset location matters as much as asset allocation
When it comes to minimizing taxes, certain investments fit better in certain accounts.
Summary
- While asset allocation focuses on how to divide investments among different asset classes, asset location determines which types of accounts—taxable, tax-deferred or tax-free—are best suited for specific investments to minimize taxes.
- Tax-efficient investments like municipal bonds and buy-and-hold stocks generally work best in taxable accounts, while actively managed funds and taxable bonds are better suited for tax-deferred accounts like traditional IRAs and 401(k)s.
- Growth-oriented investments with high appreciation potential are ideal for tax-free Roth accounts because both the growth and eventual withdrawals will be tax-free for you and your heirs.
Asset location versus asset allocation
Most investors understand asset allocation. It’s how they divvy up their savings—among stocks, bonds, annuities, cash, real estate, etc.—to manage risk and improve long-term returns.
But asset location—a similar-sounding term with a very different meaning—is no less important, especially when it comes to saving on taxes. Asset location is a tax-minimization strategy for determining which types of investments are best suited for certain accounts. One way to think of it: You wouldn’t store eggs in the freezer. Similarly, you shouldn’t put tax-exempt municipal bonds in a regular individual retirement account (IRA)—because a tax-deferred IRA is one place where tax-exempt income isn’t actually tax exempt.
However, investors tend to be more focused on the what than the where. “They’re always thinking about asset allocation and not giving any thought to asset location,” says Joe Goldgrab, a TIAA executive wealth management advisor based in New York City. “It’s one of the biggest pain points I have when I meet with clients.”
The three main types of investment accounts are taxable, tax-deferred and tax-free. Our general rule of thumb with asset location: The more tax-efficient an investment is, the better-suited it is for taxable accounts. The less tax-efficient an investment is, the better suited it is for tax-deferred and tax-free accounts.
Here’s a detailed breakdown of which assets belong where:
Taxable accounts
Taxable accounts are conventional brokerage accounts that can hold stocks, bonds, mutual funds, exchange traded funds (ETFs) or any type of security. They’re taxed when you earn interest and dividends, or when you sell investments at a profit, generating capital gains.
Which investments are best suited for taxable accounts? As we said before, tax-exempt municipal bonds and municipal bond funds are an obvious choice because the income is generally tax-free. If you held the same bonds in a tax-deferred IRA, you or your heirs would pay ordinary income tax on all the amounts distributed once you start taking required minimum distributions (RMDs).
Taxable accounts are also ideal for any individual stocks, index funds or ETFs purchased with an eye toward leaving them to heirs. (Actively managed equity funds with high turnover rates are a different story—more on those in a moment.) One of the advantages of holding such assets in taxable accounts is, under IRS rules, they get a step-up in cost basis after you pass away. “That makes them great assets to inherit,” says Evan Potash, a TIAA executive wealth management advisor in Newtown, Pa. Say you buy shares of a blue-chip stock today for $100,000, and their value soars to $600,000 by the time of your death. Thanks to the step-up in cost basis, your heirs won’t pay any tax on the $500,000 gain—had the shares been held in a tax-deferred account, all withdrawals would be taxed at your beneficiaries’ ordinary income tax rates.
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Tax-deferred accounts
This category includes traditional 401(k)s, 403(b)s and IRAs, which allow investments to grow tax deferred, with no taxes owed until you withdraw funds (which are then taxed at ordinary income tax rates). Because holdings are not subject to capital gains taxes, these accounts are ideal locations for actively managed equity funds that distribute lots of short- and long-term capital gains to fundholders due to high turnover rates.
For mutual fund investors, it can be frustrating to pay capital gains taxes on profits earned before you bought the fund. “Suddenly the fund manager sells Apple stock he’s owned since 2010,” says Goldgrab. “You didn’t own Apple in 2010, but now you’re getting a Form 1099 at the end of the year with these large capital gains. If you own the fund in a tax-deferred IRA, you don’t have to worry about that.”
Taxable bonds, taxable bond funds and
A similar argument applies to holding high-dividend stocks. In a taxable account, qualified dividends are taxed at rates up to 20%. In a tax-deferred account, you don’t owe dividend taxes, which means dividends can be reinvested (and can keep growing) with no taxes owed until you make withdrawals. That said, consult with a tax professional or your TIAA financial advisor before investing. For some investors, the difference between a lower tax on dividends now versus a higher tax on withdrawals at ordinary income tax rates later will supersede the value of tax-deferred growth.
This category includes traditional 401(k)s, 403(b)s and IRAs, which allow investments to grow tax deferred, with no taxes owed until you withdraw funds (which are then taxed at ordinary income tax rates). Because holdings are not subject to capital gains taxes, these accounts are ideal locations for actively managed equity funds that distribute lots of short- and long-term capital gains to fundholders due to high turnover rates.
Tax-free accounts
These include Roth IRAs, Roth 401(k)s and Roth 403(b)s, which are funded with after-tax dollars. As with tax-deferred accounts, the investments grow tax-free. Unlike with tax-deferred accounts, the withdrawals are generally tax-free too—for you or your heirs. One limitation of Roth IRAs: You can’t contribute to one unless your income falls below certain thresholds. Tax-deferred IRAs can be converted to Roth IRAs, but you’ll owe ordinary income taxes on the amount converted, which puts a premium on proper asset location. Whatever assets you keep in a Roth account should have enough appreciation potential to justify the cost of the conversion. Thus, the assets well-suited for tax-free accounts include equities with high earnings growth as well as equity mutual funds and equity ETFs with a similar growth trajectory.
With this in mind, Potash suggests considering Roth conversions as an estate-planning tool. Not only will the conversion reduce your taxable estate by prepaying future income taxes, but it may allow your heirs to inherit highly appreciated assets without an accompanying tax bill. Says Potash, “All the growth is tax-free to the heirs.”
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