Asset location is an advanced planning concept that involves strategically investing a portfolio to maximize wealth by optimizing your tax situation. In essence, it means allocating different types of investments across various tax-advantaged accounts.
Consider this: The three most common types of tax-advantaged accounts a retiree may have are a Roth IRA, a Traditional IRA, and a non-retirement account like a brokerage account. Each of these accounts is treated differently in terms of taxes. For instance, distributions from a Traditional IRA are typically taxed as ordinary income (assuming no non-deductible contributions, which is a topic for another article). On the other hand, distributions from a Roth IRA are generally tax-free if all rules are followed. The main difference between IRA options and a brokerage account lies in the deferral of taxes until distributions are made. Gains or losses within an IRA are not counted as income and are not subject to capital gains, unlike a brokerage account. Understanding these tax types is the first step in an asset location strategy. The second step is to be strategic with investment options to maximize tax efficiency.
Since the Traditional IRA is fully taxable, it’s best suited for more conservative investments and income-producing assets, such as bonds, CDs, or money markets, which typically generate income but offer fewer growth opportunities compared to stocks. This allows the account to defer the taxability of the income until distribution and doesn’t create much taxable growth.
The Roth IRA, with its favorable tax treatment for growth, should be more heavily allocated toward growth investments like equities, rather than bonds. Since the money can be withdrawn tax-free by the depositor or their heirs (assuming all Roth rules are followed), it makes sense to maximize growth in this account.
With the Traditional IRA focused on conservative assets and the Roth IRA focused on growth, where does that leave the non-retirement account? This account offers a unique tax advantage in the form of long-term capital gains. If an asset is held for over 12 months, it qualifies for long-term capital gains, which is generally more favorable than ordinary income tax rates, depending on the individual’s tax bracket. However, any income received in this account is immediately taxable, which is a disadvantage compared to retirement accounts. Therefore, these accounts should focus on long-term assets and avoid those that pay dividends or produce taxable income to benefit from long-term capital gains treatment. If a more conservative allocation is needed, tax-free income from municipal bonds can help mitigate the tax burden.
How does this all come together? Imagine a portfolio of one million dollars, with an equal amount of $333,000 in each account type. For a target allocation of 60% stocks and 40% bonds (a 60/40 mix), the Roth IRA and brokerage account would be entirely stocks, while the Traditional IRA would be entirely bonds.
