Asset location is a tax minimization strategy that takes advantage of the fact that different types of investments get different tax treatments. Using this strategy, an investor determines which securities should be held in tax-deferred accounts and which securities should be held in taxable accounts in order to maximize after-tax returns. This article will explain who can benefit from this investment strategy, how asset location minimizes taxes and the optimal way to locate assets.

Tutorial: Personal Tax Guide

Who Benefits from Asset Location?
For investors to benefit from this strategy, they must have investments in both taxable and tax-deferred accounts. Investors with assets split between taxable and nontaxable accounts and with similar asset mixes will get the largest benefit from asset location. For example, an investor with an asset mix of 40% fixed income and 60% equity will achieve the maximum benefit if the tax-deferred account holds 40% and the taxable accounts holds 60% of total assets. In this case, moving all fixed-income investments into the nontaxable account and all equities into the taxable account will provide the maximum benefit.

Typically, investors who use a balanced investment strategy consisting of equity and fixed-income investments can get the most benefit from asset location. However, investors with all fixed-income or all-equity portfolios can still benefit, albeit not to the same degree.

If an investor is withdrawing funds from tax-deferred accounts or will be doing so in the near future, the benefit of an asset location strategy is greater than it would be for younger investors with many years left before they will start withdrawing funds. As an example, assume an investor made $20,000 in capital gains and dividends in a Traditional IRA during the past year and withdrew the same amount. At the top tax bracket, these earnings would be taxed at 35%, leaving the investor with $13,000. If the investor made $20,000 in capital gains and dividends in a taxable account, the tax would have been only 15%, leaving $17,000. (For related reading, see Not All Retirement Accounts Should Be Tax Deferred.)

How Asset Location Minimizes Taxes
A typical investor with a balanced portfolio consisting of 60% stocks and 40% bonds might hold investments in both taxable accounts and tax-deferred accounts. Although the investor's overall portfolio should be balanced, each account does not need to have the same asset mix. Creating the same asset allocation in each account ignores the tax benefit of properly placing securities in the type of account that will assure the best after-tax return.

How a security is taxed will determine where it should be located. Under the 2010 tax code, dividends and capital gains get favorable treatment. While interest income gets taxed at a 35% rate for investors in the highest tax bracket, the tax rate for dividends and capital gains is only 15%. Since most equity investments generate returns from both dividends and capital gains, investors realize lower tax bills when holding stocks or equity mutual funds within a taxable account. Those same capital gains and dividends, however, would be taxed at the ordinary rate (up to 35%) if withdrawn from a traditional IRA, 401(k), 403(b), or other type of retirement account where taxes are paid on the withdrawal of funds.

Fixed-income investments, such as bonds and real estate investment trusts (REITs) generate a regular cash flow. In 2010, these interest payments are subject to the same ordinary income tax rates of up to 35%. A tax-deferred retirement account provides investors with a shelter for this income. (For related reading, see Using Tax Lots: A Way To Minimize Taxes.)

Achieving Optimal Asset Location
Asset location, although it provides for lower taxes, is not a replacement for asset allocation. Only after you determine the proper asset mix for your portfolio can you then locate those investments in the appropriate accounts to minimize the tax drag on your investments. (For more information, see Choose Your Own Asset Allocation Adventure and Five Things To Know About Asset Allocation.)

The best location for an investor's assets depends on a number of different factors including financial profile, prevailing tax laws, investment holding periods, and the tax and return characteristics of the underlying securities. However, there are some general principles for the types of investments that are best-suited to each type of account.

Taxable Accounts
Tax-friendly stocks should be held in taxable accounts because of their lower capital gains and dividend tax rates and the ability to defer gains. Riskier and more volatile investments belong in taxable accounts both because of the ability to defer taxes and the ability to capture tax losses on poorly performing investments sold at a recognized loss. Index funds, as well as exchange-traded funds (ETFs), are valued for their tax efficiency and should also be held in taxable accounts, as should tax-free or tax-deferred bonds. (For related reading, check out Selling Losing Securities For A Tax Advantage.)

Tax-Deferred Accounts
Taxable bonds, REITs and the related mutual funds should be held in tax-deferred accounts. Any mutual funds that generate high yearly capital gains distributions also belong in tax-deferred accounts.

Asset location is a strategy that determines the proper account to place investments in to get the most favorable tax treatment overall. It is not a replacement for asset allocation, but it adds to the overall after-tax return. The best location for a particular security depends on an investor's financial profile, prevailing tax laws, investment holding periods and the tax and return characteristics of the underlying securities.

Related Articles
  1. Budgeting

    Your Worst Financial Mistakes And Why You Made Them

    No one intends to make a financial mistake, but an unexpected disaster or poor planning could leave you in financial distress.
  2. Stock Analysis

    The 4 Best Buy-and-Hold Dividend Stocks

    Discover four of the best dividend stocks for investors to buy and hold, along with the reasons for each stocks' suitability for long-term success.
  3. Personal Finance

    4 Ways Simple Interest Is Used In Real Life

    Simple interest works in your favor when you're a borrower, but against you when you're an investor.
  4. Investing

    How To Build a Currency Hedged Strategy?

    We are still unsure of how to implement a currency hedge strategy based on the dollar's movement. So let’s focus on what’s easier to measure: time horizon.
  5. Mutual Funds & ETFs

    Top 3 Equity Energy Mutual Funds

    Explore detailed analysis of the top three equity energy mutual funds, and learn about the characteristics and suitability of these funds.
  6. Mutual Funds & ETFs

    5 Secrets You Didn’t Know About Mutual Funds

    Learn five of the "secrets" about mutual funds that can have a significant impact on mutual fund choices and investor profitability.
  7. Investing Basics

    5 Ways to Double Your Investment

    So if you want to go double, consider these five classic strategies to help turn your vision into a reality.
  8. Investing

    2 Common Ways to Misuse Target Date Funds

    The world of asset classes is just as complicated as taking vitamins. How much should you take of small caps? Intermediate bonds? Emerging market stocks?
  9. Mutual Funds & ETFs

    What Target-Date Funds Can Teach About Investing

    Target-date funds are a popular way to invest for retirement. Here's what they can teach the novice investor.
  10. Mutual Funds & ETFs

    4 Mutual Funds Warren Buffet Would Buy

    Learn about four mutual funds Warren Buffett would invest and recommend to his trustee, and discover detailed analysis of these mutual funds.
  1. What assets are taxable and what assets are not taxable?

    Most types of income are taxable by the Internal Revenue Service (IRS). In fact, all income is taxable unless it is specifically ... Read Full Answer >>
  2. How long do I need to keep income tax records?

    Keep all tax-related records for at least three years. For example, keep your 2015 tax return, filed in early 2016, at the ... Read Full Answer >>
  3. Are Cafeteria plans taxable?

    Whether the benefits you receive through your employer-sponsored cafeteria plan are taxable depends entirely on which benefits ... Read Full Answer >>
  4. What licenses does a hedge fund manager need to have?

    A hedge fund manager does not necessarily need any specific license to operate a fund, but depending on the type of investments ... Read Full Answer >>
  5. Why is the Cayman Islands considered a tax haven?

    The Cayman Islands is one of the most well-known tax havens in the world. Unlike most countries, the Cayman Islands does ... Read Full Answer >>
  6. Can mutual funds invest in hedge funds?

    Mutual funds are legally allowed to invest in hedge funds. However, hedge funds and mutual funds have striking differences ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!