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Be Tax Efficient with Asset Location



The closest thing to a free lunch in investing is diversification. In our opinion, the most appropriate way to diversify is through thoughtful asset allocation. When you spread your money among investment categories (stocks, bonds, cash, etc…) that share little in common, you help control your portfolio’s risk level and have the potential for capturing the returns of each asset class. However, few investors appreciate another smart strategy that goes hand-in-hand with asset allocation. This strategy, known as asset location, requires you to consider what type of accounts you should be putting all of those diversified investments into (taxable, tax-deferred, and tax-free).

Asset location allows you to maximize your after-tax return. Mitigating taxes where possible is a prudent strategy for any investor given that taxes have the potential to erode wealth significantly. To the extent possible, consider placing tax-efficient equity holdings in taxable accounts and fixed income and real estate holdings in tax-deferred or tax-free accounts. Here are five reasons why you should consider using your taxable account for tax-efficient equity holdings:

  • Preferential capital gains treatment as opposed to ordinary income taxation
  • The ability to tax-loss harvest
  • A stepped-up basis upon death
  • The ability to donate appreciated shares to charity
  • A foreign tax credit for international investments in taxable accounts that does not apply to international investments held in tax-deferred accounts

Real estate investment trusts (REITs), fixed income, and other tax-inefficient investments should typically be held in tax-deferred or tax-free accounts. The reason for this is that dividends from these types of investments do not enjoy a preferential tax rate; they are taxed at an investor’s ordinary income tax rate, which is generally higher.

Who Should Pay Attention to Asset Location?

Not all investors need to be concerned about asset location. This strategy is not necessary for those who only have certain types of accounts, such as IRAs, 401(k)s, and 529 college savings plans.

However, if you also have investments in taxable accounts where taxes can erode your wealth, asset location can be invaluable. The goal of affluent investors is to divide their investments among taxable and retirement accounts in a way that will defer taxes and ultimately provide the best after-tax returns.

If you adjust your investment portfolio to reduce its future tax drag, you will be doing better than most. In conclusion, here are a couple of additional points to remember:

  • Examine your mutual funds. Many mutual fund managers do not invest for tax efficiency. Be aware of the funds you own in taxable accounts and how tax-efficient they really are. Because of frequent trading, many funds have less-than-optimal after-tax returns.
  • Consider a passive investment approach: It’s been estimated that only a fraction of all investors use index-based or passively managed funds, even though studies have shown that most actively managed funds fail to beat their benchmarks over the long term. Among other things, index and passive funds are valued for their tax efficiency and low costs.