Asset Location

CuteGuy
 

Asset location is the process of dividing different kinds of assets among tax-free, tax-deferred and taxable accounts to maximize the after-tax return of your overall portfolio. Asset location is not to be confused with asset allocation, which is the process of investing your dollars across various asset classes (regardless of the kind of account in which the assets are held).

Sooner or later you will be saving in both taxable and tax-deferred accounts. In this situation, your first decision, as always, is your asset allocation decision—the percentage of your total savings that you invest in the various asset categories.

But your next decision is where to locate these assets. Part of this will be a function of the choices available to you in your 401(k) plan. But assuming unlimited choices, how do you decide where to locate your assets? There are three features of the tax code that favor holding certain assets over others in taxable accounts.

  • First, long-term capital gains are taxed at lower rates when realized in taxable accounts; 
  • Second, losses can be realized and the government can share the loss in taxable accounts; 
  • Third, capital gains taxes can be avoided by awaiting the step-up in basis at death or giving the appreciated asset to charity instead of a cash contribution in taxable accounts.

These tax code features tend to favor the placement of assets that generate investment returns in the form of long-term capital gains (and the longer, the better) in the taxable account and those that tend to generate primarily income in the retirement accounts.

Here is a break down for specific investments. But remember, it is only a list of where to locate assets if you have already decided to invest in that type of asset.

Hold in Your Taxable Accounts: Higher-Returning Assets With Low Tax Costs

Taxable Accounts

The first assets to place in taxable accounts are assets you never intend to sell or that you will give to charity as an appreciated asset, and passively held stocks and other assets that are expected to provide substantial long-term capital gain potential. The key is that you want to let capital gains grow unrealized for long horizons. Stocks can be tax-efficient stock mutual funds that realize (and thus distribute) minimal capital gains, such as index funds, or individual stocks that you will passively hold for at least a decade. Other good candidates include tax-managed stock mutual funds and index funds or exchange-traded funds that track a large-cap or total market stock index. Undeveloped real estate that will be bought and held for long horizons would also be a good asset to hold in taxable accounts, as would gold bullion, or Bitcoin (remember, though, these are not investment recommendations, they are simply suggestions on where to locate them if you want to own them). Although not optimal, it is better to hold actively managed stock funds—especially those that realize minimal short-term capital gains—rather than bonds or bond funds, in taxable accounts. The last asset in the taxable pocket should be whatever asset is needed to satisfy your asset allocation that cannot be held in a retirement account, for example, Municipal Bonds and funds.

Another key reason to hold stock in your taxable accounts is that stock investors can also exert a higher level of control over the receipt of capital gains than bond investors--for example, by buying and holding individual stocks or by investing in equity exchange-traded funds, which have a built-in mechanism for limiting taxable capital gains payouts. Tax-managed funds and traditional broad-market stock index funds and exchange-traded funds also tend to do a good job of keeping the lid on distributing capital gains.

That said, not all stocks belong in the taxable bin. Although they enjoy relatively low tax treatment currently, dividend-paying stocks are arguably a better fit for tax-sheltered rather than taxable accounts. The key reason is control. Dividend income, like bond income, isn't discretionary. Whereas stock investors can delay the receipt of capital gains simply by hanging on to the stock, investors in dividend-paying stocks don't have that kind of control; they get a payout whether they like it or not. That makes dividend-payers, regardless of tax treatment, less attractive than non-dividend-payers from a tax standpoint.

Finally, it's worth noting that the right asset-location prescription depends on life stage. Whereas an accumulator might dogmatically hold stocks in her taxable brokerage account and bonds in her tax-sheltered accounts, retirees would do well to stay diversified within each of their accounts: taxable brokerage accounts, IRAs, and company retirement plans. Maintaining intra-account diversification enables retired investors to pull withdrawals from the accounts that will keep them in the lowest tax bracket in a given year; by holding stocks, bonds, and cash within each account type, the retiree won't have to tap an asset class when it's in the dumps.

Hold in Your Tax-Sheltered Accounts: High-Returning Assets With High Tax Costs

401(k) Plans and Other Tax-Deferred Retirement Accounts

The first asset to place in retirement accounts are bonds, which tend to generate returns that are almost entirely taxed as income. The exception is that any liquidity reserves—usually short-term fixed income held for emergencies and other short-term cash needs—should be held in taxable accounts where it is readily available. The next choice for assets in retirement accounts are REITs (real estate investment trusts), which pay large cash dividends that, unlike dividends on other assets, are taxed at ordinary income tax rates.

Tax-inefficient stock funds come next in the retirement account pocket, and these include most actively managed stock funds. The most tax-inefficient funds are those that realize capital gains quickly, especially those that realize substantial short-term capital gains.

Because you don't have to pay taxes from year to year on income or capital gains you earn in tax-sheltered accounts like IRAs and 401(k)s, these are good receptacles for higher-returning investments that also have heavy tax consequences. The best example would be junk bonds, junk-bond funds, emerging-markets bond funds, and multisector-bond funds, all of which kick off a high percentage of taxable income. And while it's a stretch to call high-quality bonds and bond funds "high returning" right now, they're also a better fit for tax-sheltered accounts than for taxable because their payouts are taxed at an investor's ordinary income tax rate.

So, generally speaking, to the extent that you hold bonds, you're better off doing so within the confines of a tax-sheltered account. If you need to hold bonds in your taxable accounts for liquidity reasons, determine whether a municipal bond or bond fund might offer you a better after-tax yield than a taxable-bond investment. (Income from munis is free from federal and, in some cases, state income taxes.

Your tax-sheltered accounts are also the right spot for REITs, whose payouts are generally considered nonqualified and taxed at ordinary income tax rates. Preferred stock, too, is on the bubble, depending on the type of preferred you're dealing with and therefore is apt to be a better fit within the confines of a tax-sheltered account. Traditional preferreds generally qualify for dividend tax treatment, whereas income from trust preferreds is taxed at an investor's ordinary income tax rate. Dividends from some foreign stocks and funds may also be classed as nonqualified, meaning they will be taxed as income. (Master limited partnerships are an unusual income-rich security in that they're usually best held outside of an IRA.)

Finally, to the extent that you hold mutual funds that churn through their portfolios frequently, you're better off doing so within your company retirement plan or IRA. Such funds tend to generate a lot of short-term capital gains, which are also taxed as ordinary income.