What Is Asset Location? (And How It Minimizes Taxes and Maximizes Investment Returns)

Effective asset location can play a pivotal role in your retirement planning by not only reducing your tax liabilities and amplifying investment returns, but also potentially boosting your after-tax retirement income. While you can't control tax laws, you can use a strategic asset location approach to better organize your investments in a tax-efficient manner. This can lead to a more successful retirement.

In this article, you will learn: 

• What is asset location?
• Asset location vs. asset allocation
• Why is asset location important? How does it benefit your retirement plan? 
• How asset location reduces your tax burden and maximizes your after-tax returns
• Types of investment accounts for asset location 

WHAT IS ASSET LOCATION? 

Retirees can choose from a variety of investment accounts to build and increase their wealth. They can use asset location as a powerful strategy to enhance tax efficiency. This involves strategically placing investments across different accounts to maximize tax benefits. These accounts can fall under three primary categories: taxable, tax-deferred, or tax-exempt.

Asset location lowers your tax bill using the principle that investment accounts are taxed differently and are subject to different tax laws. And the type you choose is a huge determiner of your after tax returns. For instance, where you hold your investment can be the difference between deferring taxes until withdrawal, paying them annually, or not paying them at all.

The other factor in asset location is the type of investments you have. Some investments distribute income regularly.  In those cases, it can make sense have those specific investments in tax-deferred accounts.

ASSET LOCATION VS. ASSET ALLOCATION: WHAT'S THE DIFFERENCE? 

Asset location is a strategic approach aimed at minimizing taxes by carefully considering the placement of investments in different types of accounts. While asset allocation focuses on balancing risks and returns through diversification across stocks, bonds, cash, and real estate, asset location emphasizes the tax implications of investment placement.

It's important to note that asset allocation takes precedence over asset location. Before delving into the tax benefits of organizing assets across accounts during retirement, it is crucial to allocate them based on your individual risk tolerance and investment objectives. Alternatively, seeking guidance from a retirement planning expert can ensure optimal asset allocation.

Once the appropriate asset allocation is determined, asset location comes into play. This involves analyzing the tax characteristics of various investment accounts and strategically placing investments in the most tax-efficient manner. Different types of accounts, such as taxable, tax-deferred, or tax-exempt, have distinct tax treatments, impacting the overall tax liability and potential investment returns.

WHY IS ASSET LOCATION IMPORTANT? 

Asset location focuses on strategically placing your investments in the most advantageous locations from a tax perspective. It recognizes that gross returns alone are not the sole determinant of investment success; what truly matters is the net returns after taxes.

By implementing asset location strategies, you can intelligently allocate your funds across various accounts to optimize tax benefits, ultimately reducing your tax burden and increasing your net returns during retirement. For instance, this approach involves placing investments with low turnover or those that generate high income into tax-advantaged retirement accounts. Conversely, investments with higher turnover or lower tax implications can be allocated to taxable brokerage accounts. This thoughtful placement helps minimize your overall tax liability.

The goal of asset location is to maximize after-tax returns by ensuring that each investment is in its most tax-efficient location. By taking advantage of the tax benefits offered by different types of accounts, you can keep more of your investment earnings for yourself, allowing for greater wealth accumulation over time in retirement.

TYPES OF INVESTMENT ACCOUNTS FOR ASSET LOCATION 

Investors can invest in three different types of investment accounts.

• Taxable brokerage accounts
• Tax-deferred accounts
• Tax-free accounts

Let's look at each in detail. 

TAXABLE BROKERAGE ACCOUNTS

A taxable brokerage account is an investment account that is not associated with any specific tax advantages or restrictions. Unlike tax-advantaged retirement accounts, there are no contribution limits or penalties for early withdrawals in taxable brokerage accounts. They offer flexibility and liquidity but require investors to consider the potential tax implications of their investment activities.

Investments held in taxable brokerage accounts can be subject to different types of taxation, including long-term capital gains, the dividend rate, or short-term capital gains.

1. Long-Term Capital Gains: When investments held in a taxable brokerage account are sold after being held for more than one year, any resulting profits are typically taxed at the long-term capital gains rate. This rate is generally lower than the ordinary income tax rate, offering potential tax advantages for investors.
2. Dividend Rate: If the investments in a taxable brokerage account generate dividends, these earnings are typically taxed at the dividend rate. Dividends can be classified as qualified or non-qualified, with qualified dividends often taxed at a lower rate similar to the long-term capital gains rate. Non-qualified dividends are generally taxed at the investor's ordinary income tax rate.
3. Short-Term Capital Gains: If investments in a taxable brokerage account are sold within one year of purchase, any resulting profits are considered short-term capital gains. Short-term capital gains are typically taxed at the investor's ordinary income tax rate, which is typically higher than the long-term capital gains rate.

TAX-DEFERRED ACCOUNTS

Tax-Deferred Accounts, such as 401(k) plans, individual retirement accounts (IRAs), and 403(b) plans. As the name suggests, tax-deferred accounts allow you to delay taxes until you withdraw the money. 

These tax-advantaged accounts allow your money to grow untouched by taxes, and you get tax deductions for contributions. This offers immediate tax benefits. But when you withdraw the money, it is taxed as ordinary income.

TAX-FREE ACCOUNTS

Tax-free accounts, such as Roth IRAs, Roth 403(b) plans, and Roth 401(k) plans, offer individuals the opportunity to save money using after-tax contributions. Unlike tax-deferred accounts, tax-free accounts do not provide an upfront tax break when contributing funds. However, the key advantage is that qualified withdrawals from these accounts are not subject to additional taxes.

By adhering to the IRS regulations governing these accounts, individuals can enjoy the benefit of tax-free growth on their investments. This means that any earnings or capital gains generated within these accounts are not taxed as long as the withdrawal is made according to the established guidelines.

TAX-EFFICIENT INVESTMENTS FOR YOUR ASSET LOCATION STRATEGY

When considering your asset location strategy, it's crucial to focus on tax efficiency. Taxes can be incurred not only when you sell an investment but also when your assets generate returns in the form of dividends or capital gains. Therefore, certain investments are more tax-efficient than others.

For example, passively managed funds like index funds tend to be more tax-efficient than actively managed funds. This is because they involve fewer capital gains distributions due to their lower turnover.

On the contrary, actively managed funds often engage in frequent buying and selling of securities, resulting in higher capital gains distributions and a potentially higher tax burden for investors.

Municipal bonds are renowned for their tax efficiency. They often provide triple tax benefits, as the interest earned is typically not taxable at the federal, state, or local levels. Consequently, placing municipal bonds in taxable accounts can be advantageous.

In general, investments without specific tax benefits are better suited for tax-advantaged accounts, helping to reduce overall tax liability. For instance, exchange-traded funds (ETFs) generally generate fewer distributed gains compared to actively managed stock funds. As a result, actively managed funds are better placed in tax-advantaged accounts to minimize taxes.

HOW ASSET LOCATION REDUCES YOUR TAX BILL

Investments such as equity mutual funds and stocks generate returns through capital gains and dividends. By strategically placing these investments within a taxable account, you can effectively reduce your tax bill. The favorable tax treatment of qualified dividends and long-term capital gains (taxed at rates of 20%, 15%, or even 0%, depending on your income) can result in significant tax savings.

In contrast, if you were to withdraw an equal amount from a retirement account, where taxes are incurred upon withdrawal, you would be subject to the ordinary income tax rates (up to 37%). Similarly, interest received from bonds held in retirement accounts would be taxed at the same rates, potentially eroding your returns.

Mastering the art of placing your funds in the appropriate investment accounts allows for intelligent investing, optimized income, and a reduced tax burden. While every investment carries its own costs, taxes can often be the most significant expense, significantly impacting your overall returns. By implementing a tax-efficient investment strategy, you can effectively minimize your tax bill and retain more of your hard-earned investment gains.

HOW TO CREATE A TAX-EFFICIENT INVESTMENT STRATEGY

Investing tax-efficiently begins with understanding the accounts you want to put your money in and your financial goals. It's best to have multiple types of investment accounts that are taxed differently. 

If you are unsure how to choose tax-efficient investments, your financial planner can walk you through everything you need to know. That way, you eliminate guesswork and make smart investments. 

Additionally, consider tax-minimizing techniques, such as tax-loss harvesting. You deliberately incur capital losses to offset taxes on capital gains. This method helps you reduce your overall tax bill. 

One point to remember, though, a tax-efficient investment strategy isn't a set-it-and-forget-it approach. It can be a long-time thing that you update as you near leaving the workforce and changes occur in your income level. 

ASSET LOCATION MADE EASIER FOR RETIREES

Proper asset location is just as vital as managing asset allocation when it comes to optimizing your financial plan. Making informed decisions about where to place your investments can significantly reduce your tax bill, as certain accounts offer greater tax efficiency. This is a key consideration to keep in mind while strategizing for your retirement.

By strategically allocating your funds to the most suitable accounts, you ensure that you only pay the required amount of tax and nothing more. This proactive approach helps to minimize your overall tax burden, allowing you to maximize your net earnings during your retirement years.

If you find asset location to be complex or overwhelming, seeking assistance from a qualified retirement planning expert is highly recommended. These professionals possess in-depth knowledge of tax laws and have access to specialized financial tools that can help you navigate the intricacies of asset location and take full advantage of available tax benefits.

By leveraging the expertise of a retirement planning expert, you can simplify the asset location process, optimize your tax situation, and ultimately enhance the success of your retirement plan.

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