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Asset Location

Most people have heard of Asset Allocation, but not necessarily Asset Location.  While asset allocation has to do with how much of your portfolio is in stocks and bonds, asset location has to do with what types of assets are placed in what types of accounts.

Generally speaking, we prefer to place assets that have higher expected growth and are more tax efficient in taxable accounts.  These can be individual, joint, or trust accounts. Alternatively, we prefer to place the more stable, lower growth, tax inefficient assets in tax-deferred accounts, such as IRAs.

There are three primary drivers behind how these decisions can impact your portfolio:

  1. Interest from fixed income is taxed at normal income rates (10%-37%, depending on your income) while long-term capital gains are taxed at preferential tax rates (0, 15%, or 20%, depending on your income).  
    • Therefore, we like to put fixed income in tax-deferred accounts, where the interest is not taxed on an annual basis, allowing you to avoid taxes until you take a distribution from the account.  
    • We like to put equities in taxable accounts because you generally only pay taxes when you sell shares.  As long as those shares were held for over a year, you will only pay taxes on the gains and at the preferred long-term capital gains rate.
  2. IRA accounts have Required Minimum Distributions that start at age 70.5.  By putting the assets with lower expected growth in the IRA account, we are able to better control the amount of money that has to be taken out of the account when you reach age 70.5.  The IRS mandates that a minimum amount needs to be taken out every year from an IRA at this age, and that amount is typically fully taxable at normal income rates.
  3. Taxable account assets get a “step up” in basis when the account owner passes away.  Equities are not only more tax-efficient on an annual basis (point 1 above), but also provide for higher expected growth over the long term.  This growth comes in to play as we look at wealth transfer to future generations. All the gains in any investment position are wiped away at the account owner’s death – this is called a “step up” in basis, which leads to a virtually tax-free inheritance for the account beneficiaries.

We will look to place less tax-efficient asset classes like alternatives and fixed income in tax-advantaged accounts. Over time, this should help reduce your tax burden and consequently improve after-tax return. It also means that each account will not be allocated the same since some asset classes may be held in one account but not in others. Focusing on achieving the overall allocation in a tax-efficient manner is the reason for this approach.