In the world of personal finance and investment, we frequently encounter the term “asset allocation,” which refers to the mix of asset classes in a portfolio, like stocks, bonds, real estate, cash, and gold. However, there’s another critical concept that often gets less attention but can significantly impact your investment efficiency: asset location.
What is Asset Location?
Asset location is the strategic decision about where to hold different types of investments across various account types. This strategy is primarily about tax efficiency – making sure your investments are in accounts where they will be taxed most favorably.
Why Does Asset Location Matter?
The importance of asset location lies in the tax treatment of different types of investment income. For instance, interest income is generally taxed at a higher rate than qualified dividends or long-term capital gains. By understanding and utilizing asset location effectively, investors can significantly reduce their tax liability, leading to better overall investment returns.
Example of Asset Location Strategy
A classic example of using asset location to your advantage involves interest-bearing investments and investments that yield qualified dividends. Since interest income is taxed at a higher rate, it’s often beneficial to place high-interest-bearing assets in tax-deferred accounts, like 401(k)s or IRAs. By doing so, you defer the taxes on this income, potentially until retirement when you might be in a lower tax bracket.
Conversely, assets that produce qualified dividends, which are taxed at a lower rate, are better placed in taxable accounts. This approach ensures that your non-retirement portfolio income benefits from lower tax rates, enhancing tax efficiency.
How Can Asset Location Boost Returns?
Implementing an effective asset location strategy can add a few percentage points to your returns. Over time, these percentages can compound, leading to a significant increase in your overall investment wealth. This boost comes from the money you save on taxes, which remains invested and continues to grow.
Considerations for Asset Location
- Tax-Deferred vs. Taxable Accounts: Understand the difference in tax treatment between various account types. Tax-deferred accounts, like IRAs, delay taxes until withdrawals, whereas taxable accounts require you to pay taxes on income and gains in the year they’re realized.
- Types of Investments: Different investments receive different tax treatments. Interest, dividends, and capital gains can all be taxed at different rates.
- Your Tax Bracket: Your current and expected future tax bracket plays a crucial role in deciding where to place different assets.
- Investment Horizon: Your timeframe for investing can influence where to best locate assets. Long-term investments might benefit more from tax-deferred growth.
- Estate Planning Considerations: Asset location can also impact estate planning, especially with tax-advantaged accounts like Roth IRAs.
- Changing Tax Laws: Stay informed about tax law changes, as they can affect the efficiency of your asset location y.
While asset allocation is crucial in determining your portfolio’s risk and return characteristics, asset location plays a pivotal role in how much of your returns you get to keep after taxes. By judiciously placing assets in the most tax-efficient accounts, you can enhance your investment returns without increasing your risk. Remember, it’s not just about what you earn, but also about what you keep after taxes. Asset location, therefore, should be a key component of your overall investment strategy.
Matt Ward is a financial advisor and the president of New Century Investments, an independent investment advisory firm serving business owners, pre-retirees, and retirees in the Dallas-Fort Worth area and beyond. Matt is passionate about integrating investing, planning, and tax management into a holistic approach. Matt’s breadth of knowledge and experience in both taxes and investment management sets him apart, giving him the ability to design, advise on, and manage business strategies, tax efficiency, and retirement planning. He is known for his care and attention to detail and works hard to develop personal relationships with each of his clients so they can benefit from his customized service and guidance. He loves walking with his clients through their financial journey, supporting them and celebrating with them as they reach their goals.
Matt graduated from Texas Tech University with a bachelor’s degree and is a certified financial planner™ and chartered retirement planning counselor℠ professional. When he’s not working, you can find Matt hiking, playing the guitar, and spending time with his family. To learn more about Matt, connect with him on LinkedIn!