Understand What Is Asset Location, And Why Does It Matter

Nov 14, 2023 By Triston Martin

When putting together an investment portfolio, you make it a point to consider your asset allocation and how it compares to the amount of risk you are willing to take. But it would help if you didn't mix asset allocation with asset location.

Asset location is a separate component of your investment plan that aims to reduce the amount of money you must pay in taxes. In general, it refers to a tax-minimization approach that uses the fact that various kinds of investments are subject to various tax regulations.

If you have a good understanding of these differences, you will be better able to strategize the placement of your assets inside taxable, tax-free, tax-deferred accounts. Let's look at it as a means of developing the idea further.

What Is Asset Location?

When you are optimizing your after-tax returns, one strategy that might help is asset placement. This strategy divides your investment into tax-advantaged, tax-free, and taxable accounts. That is not the same thing as asset allocation, which is more concerned with the investments you choose to make with your money.

It illustrates how asset allocation works: if 60% of your portfolio is invested in stocks, 30% is invested in bonds, and 10% is placed in cash, your portfolio is properly allocated. Properly allocating your assets requires you to strike a balance between the risks you are willing to take.

Also, how your investments are structured to assist you in meeting your short- and long-term financial objectives. When discussing asset placement, you may be discussing how much money you should put into your workplace's 401(k) plan.

Or how much money you should put into an online brokerage account. Both of these are examples of locations for assets. The focus is not on how to invest but on where to invest, including an eye toward the tax consequences of the various options.

How Does It Work?

You can reduce or even eliminate tax inefficiencies if you store the investments with the lowest potential return on investment in accounts exempt from paying taxes. For instance, fixed-income and real estate investment trust funds are often less tax-efficient than stock holdings.

And even within stock asset classes, certain varieties offer superior or inferior tax efficiency. Intuitively, it makes perfect sense to position these and other asset types according to the anticipated tax savings that they will provide. However, unlike what you believe, putting it into practice is not simple.

The amount of money that may be saved in your tax-deferred accounts is limited. After all, if there were an unbounded number of opportunities to prevent you from having to pay income taxes on your investments, you would just put all of them in a tax haven and be done with it.

Truthfully, maximizing the "room" provided by your tax exemption will require you to make some tough choices. Second, avoiding taxes on your assets is not the only consideration here. It would help if you also planned for the possibility that you will one day want to spend them or leave them as a gift to someone else.

How Does Asset Location Minimize Taxes?

When considering where an asset should be located, how security is taxed is often the most crucial factor to consider. Typically connected with stocks, long-term capital gains and eligible dividends are afforded a more advantageous tax treatment (0%, 15%, or 20%), depending on the taxable income they generate.

Both taxable interest, which often comes from bonds, and regular dividends are subject to taxation at the same rates as ordinary income, reaching as high as 37% under the present tax code. Therefore, one way to increase a portfolio's tax efficiency is to allocate more of its equity holdings to a taxable account and more of its fixed-income holdings (excluding municipal fixed income) to a tax-deferred vehicle.

Your current and future tax rates can strongly influence the optimal skewing of accounts. It can be a significant factor even if this approach for skewing accounts is beneficial in many situations when utilized.

The Importance of Asset Location When Investing

It makes the most sense for most investors to use asset placement rules to decide which holdings belong in which accounts, when, and where possible. But we would advise investors to exercise common sense when implementing an asset placement plan.

If, for instance, you needlessly generate taxable income to rebalance your portfolio, you'll be defeating the primary goal of asset placement, which is to reduce your tax liability. You may do several things to better match your holdings with an asset placement strategy that works for you.

When feasible, make changes to your retirement account so that you pay less or no taxes. When implementing an asset location plan, it is best to use the fresh capital to increase existing holdings.

If you want to improve your portfolio's asset location strategy, remember this while regularly rebalancing your holdings. It would be ideal if tax losses were realized from taxable accounts and used in this procedure. Your portfolio's asset placement plan should consider both present and potential tax consequences.

Conclusion:

Many in the wealth management field view optimal asset positioning as the industry's version of a free lunch. It is possible to increase the potential after-tax return while keeping the same degree of risk by spreading investments over multiple account types out of three available kinds: taxable, tax-deferred, and tax-exempt.

In most cases, this benefit can be attained by rebalancing your investments so that the assets with the lowest tax efficiency are held in the accounts subject to the most favorable tax rates, and the assets with the highest tax efficiency are held in the accounts subject to the lowest tax rates, while still maintaining your overall asset allocation.

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