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.