{"id":159475,"date":"2025-03-27T10:07:18","date_gmt":"2025-03-27T10:07:18","guid":{"rendered":"https:\/\/peraltafinancing.com\/business\/finance\/the-asset-location-dilemma-tax-strategy-or-tax-trap-2\/"},"modified":"2025-03-27T10:07:18","modified_gmt":"2025-03-27T10:07:18","slug":"the-asset-location-dilemma-tax-strategy-or-tax-trap-2","status":"publish","type":"post","link":"https:\/\/fivemor.com\/?p=159475","title":{"rendered":"The “Asset Location” Dilemma: Tax Strategy or Tax Trap?"},"content":{"rendered":"


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Before the article, here\u2019s what\u2019s happening this week on our podcast, <\/em>Personal Finance for Long-Term Investors<\/em><\/strong>:<\/em><\/p>\n

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The world of financial planning comprises many strategies and tactics, some big and some small. Dollar-cost averaging, sequence of returns, tax-loss harvesting<\/em>, and the list goes on.<\/p>\n

Depending on who you ask, the process known as \u201casset location\u201d<\/strong> could be one of the more impactful arrows in your financial planning quiver\u2026or it could be a total waste of time. <\/p>\n

So which is it? Does asset location matter in the long run? And if so, can we quantify it? <\/p>\n

What is Asset Location? <\/h2>\n

Let\u2019s start two fundamentals of investing that set the table for today\u2019s discussion: <\/p>\n

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  1. Many investments provide cash <\/strong>back to the investor as an annual return on investment. Stocks can yield a dividend payment. Bonds pay income. Mutual funds and ETFs can trigger yearly realized capital gains for their investors, even if the investor didn\u2019t actually sell off their shares!<\/li>\n
  2. These dividends, bond income, realized gains, etc., are all subject to taxes\u00a0unless<\/em><\/span> the assets are held in a qualified tax-advantaged account, such as a 401(k) or IRA. Only a taxable investing account suffers the annual taxation described above. <\/li>\n<\/ol>\n

    These two facts raise an interesting question: <\/p>\n

    Can we intentionally place \u201chigh-tax\u201d investments in our qualified, tax-advantaged accounts and then put the \u201clower-tax\u201d investments in our taxable accounts? <\/strong><\/p>\n

    Won\u2019t this lower our annual tax bill, leaving more assets in our portfolio to compound, creating a positive long-term advantage?! In other words, can we maximize our total after-tax returns this way? Can we minimize \u201ctax drag?\u201d<\/strong><\/p>\n

    This is asset location<\/strong>. <\/p>\n

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    Investing Dog, Tax Tail<\/h2>\n

    A discerning investor might ask,\u00a0\u201cWhy not\u00a0<\/em><\/span>completely avoid investments that shed off too much taxable income? Wouldn\u2019t that be an easier path?\u201d <\/em><\/p>\n

    The short response is,<\/span>\u00a0\u201cDon\u2019t let the tax tail wag the investing dog.\u201d <\/strong><\/p>\n

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    Tax considerations should not dictate investment decisions at the expense of sound strategy. While minimizing taxes is important, it should be a secondary goal behind risk tolerance, time horizon, diversification, and overall portfolio objectives.<\/p>\n

    And I can say from experience: asset location isn\u2019t the only place where investors let the tax tail wag their investing dog. <\/em><\/p>\n

    People avoid necessary portfolio rebalancing. They hold onto bad investments to defer capital gains. They stay overweight in their own company stock, RSUs, stock options, etc. People permit the fear of taxes to cause them to do dumb stuff.<\/p>\n

    Smart investors optimize for taxes. It\u2019s important! But they don\u2019t let tax concerns override sound investing principles.<\/p>\n

    Asset Location \u201cTheory\u201d<\/h2>\n

    The basics of asset location are straightforward. <\/p>\n

    Bonds<\/strong> tend to be tax-inefficient<\/em>. Bond returns come from annual interest, which cannot be deferred into future years and<\/em> is taxed at ordinary income tax rates. If a bond has a 4% annual return, taxes could quickly reduce that to a 3% (or lower) after-tax return.<\/p>\n

    Stocks<\/strong>, though, are typically much more tax-efficient. Though dividend yields can vary, it\u2019s common for large, diversified funds (e.g. VTI<\/strong><\/em>, Vanguard\u2019s Total Stock Market ETF) to have a dividend yield in the 1-2% range. Most of those dividends are taxed at the capital gains rates (0%, 15%, 20%).<\/p>\n

    Therefore, asset location theory is simple.<\/p>\n

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    If your portfolio needs bonds, keep them in a qualified account to nullify the tax inefficiency. <\/p>\n

    Then, fill up the rest of your accounts \u2013 including your taxable account(s) \u2013 with stocks.<\/p>\n

    You can use the same thought processes if you own other assets (REITs, alternatives, etc.). How tax-efficient is this investment? How does that compare to the different assets I own? <\/em><\/p>\n

    The Numbers: How Much Money Do You Save With a Smart Asset Location Technique?<\/h2>\n

    Time for the good stuff: does asset location work over the long haul? <\/p>\n

    A recent (2022) study from Vanguard<\/a> clearly shows that<\/span> asset location provides measurable benefits to investors<\/strong>.<\/p>\n

    The bigger question we\u2019ll answer below is how <\/em>and why<\/em> particular investors receive much more benefit than others. We\u2019ll also discuss when <\/em>and why<\/em> asset location strategies can go \u201ctoo far,\u201d becoming a detriment to other aspects of a financial plan.<\/p>\n

    For most investors, optimal asset location will yield an annual performance improvement of 0.10% to 0.20% per year<\/strong> when averaged over their portfolio timeline.**<\/p>\n

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    **0.10% to 0.20% better\u2026compared to what?<\/em> The \u201cbaseline\u201d in this study was an \u201cequal location\u201d portfolio that assumed all accounts \u2013 Traditional, Roth, and Taxable \u2013 had identical allocations. e.g. 60\/40 in all three accounts, as opposed to optimizing the asset location. <\/em><\/p>\n

    Who Does Asset Location Help the Most? And Why? <\/h2>\n

    Why does asset location impact different investors in different ways? There are 3 main reasons: <\/p>\n

    More balanced\/conservative investors see a larger benefit.<\/strong> This is because these portfolios have a significant bond allocation. Asset location works better with tax-inefficient assets, just like bonds. <\/p>\n

    Higher-income (high tax bracket) investors see a larger benefit.<\/strong> High earners have higher marginal tax rates. Up to 37% on bond interest and up to 24% on capital gains (when including the NIIT tax). A high earner simply has more taxes to save than a lower earner. <\/p>\n

    Those who will bequeath (leave to heirs) a more significant portion of their taxable account see a larger benefit.<\/strong> Owning stocks in your taxable account is efficient, but can become quite costly (capital gains taxes) if you need to sell those stocks. But if an investor plans to bequeath those stocks at their death, they\u2019ll achieve a step-up in cost basis and will avoid the entire capital gains tax<\/a>. As I\u2019ve written before\u2026this is a controversial aspect of current tax law! <\/em><\/p>\n

    Nevertheless, if a large portion of one\u2019s assets will be bequeathed, asset location can become even more valuable. <\/p>\n

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    These types of investors could see their asset location strategy yield an annual performance improvement up to 0.30% to 0.40% per year. <\/strong><\/p>\n

    But Are There Downsides? <\/h2>\n

    If you\u2019ve played around with a compound interest calculator, you\u2019ll know that 20 or 30 basis points can make a huge difference when compounded over an investing career. <\/p>\n

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    Example: let\u2019s examine a retiree with $1M and a 30-year retirement. After annual withdrawals to pay for retirement, their portfolio still grows<\/em> at 2% per year. With proper asset location, it would grow at 2.2% instead (the 0.20% advantage we just defined). After their 30-year timeline, that 0.20% from asset location would have made a $100,000 difference. <\/em><\/p>\n<\/blockquote>\n

    But asset location isn\u2019t perfect, and you should know the downsides before you decide to enact it. <\/p>\n

    Liquidity, Accessibility, and Timeline Issues<\/h3>\n

    One of the significant downsides of an optimized asset location is that your accounts will assuredly no longer match the timelines in your financial plan. <\/p>\n

    For example, because of the time flexibility of a taxable brokerage account, I believe it should generally be more conservatively positioned (bonds!) than qualified accounts. Similarly, most people view their Roth accounts as the last assets they\u2019ll ever touch. In fact, many people see Roth accounts as the crown jewels of the inheritance they\u2019ll leave to their kids. Roth accounts have the longest timelines in most people\u2019s financial plans. And therefore, Roths should be the most<\/em> aggressively positioned account (all stocks!).<\/p>\n

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    Asset location strategies, though, typically conflict with these ideas. Asset location would have no<\/em> bonds in taxable accounts. Instead, the bonds would reside in qualified accounts (traditional or Roth). <\/p>\n

    Also, depending on the investor\u2019s age, an optimized asset location strategy can quickly be self-defeating in turbulent markets. By sheltering bonds in qualified accounts, we\u2019re also making them illiquid until retirement age (barring special planning techniques). As such, a turbulent market could force us to sell stocks out of our taxable account at a bad time.<\/p>\n

    Rebalancing Problems<\/h3>\n

    For reasons similar to those just stated, optimizing your asset location will likely lead to issues when rebalancing your portfolio. You can no longer rebalance within<\/em> a single account. <\/p>\n

    Again, this is a tax tail (asset location) wagging the investment dog (asset allocation). That\u2019s a bad thing. <\/p>\n

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    Changes in Tax Law<\/h3>\n

    Typically, I make tax planning decisions based on the knowledge we have today<\/em>. I\u2019m not in the game of predicting future tax law. But some people would argue with me. The most common argument is that income taxes will almost assuredly increase in coming years. Time will tell.<\/p>\n

    Changes in tax rates, capital gains treatment, or new legislation could radically alter the effectiveness of an asset location strategy. This has happened before and will undoubtedly happen again.<\/p>\n

    What if the step-up in basis is written out of law? <\/p>\n

    What if capital gains taxes are dramatically increased above income tax rates? <\/p>\n

    These types of changes would make today\u2019s best-laid asset location obsolete. <\/p>\n

    Unforeseen Externalities<\/h3>\n

    Like a spider web, when you touch a financial plan over here<\/em>, you send reverberations to all the other corners of the plan. Most aspects of a plan are connected, even if in small or subtle ways. As such, optimizing for asset location can cause unforeseen externalities in other areas of your plan. <\/p>\n

    For example, when drawing down assets in retirement, our Traditional tax-deferred accounts often (accidentally) lead to high taxable income, Medicare IRMAA surcharges, extra Social Security taxation, and phaseouts of deductions.<\/p>\n

    If you over-index on asset location, you might overlook these other consequences.<\/p>\n

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    Legacy and Estate Planning<\/h3>\n

    We must always ask, \u201cWhat happens when I die?\u201d<\/a><\/p>\n

    As far as asset location is concerned, my main concerns are: <\/p>\n