In an earlier blog discussing the importance of proactive tax planning, we explained how we integrate tax planning into our clients’ financial plans. Successful tax planning results in more money in your pocket every April, and under normal circumstances, it can significantly reduce your tax burden over your lifetime. 

In this article, we distinguish between asset location and a more commonly known term, asset allocation. While both are necessary aspects of a financial plan, this article serves as an introduction to asset location—how it works and why it matters to the health and sustainability of your portfolio.

How asset location differs from asset allocation

Asset location adds another layer of tax-efficiency to your portfolio. It is a tax minimization strategy that places your assets in the most tax-efficient type of investment accounts. Asset location functions from two things:

-The “location” or account of each asset like IRA, Roth IRA, 401(k), brokerage account, etc.

-The tax-efficiency of the securities in your portfolio like stocks, bonds, ETFs, real estate, etc.

This strategy organizes your securities in the investment account that will be the most tax-favorable.  

Asset allocation, on the other hand, involves optimizing and spreading out investment risk. It does this by positioning your portfolio holdings across different asset classes both domestically and internationally while also taking into consideration company size and the portfolio’s percentage of stocks and bonds. 

While asset allocation aims to minimize portfolio volatility and enhance returns over time, asset location specifically focuses on tax efficiency and how to minimize your annual (and lifetime) tax burden.

Let’s take a closer look at how asset location works and the ways you can apply it to your investment plan. 

Three primary asset location classes

For ease of understanding, consider asset location as akin to unloading the contents of a moving truck into three rooms in your house, where the contents are placed strategically in locations most appropriate to the room’s purpose. In the financial lexicon, these three rooms are accounts and are referred to as taxable, tax-deferred, and tax-exempt. 

Each type of account comes with a specific tax treatment, which refers to how, when, and how much the assets are taxed. Our detailed knowledge of your financial goals and assets help us assign the right “room” for each investment. Now, we are going to show you how each “room” or account type is taxed.

Taxable accounts

Taxable accounts indicate that your investments are only taxed when they are sold, traded, or generate income. Your brokerage account is a great example of a taxable account. It doesn’t hold any special tax treatment but the money can be withdrawn at any time without incurring an additional tax penalty.

So how is a brokerage account taxed? The investments in your brokerage account are taxed in one of two ways:

-Capital gains tax

-Ordinary income tax

Investments taxed at a capital gains rate receive more favorable treatment than ordinary income tax. There are two different types of capital gains: short-term and long-term capital gains. If you hold your investments for at least a year (which is preferable) you are eligible for long-term capital gains which comes out to a lower tax percentage. 

You will pay ordinary income tax, the specific rate depending on your tax bracket, on most dividends and interest payments you receive from your investments. Some dividends are taxed at qualified rates, so be sure you know the type of dividend you have (qualified or unqualified) to plan for your tax bill.

Tax-deferred accounts

Tax-deferred accounts are the ones you are probably most familiar with. These accounts allow you to fund them with pre-tax dollars which lowers your taxable income for the year. Some common examples include:

-401(k)

-Traditional IRA

-403(b)

-457(b)

-HSAs

-Series EE or Series I bonds

-Earnings in a whole life insurance policy

Earnings in these accounts grow tax-free, which means you can buy and sell assets as often as you like without incurring immediate tax repercussions. Dividends, interest, and capital gains on assets inside the account also aren’t taxable. So when are they taxed? Assets in tax-deferred accounts are taxed as ordinary income upon distribution. 

Tax-exempt accounts

Tax-exempt accounts function opposite than tax-deferred accounts. You don’t get a tax benefit when you contribute to the account but qualified distributions are tax-free. The two most common types of tax-exempt accounts are:

-Roth IRA

-Roth 401(k)

Contributions are made with after-tax dollars and the money in the account grows tax-free. The most unique part about these accounts is that the distributions are tax-free which rewards those who are able to contribute at a lower tax bracket and later on withdraw assets at a higher tax bracket—resulting in added tax savings for you!

How Blue Rock Dravo Bay advisors ‘locate’ your assets

No matter what the tax treatment, when we’re planning your asset location strategy, we focus on the big picture. For us that means analyzing qualified/non qualified dividends, interest, capital gains as well as the potential return of each asset class.

Let’s use a plant analogy to explain how we select the best asset classes for your portfolio. 

Consider investment choices as plants and the asset classes as rooms in your house. Your Blue Rock Dravo Bay advisor team identifies the level of sun exposure in each room and places your plants in the rooms where they (the assets) and you (the taxpayer) will benefit the most.  

Simply put, asset location matters, and because it’s complex, you can count on us to divvy up your investments in the most appropriate asset classes. We’ll have gathered all the data from you that we need to make the best decisions for your portfolio.

The continuum of tax-efficiency vs. tax-inefficiency

Now that we introduced the three types of accounts your assets can be held in, we get to move onto the second piece of asset location, the tax-efficiency of the securities themselves. 

The tax-efficiency of each security will help indicate which account it will perform best in. First, let’s look at what makes a security tax-efficient or not. A tax-efficient investment is one that triggers a lower tax bill than a different option. A tax-inefficient investment is one that carries a larger tax consequence. 

For the purposes of asset location, you can think of this on a scale of tax-efficient to tax-inefficient. 

In general, we place high-return, tax-inefficient investments into tax-deferred accounts like a 401(k) or IRA. Why? This strategy harnesses the short-term market volatility of the securities as well as deferring additional income like interest or dividends. It allows the investments to grow and eschew tax responsibilities until distribution. A few examples would be:

-High-yield bonds

-Taxable bonds

-Real estate investment trusts (REITs)

-Treasury Inflation-Protected Security (TIPS)

With high-return tax-efficient investments, we like to place these in taxable accounts. Examples of these types of investments are:

-Tax-exempt muni-bonds, 

-Series I and EE Savings Bonds

-Tax-managed stock funds

-Index funds

Simply put, our process of asset location is an outside-in, one by one approach to place your investments into their ideal location. The investment landscape is always changing, and with it, the efficiency of a given asset. This is why we revisit your asset location strategy each year to ensure that it is still working for you.

The continuum of tax-efficiency vs. tax-inefficiency

Now that we introduced the three types of accounts your assets can be held in, we get to move onto the second piece of asset location, the tax-efficiency of the securities themselves. 

The tax-efficiency of each security will help indicate which account it will perform best in. First, let’s look at what makes a security tax-efficient or not. A tax-efficient investment is one that triggers a lower tax bill than a different option. A tax-inefficient investment is one that carries a larger tax consequence. 

For the purposes of asset location, you can think of this on a scale of tax-efficient to tax-inefficient. 

In general, we place high-return, tax-inefficient investments into tax-deferred accounts like a 401(k) or IRA. Why? This strategy harnesses the short-term market volatility of the securities as well as deferring additional income like interest or dividends. It allows the investments to grow and eschew tax responsibilities until distribution. A few examples would be:

-High-yield bonds

-Taxable bonds

-Real estate investment trusts (REITs)

-Treasury Inflation-Protected Security (TIPS)

With high-return tax-efficient investments, we like to place these in taxable accounts. Examples of these types of investments are:

-Tax-exempt muni-bonds, 

-Series I and EE Savings Bonds

-Tax-managed stock funds

-Index funds

Simply put, our process of asset location is an outside-in, one by one approach to place your investments into their ideal location. The investment landscape is always changing, and with it, the efficiency of a given asset. This is why we revisit your asset location strategy each year to ensure that it is still working for you and make any necessary changes to improve overall tax-efficency. 

Three takeaways about asset location and your portfolio

Asset location is a complex strategy but one that can significantly improve both your short-term and long-term tax planning. We covered a lot of information with you here today, so let’s recap some of the basics. 

Three messages we hope you take away from this article:

-Asset location is an important investment strategy that brings maximum tax-efficiency to your portfolio.

-When your portfolio is mindful of tax treatments, you get more money in your pocket at tax time.

-As your trusted financial advisor team, we’re committed to the short term and long term health and sustainability of your portfolio.

We’re here for you, to answer questions about your existing portfolio, or to connect (by phone during shelter in place) to start optimizing your tax planning strategy. Contact us today.