Many investors are unaware of a powerful tax strategy called asset location, which is choosing where to place your investments based on tax treatment. This idea might seem straightforward, but there are some nuances, and the "ideal" execution depends on your personal situation.
Here's how asset location works and some factors to keep in mind. Our research shows it can make a meaningful difference in the taxes you pay over your investing lifetime.1
Asset location takes advantage of these basic principles:
Not all account types are taxed the same way. Traditional IRAs are tax-deferred until you withdraw assets and then taxed as ordinary income. Roth IRAs are tax-free—the growth is never taxed (assuming you meet the requirements).2 And earnings in taxable accounts (whether interest, dividends, or distributed capital gains) are taxed as they're paid out, not upon withdrawal.
Not all kinds of investment income are taxed the same way. Interest is taxed at your ordinary income tax rate. Long-term capital gains and dividends are taxed at a lower rate—15% for many investors and up to 20% for the highest-income investors (plus any surcharges that may apply).
Learn about paying taxes on your investment income
Here's the key behind asset location: You may be able to reduce your taxes by matching account types and asset types.
In its simplest form, asset location is sometimes explained as "bonds in traditional, stocks in taxable." That's because income from stock investments is usually taxed at more favorable dividend and capital gains rates. But earnings from bond investments are mostly interest and taxed at ordinary income tax rates, meaning a hit of up to 37% plus any surcharges for high-income investors. So you want those bonds to be sheltered.
Simple, right? Well, the first nuance that can make asset location more complicated is eligibility to save in a Roth account, which is increasingly popular. If you have one, you'll have additional considerations for where to place your assets. (If you don't, an advisor can help you determine whether you'd benefit from opening one or converting some of your traditional assets.)
Say an investor has a $1 million portfolio split equally between stocks and bonds and owns all 3 account types (traditional, Roth, and taxable). If treated all the same way, their accounts would look like this.
For many investors, implementing an asset location strategy in this situation could mean:
Here's what the portfolio would look like after asset location.
(This is a simple example to illustrate the basic idea. You'd also want to consider your international stocks and bonds separately from your U.S. stocks and bonds because they tend to have different income patterns.)
So how would this affect after-tax returns? Our research shows that following asset location principles can boost returns between 0.05% and 0.30% per year.1 In a case like the one above, that can mean $74,000 less in taxes over the next 30 years.
Asset location may drastically reduce taxes
The example given is based on a 30-year investment horizon and represents the median outcome. The portfolio as modeled maintained a 50/50 stock/bond mix throughout the time period and was rebalanced annually. In this example, the initial $1 million portfolio included $400,000 in a tax-deferred account, $200,000 in a tax-free account, and $400,000 in a taxable account. The asset location approach placed bonds in the tax-deferred account first, tax-free account second, and taxable account third as needed to achieve the target asset mix. Annual withdrawals of $35,000 (3.5% of initial balance) were included, increasing each year with inflation. Withdrawals were taken from the taxable account first, then the tax-advantaged account, followed by the tax-free account. Annual taxable dividends from stocks were taxed at a 15% long-term capital gains rate and qualified dividend rate. Annual fixed income interest was taxed at the 22% marginal tax rate. Bequests were taxed at a 22% tax rate. Inflation, asset class return, and income estimates were based on 30-year median growth rates derived from 10,000 simulations through the long-term Vanguard Capital Markets Model® (VCMM) as of 12/31/2022. Actual results will vary. This example does not represent any actual client outcome. Cost of the underlying investments was not factored into the hypothetical returns. Past performance is no guarantee of future results.
IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of 12/31/2022. Results from the model may vary with each use and over time.
A lot of variables affect the value you might get from asset location. We'll dive into that next—but for more detail, see our white paper.
As with all tax strategies, your tax bracket impacts how much money you can save with this strategy. You'll generally benefit more if:
It also depends on the types of accounts you own and how much money they hold. Asset location adds the most value if you own a Roth account in addition to traditional and taxable accounts, and if your money is relatively balanced across asset types and among accounts. (After all, if you only have one kind of asset or account, there's not much locating you can do!)
Finally, your plans for your money matter too. If you intend to leave money to heirs rather than spend it, asset location can help you make the most of the step-up in cost basis that comes with inherited assets.
Looking for an expert approach to asset location?
Rules of thumb are great, but there are always exceptions. Here are some that might affect you:
The drawdown phase is more complicated than the accumulation period in many ways, and asset location is no different. Your asset location strategy needs to work with your drawdown strategy, all while your portfolio's balance of stocks and bonds is likely getting more conservative.
Because of the interplay of these factors, retirement is an ideal time to see if you'd benefit from a custom asset location strategy.
The standard approach to asset location relies on the differences in taxation mentioned earlier. But you might own stocks and bonds that don't follow the "norm," and that changes the math.
For example, tax-exempt (municipal) bonds are treated differently than other bonds when it comes to asset location, because you don't pay federal taxes on their interest.
And active funds can be a special case when it comes to stocks. While active funds can be a valuable part of your strategy, they're more likely than index funds to distribute capital gains (because of their more frequent trading), including short-term capital gains that are taxed as regular income—just like bonds.
When following an asset location strategy, you'll generally rebalance your "overflow" account (because it'll hold both stocks and bonds). If that happens to be your taxable account, it can cause a tax spike every time you rebalance. This is a good example of how investment strategies can intersect and have unintended consequences.
A straightforward approach to asset location can work well for most investors. The more complex your situation is, the harder it can be to implement—but the greater opportunity you might have to squeeze more "juice" out of your strategy.
Ready to implement your asset location strategy? Remember that big portfolio moves—like selling assets in your taxable account—can also have a significant tax cost. You'll need to be strategic about it and potentially use other tax strategies to help offset the impact.
An advice service like Vanguard Personal Advisor® can build an asset location strategy into client portfolios automatically. And a service like Vanguard Personal Advisor Select™ can use advanced technology to implement customizations that add value for clients.
Remember that taxes aren't the be-all and end-all when it comes to investing—avoiding them shouldn't be your main goal when deciding what to invest in. That said, smart tax strategies can let you avoid paying more than necessary, increasing your after-tax returns so you have more money working toward your goals.
1Source: Vanguard, Asset location for equity 2023. (PDF)
2When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax. Withdrawals from a Roth IRA are tax free if you are over age 59½ and have held the account for at least five years; withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both. (A separate five-year period applies for each conversion and begins on the first day of the year in which the conversion contribution is made.)
All investing is subject to risk, including the possible loss of the money you invest.
Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
Neither Vanguard nor its financial advisors provide tax and/or legal advice. This information is general and educational in nature and should not be considered tax and/or legal advice.
Any tax-related information discussed herein is based on tax laws, regulations, judicial opinions, and other guidance that are complex and subject to change. Additional tax rules not discussed herein may also be applicable to your situation. Vanguard makes no warranties regarding such information, or the results obtained by its use, and disclaims any liability arising out of your use of, or any tax positions taken in reliance on, such information. We recommend you consult a tax and/or legal advisor about your individual situation.
Vanguard's advice services are provided by Vanguard Advisers, Inc. ("VAI"), a registered investment advisor, or by Vanguard National Trust Company ("VNTC"), a federally chartered, limited-purpose trust company.
The services provided to clients will vary based upon the service selected, including management, fees, eligibility, and access to an advisor. Find VAI's Form CRS and each program's advisory brochure here for an overview.
VAI and VNTC are subsidiaries of The Vanguard Group, Inc., and affiliates of Vanguard Marketing Corporation. Neither VAI, VNTC, nor its affiliates guarantee profits or protection from losses.
IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard's primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
