As a financial advisor, I work with a lot of successful and sophisticated investors. But many are unaware of a powerful tax strategy called asset location. Our research shows it can make a meaningful difference in the taxes you pay over your investing lifetime.1
Investing strategies
Asset location can lead to lower taxes. Here's how to get more value.
Asset location can be a powerful tax strategy. Here's what it is and considerations to think about when implementing asset location in your portfolio.
8 minute read
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August 16, 2024
Investing strategies
Managing portfolios
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Asset location—choosing where to place your investments based on tax treatment—might seem straightforward. But there are some nuances, and the "ideal" execution depends on your personal situation. Here's how it works and the types of considerations I think about when implementing asset location for my clients.
An intro to asset location
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). 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
So 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 the majority of 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 the growing popularity of Roth accounts. 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.)
Asset location can seem straightforward, but there are some nuances, and the 'ideal' execution depends on your personal situation.
—Connor McGuire, CFP®
Asset location in action
Say an investor has a $1M 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.
Without asset location, stocks and bonds are evenly spread among accounts
But the investor would like to enact an asset location strategy. For many investors, asset location can mean:
- Placing bond investments in a traditional account first.
- Placing any remaining bonds (overflow) in a Roth account.
- Filling the taxable account—and any remaining space in the Roth account—with stock investments.
So here's what the portfolio would look like after asset location.
With asset location, stocks and bonds are matched with specific accounts
(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 0.3% a year.1 In a case like the one above, that can mean $74K less in taxes over the next 30 years.
Asset location can 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 $1,000,000 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.
Revisiting the Conventional Wisdom Regarding Asset Location (PDF)
Who benefits the most from asset location?
As with all tax strategies, your tax bracket impacts how much money you can save with this strategy. You'll generally benefit more if:
- You're in a high tax bracket.
- There's a big difference between your tax rate today and the one you expect to be subject to in the future.
It also depends on what kinds of accounts you own and how much money is in them. 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 by asset type 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 basis that comes with inherited assets.
Looking for an expert approach to asset location?
Unique considerations for asset location
Rules of thumb are great, but there are always exceptions. Here are some I frequently see with my clients.
You're drawing down assets
The drawdown phase is more complicated than accumulation 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.
You own stocks and bonds that don't meet the typical profile
The standard approach to asset location relies on the differences in taxation I talked about 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 completely differently than other bonds when it comes to asset location, because you don't pay federal taxes on their interest at all.
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 like regular income—just like bonds.
How rebalancing works with asset location
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. It's a good example of how your strategies can intersect and have unintended consequences.
Making the best decisions for your portfolio
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 as an advisor in Vanguard Personal Advisor Select™, I can use our advanced technology to implement customizations that add value for my clients.
The more complex your situation is, the harder asset location can be to implement—but the greater opportunity you might have to squeeze more 'juice' out of your strategy.
—Connor McGuire, CFP®
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 you have to, increasing your after-tax returns so you have more money working toward your goals.
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1Source: Vanguard, Revisiting the Conventional Wisdom Regarding Asset Location, 2022. (PDF)
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