The “Asset Location” Dilemma: Tax Strategy or Tax Trap?

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

Depending on who you ask, the process known as “asset location” could be one of the more impactful arrows in your financial planning quiver…or it could be a total waste of time.

So which is it? Does asset location matter in the long run? And if so, can we quantify it?

What is Asset Location?

Let’s start two fundamentals of investing that set the table for today’s discussion:

1. Many investments provide cash 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 capital gains taxes for their investors, even if the investor didn’t actually sell off their shares!
2. These dividends, bond income, realized gains, etc., are all subject to taxes unless 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.

These two facts raise an interesting question:

Can we intentionally place “high-tax” investments in our qualified, tax-advantaged accounts and then put the “lower-tax” investments in our taxable accounts?

Won’t this lower our annual tax bill, leaving more assets in our portfolio to compound, and indeed create a positive long-term advantage?! In other words – can we maximize our total after-tax returns this way? Can we minimize “tax drag?”

This is asset location.

Investing Dog, Tax Tail

A discerning investor might now ask, “Why not simply avoid investments that shed off too much taxable income? Wouldn’t that be an easier path?”

The short response is, “Don’t let the tax tail wag the investing dog.”

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.

And I can say from experience: asset location isn’t the only place where investors let the tax tail wag their investing dog.

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 allow the fear of taxes to cause them to do dumb stuff.

Smart investors certainly optimize for taxes. It’s important! But they don’t let tax concerns override sound investing principles.

Asset Location “Theory”

The basics of asset location are straightforward.

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

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

Therefore, asset location theory is simple.

If your portfolio needs bonds, keep them in a qualified account to nullify the tax inefficiency.

Then fill up the rest of your accounts – including your taxable account(s) – with stocks.

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?

The Numbers: How Much Money You Save With a Smart Asset Location Technique

Time for the good stuff: does asset location work over the long haul?

A recent (2022) study from Vanguard clearly shows that asset location provides a measurable benefit to investors.

The bigger question we’ll answer below is how and why particular investors receive much more benefit than others. We’ll also discuss when and why asset location strategies can go “too far,” becoming a detriment to other aspects of a financial plan.

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

**0.10% to 0.20% better…compared to what? The “baseline” in this study was an “equal location” portfolio that assumed all accounts – Traditional, Roth, and Taxable – had identical allocations. e.g. 60/40 in all three accounts, as opposed optimizing the asset location.

Who Does Asset Location Help the Most? And Why?

Why does asset location impact different investors in different ways? There are 3 main reasons:

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

Higher-income (high tax bracket) investors see a larger benefit. 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.

Those who will bequeath (leave to heirs) a more significant portion of their taxable account see a larger benefit. 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’ll achieve a step-up in cost basis and will avoid the entire capital gains tax. As I’ve written before…this is a controversial aspect of current tax law!

Nevertheless, if a large portion of one’s assets will be bequeathed, asset location can become even more valuable.

These types of investors could see their asset location strategy yield an annual performance improvement up to 0.30% to 0.40% per year.

But Are There Downsides?

If you’ve played around with a compound interest calculator, you’ll know that 20 or 30 basis points can make a huge difference when compounded over an investing career.

Example: a retiree with $1M and a 30-year retirement. After annual withdrawals to pay for retirement, their portfolio still grows at 2% per year. With proper asset location, it would grow at 2.2% instead. After their 30-year timeline, asset location would have made a $100,000 difference.

But asset location isn’t perfect, and you should know the downsides before you decide to enact it.

Liquidity, Accessibility, and Timeline Issues

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.

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’ll ever touch. In fact, many people see them as the crown jewel of the inheritance they’ll leave to their kids. Roth accounts have the longest timelines in most people’s financial plans. And therefore, it should be the most aggressively positioned account (all stocks!).

Asset location strategies typically conflict with these ideas.

Then, depending on the investor’s age, an optimized asset location strategy can quickly be self-defeating in turbulent markets. By sheltering bonds in qualified accounts, we’re 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.

Rebalancing Problems

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 a single account.

Again, this is a tax tail (asset location) wagging the investment dog (asset allocation). That’s a bad thing.

Changes in Tax Law

Typically, I make tax planning decisions based on the knowledge we have today. I’m 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 future years. Time will tell.

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.

Unforeseen Externalities

Like a spider web, when you touch a financial plan over here, 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.

For example, when drawing down assets in retirement, our Traditional tax-deferred accounts often (accidentally) lead to higher taxable income, potential Medicare IRMAA surcharges, higher Social Security taxation, and phaseouts of deductions.

If you over-index on asset location, you might overlook these other consequences.

Legacy and Estate Planning

It’s important we always ask, “What happens when I die?”

As far as asset location is concerned, my main concerns are:

• What happens to your taxable investement accounts?
• What happens to your Traditional accounts?

In general, your taxable accounts will be left to your heirs at a stepped-up cost basis, effectively nullifying any unrealized capital gains in that account!

And your Tradtional accounts will be converted into Inherited IRAs for your beneficiaries, subject to specific withdrawal rules (e.g. the 10-Year Rule) and the accompanying income taxes.

These different tax treatments matter. Over-optimizing for tax efficiency during your lifetime might not align with the best estate planning outcomes.

Is Asset Location Worthwhile?

I’m a supporter of asset location. After all, those 0.10%, 0.20%, 0.30% savings can add up over an investing lifetime.

BUT! I’m also a proponent of maintaing proper investing principles and looking at the bigger picture. When focused on too intently, asset location can cause more harmful side effects than positive main effects.

Are you pursuing an asset location strategy in your financial plan?

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-Jesse

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