How “Asset Location” Can Result in a Larger Portfolio Balance
You’ve likely heard of asset allocation before. Usually, asset allocation is referred to when talking about balancing or diversifying your portfolio. Asset allocation is all about making sure that your assets are properly spread across a variety of different investments. In other words, they’re “allocated” appropriately based on your retirement timeline, and a number of other factors.
Asset location, on the other hand, is a little bit different. Asset location is focused on where (or in what accounts) your assets are located. Asset location, though not as frequently talked about in the world of personal finance and financial planning, is equally important to asset allocation. Each play a specific role in your retirement portfolio strategy. Let’s take a closer look at asset location, and how it impacts your investments.
Asset location primarily focuses on minimizing taxes by sorting your investments into different types of accounts. From there, you may develop a unique strategy for each account according to your retirement or investing goals, or still use a holistic approach to your investment strategy.
Asset location leverages both tax-deferred and taxable accounts, and you can determine which securities should be held in which account type to maximize returns. The primary benefit of asset location is reducing your tax bill while you are investing and also when withdrawing funds to provide income. The savings you’re able to accumulate over the years can really start to add up, which makes a big difference as you get closer to retirement.
How Does Tax Location Work?
Asset location is probably easier to wrap your mind around than you might think. Each type of investment account has a different tax treatment, which impacts your earnings over time. By using different account types that each have their own tax advantages, you’re creating space for you and your spouse or partner to strategically plan your retirement income to minimize taxes throughout retirement.
Matthew Kenigsberg, VP of Investment & Tax Solutions at Fidelity Investments explains, “You can’t control market returns, and you can't control tax law, but you can control how you use accounts that offer tax advantages—and good decisions about their use can add significantly to your bottom line.”
To start building your asset location strategy, you have to look at each asset’s taxability. From there, you can determine what account location makes the most sense for a given asset. To simplify things, you can look to follow these basic rules of thumb (1):
Assets that earn interest should be held in a tax-deferred account, as it’s taxed at your income tax rate
Assets that earn qualified dividends and capital gains should be in a taxable account, as they have different tax rates than your income
Index funds and passive ETFs should mostly be held in taxable accounts
Taxable bonds can be held in tax deferred accounts
Real estate investments and actively managed mutual funds should be held in tax-deferred accounts
Let’s look at an example of how asset location might look in action (example from “Nerds Eye View” by author and researcher Michael Kitces):
The example above illustrates the dramatic impact that asset location strategy can have on your portfolio over the course of your retirement.
Keep in mind that asset location works best when people have a balanced portfolio ( e.g. 60% equities / 40% fixed income). If you’re heavily invested in equity or fixed income, then the asset location strategy will have less of an impact on your tax situation.
Remember – asset allocation and asset location strategies work best when employed together. The two strategies combined can help you to create an ideal retirement portfolio that’s both tax-efficient, and well-balanced.
Want To Learn More?
I know that asset allocation and asset location strategies can be difficult to navigate on your own. As a fee-only financial planner, I can help you to build a strategy for your retirement portfolio that plans for tax-efficiency and longevity. This will put you on the path to live the retirement you’ve always imagined. Why don’t you schedule a time to fill me in on your situation?