Asset location is a tax optimization strategy that takes advantage of the fact that different types of investments receive different tax treatment. <\/p>\n
To benefit from this strategy, you must have investments in both a taxable account (e.g. a brokerage account) and a tax-deferred account (e.g. an IRA, 401(k) and\/or 403(b)). You determine which investments should be held in your tax-deferred accounts and which securities should be held in taxable accounts with the objective of maximizing your after-tax return.<\/p>\n
How an investment is taxed will determine where it should be located. Under the tax code, dividends and capital gains receive favorable treatment. While interest income is taxed as ordinary income, dividends and capital gains are taxed at lower rates.<\/p>\n
Most equity investments (like individual stocks, equity mutual funds and equity exchange-traded funds) generate returns from both dividends and capital gains. Owning these investments in your taxable account means that this return will be taxed at favorable rates. If, on the other hand, the equity investments were owned in your tax-deferred IRA, 401(k), etc, the dividends and capital gains would be taxed as ordinary income when withdrawn from the account.<\/p>\n
In the same vein, fixed income investments, like bonds and real estate investment trusts (REITs) generate a regular distribution. These distributions are taxable as ordinary income if held in your taxable account. Holding them in your tax-deferred retirement account shelters this income from tax until distributions are made.<\/p>\n
Let\u2019s look at an example. Say your portfolio of investment and retirement accounts is worth $1 million. Half of this is in your Schwab IRA and half in your Schwab taxable brokerage account. By chance, you\u2019ve determined that your optimal asset allocation is 50% to stocks, and 50% to bonds and cash. Ideally, you would hold all of your stock investments in your taxable account, and all of your bonds and cash (and perhaps REITS, too, if you own them) in your IRA. In this example the math works perfectly, and so you own $500,000 of stocks in your $500,000 brokerage account, and $500,000 of fixed income investments in your $500,000 IRA.<\/p>\n
Note that each account does not have the same investment mix. Creating the same asset allocation in each account ignores the tax benefit of properly placing investments in the type of account that will maximize your after-tax return.<\/p>\n