Asset Location vs. Asset Allocation: One of the Most Overlooked Tax Strategies
When people think about investing, they usually focus on asset allocation—how much of their portfolio should be invested in stocks, bonds, cash, or other asset classes. That's an important decision because it largely determines the level of risk and return you can expect over time.
What many investors don't realize is that there's another decision that's almost as important: where those investments should be held.
This concept is called asset location, and while it doesn't receive nearly as much attention as asset allocation, it can have a meaningful impact on your after-tax wealth over the course of retirement.
In fact, two investors could own the exact same investments with the exact same overall allocation, yet one may keep considerably more of their returns simply because those investments are held in different types of accounts.
Think of All Your Accounts as One Portfolio
Many people naturally look at each account separately. They might decide their IRA should be invested 60% in stocks and 40% in bonds, then give their Roth IRA and brokerage account the exact same allocation.
While that seems logical, it often isn't the most tax-efficient approach.
Instead, we encourage clients to think of all of their accounts as one combined portfolio.
Suppose your long-term investment strategy calls for an overall allocation of:
- 70% stocks
- 25% bonds
- 5% cash
That allocation doesn't need to exist inside every individual account. Rather, it should exist across your household's total investment portfolio. Once you've determined the appropriate mix of investments, the next step is deciding which account is the best home for each asset.
That's where asset location comes in.
Every Type of Account Is Taxed Differently
Because taxable accounts, traditional retirement accounts, and Roth accounts all receive different tax treatment, certain investments tend to be more efficient in some accounts than others.
Taxable Brokerage Accounts
Taxable brokerage accounts often provide the greatest flexibility. Long-term capital gains and qualified dividends are generally taxed at lower rates than ordinary income, and investors may also benefit from tax-loss harvesting opportunities. Appreciated assets held in taxable accounts may also receive a step-up in basis when passed to heirs under current law.
For those reasons, taxable accounts are often a good place to hold investments that are already relatively tax-efficient, such as broad stock index funds, ETFs, or individual stocks intended to be held for many years.
Traditional IRAs and Traditional 401(k)s
Traditional retirement accounts grow tax-deferred, but every dollar withdrawn is generally taxed as ordinary income. Because of that, these accounts are often a logical place to hold investments that naturally generate taxable income each year, including bond funds, REITs, or actively managed funds that produce larger annual distributions.
Rather than paying taxes on that income each year, those taxes are deferred until money is withdrawn in retirement.
Roth IRAs
Roth accounts are unique because qualified withdrawals are generally tax-free. Since every dollar of future appreciation may never be taxed again, many investors choose to reserve Roth accounts for investments with the highest long-term growth potential.
That doesn't necessarily mean taking more risk. It simply means that if part of your portfolio is expected to experience the greatest appreciation over several decades, the Roth account can often be the most tax-efficient place for those investments to grow.
Every Account Has a Different Purpose
One of the concepts we regularly discuss with clients is that not every dollar has the same job.
A taxable brokerage account might be earmarked for flexibility—funding early retirement, a second home, or other large purchases before retirement account withdrawals begin.
A traditional IRA may be intended to provide retirement income throughout your lifetime.
Meanwhile, a Roth IRA often serves a different purpose altogether. Because of its favorable tax treatment, many retirees hope to spend it last—or perhaps leave much of it to the next generation.
Recognizing the purpose of each account can help shape not only withdrawal decisions, but also how those accounts are invested in the first place.
Investing for Retirement Is Different Than Investing for the Next Generation
As retirement approaches, many people realize they may not spend every dollar they've accumulated. That's when investment strategy often expands beyond simply generating retirement income and begins incorporating estate planning.
For example, under current law, taxable investments may receive a step-up in basis at death, potentially eliminating built-in capital gains for heirs. Roth IRAs can generally pass to beneficiaries income-tax free, while traditional retirement accounts often pass along deferred ordinary income taxes.
Those differences don't mean one account is always better than another. Instead, they illustrate why asset location becomes increasingly valuable when retirement income planning, tax planning, and legacy planning all intersect.
Bringing It All Together
Asset allocation answers the question, "How should my money be invested?"
Asset location answers, "Which account should hold each investment?"
Both decisions matter, but asset location is often overlooked because it doesn't involve choosing a new investment or trying to outperform the market. Instead, it's about helping your investments work more efficiently from a tax perspective.
At Birch Street Financial Advisors, we believe investments, taxes, retirement income, and estate planning shouldn't be managed separately. When those pieces work together, your portfolio may become more tax-efficient without taking on additional investment risk—and sometimes that's where some of the greatest long-term value can be created.
How Birch Street Financial Advisors Can Help
Every client's situation is different, which means there isn't a one-size-fits-all formula for asset location. We evaluate your entire financial picture—including your taxable accounts, retirement accounts, Roth accounts, future tax brackets, retirement income needs, and estate planning goals—to help determine not only what investments you own, but where they belong.
Sometimes improving long-term outcomes isn't about finding a better investment. It's about putting the right investment in the right account.
