What Is Asset Location & How Does It Work?

Have you ever wondered why two people could invest in the exact same stocks or bonds but end up with different net returns? Enter the art and science of asset location. No, it is not about which coffee shop you are in when buying stocks. It is about where within your investment accounts you are holding them.

Let’s dive in!

What is Asset Location?

First, let’s clear the air: Asset location is NOT asset allocation. Asset allocation is about the mix of investments you own, like 70% stocks, 30% bonds, etc.

Asset location, on the other hand, is about which types of accounts hold those investments. Think of it as a house. The rooms are like your different investment accounts: 401(k), Roth IRA, taxable brokerage, etc. The furniture (your assets) needs to be arranged in a way that maximizes the space and functionality of your home.

 

You would not place your bed in the kitchen, right? Similarly, not all assets fit perfectly in every account.

Why Does It Matter?

Taxes. That is right! Taxes. Every account has its tax rules. Knowing where to place certain investments can mean saving big bucks. For example:

• Taxable Accounts: Profits here get slapped with capital gains tax. But some investments, like stocks held long-term, might benefit from lower tax rates.

Not only that. It can also help you boost your after-tax return rate.

• Tax-Deferred Accounts (Traditional IRA, 401(k)): These beauties let your investments grow tax-free. But you will pay income tax upon withdrawal.
• Tax-Free Accounts (Roth IRA): You have already paid taxes on the money you put in, so everything, including earnings, comes out clean and free.

Putting Theory into Practice

Imagine you are juggling three types of investments:

• Stocks: Generally more growth potential but also more risk.
• Bonds: Typically slower growth, some with regular taxable income.
• REITs (Real Estate Investment Trusts): Produce high dividends but can be tax-inefficient.

In this scenario, you might:

• Place the stocks in a taxable account because long-term capital gains could get preferential tax rates.
• Stash bonds in a tax-deferred account because interest can be taxed as regular income.
• Tuck the REITs into a tax-free Roth IRA to shield those juicy dividends from immediate taxes.

See what we are getting at? It is all about efficiency.

 

Caveats and Considerations

As with all things finance, it is not one-size-fits-all:

• Future Tax Rates: No one has a crystal ball to predict future tax rates. What is efficient today might change tomorrow.
• Liquidity Needs: Need quick cash? It is easier to sell from taxable accounts without penalties or tax surprises.
• Your Specific Goals: Saving for a yacht? Retirement? An alpaca farm? Your goals dictate your strategy.

Wrapping It Up

Think of asset location as the behind-the-scenes stage manager of your financial theatre. While asset allocation steals the spotlight (and for good reason), a well-managed backstage ensures the entire show runs smoothly.

If you are feeling a tad overwhelmed, do not sweat it! Financial advisors love sorting out this stuff. So, chat with a pro, or start with small shifts and learn as you go.

Remember, every dollar saved in taxes is another dollar working for your dreams. So, get those assets in the right locations and watch your financial performance truly shine!