Say you want to plant a vegetable garden, and you’ve already picked out the right mix of plants that are suited to your particular climate. The next step is to figure out where to put them in the garden, given considerations like soil quality, shading, and which plants do well together. Just like certain vegetables do best in certain spots in the garden, different investments grow best in certain accounts. The goal of asset location is to maximize the after-tax value of your wealth after you’ve selected the right mix of investments for your time horizon and risk tolerance, (a process known as asset allocation). The basic idea is this: if you’ve got investments growing in a regular brokerage account or a traditional tax-deferred retirement account, a portion of those earnings belong to the government by law. But, by managing the types of accounts in which you place different investments and how frequently you trade them, you’ll have some control over when and how much you’ll ultimately pay in taxes. Over time, the savings can be very meaningful, depending on your situation.

Basic Account Types

For simplicity, there are three main types of investment accounts, each of which has different strengths and weaknesses that make them ideal for different types of investments.

Tax-Deferred (Traditional IRAs, 401k, 403b):

Think of it like this, the government is your investment partner in your tax-deferred retirement accounts. You get the benefit of investing earnings that haven’t been taxed yet, which will grow without being taxed along the way. However, when you take the money out, Uncle Sam will want his share of the entire distribution at your current income tax rates. As your account grows, the taxman’s share of it grows at the same rate (assuming a constant effective tax rate). Tax-deferred accounts like Traditional IRAs and 401(k)/403(b) employer retirement plans are ideal for investments which are expected to appreciate significantly and are tax-inefficient because you won’t need to pay any tax when you earn dividends or interest on your investments or when you sell securities within the account. Tax in-efficient refers to investments that pay unqualified dividends or pay higher interest amounts (both of which are taxed at ordinary income rates), or investments that have higher turnover, which tend to produce short-term taxable gains that are also taxed at ordinary income tax rates instead of lower long-term capital gains rates.

Taxable (Brokerage Account):

Taxable accounts are best suited for assets that are expected to appreciate significantly and are tax-efficient investments. Tax-efficient investments include individual equities or funds that pay only qualified dividends and have low turnover with long-holding periods, as these will benefit from being taxed at lower long-term capital gains rates, which range from 0%-23.8%, depending on your tax bracket. If you sell an investment in a taxable brokerage account after holding it for at least one year and one day, any gains will receive long-term capital gain tax treatment.  Also, only assets that are held in taxable accounts would be eligible for a step-up in basis upon death, which zeros out any capital gains obligations on appreciated securities when you pass them to your heirs.

Tax-Free or Tax Exempt (Roth accounts):

These accounts have the potential for the greatest tax advantage of all. If you follow the rules, Roth accounts will never be taxed again, making them ideal for any highly appreciating, long-term investments, whether they’re tax efficient or not. Investments in a Roth account grow tax-free (no capital gains, dividend income, or interest income taxes along the way), and are tax-free when distributed (subject to rules). HSA and 529 College Savings Plans have similar tax-exempt characteristics to Roth retirement accounts but given their specialized purposes and potentially different investment time horizons, the general strategies highlighted in this article may or may not be appropriate for these accounts.

Asset Types:

Growth Stocks & Small Cap Equity:

These are likely to generate the highest expected return for your portfolio over the long term, therefore they are best kept in a Roth account where they will never be taxed again. Typically, you don’t want to hold highly appreciated securities in a tax-deferred account, where their growth will just generate a greater tax bill later when you make distributions from your account (remember, Uncle Sam is your investment partner in a tax-deferred account!). However, sometimes holding this tax-efficient, highly appreciating securities in a taxable account also makes sense because of the added flexibility and lower capital gains rates that you’ll typically benefit from. There are also several strategies available to offset larger unrealized capital gains on securities held in taxable accounts.

Dividend Paying Stocks & Large Cap Equity:

With typically less appreciation potential, these are a lower priority for a tax-advantaged account. If the dividends are qualified (i.e. taxed at lower long-term capital gains rates) you may want to hold them in a taxable account.

Actively Managed Funds:

More actively traded mutual funds tend to generate short-term gains, which are taxable at higher ordinary income rates when they’re passed through to you. Mutual funds can sometimes build up larger unrealized capital gains, which will be distributed to investors in the future who may have not been around to benefit from the appreciation but will be taxed on it anyway. Putting these funds into a tax-deferred account will neutralize the short-term tax impact.

Foreign Stocks:

When you invest in foreign stocks (whether directly or through an index mutual fund or ETF) you’ll receive a tax credit for taxes that were paid to the governments in which those companies are domiciled, but only if you hold them in a taxable account.

Higher-Yielding Taxable Bonds:

Best held in an IRA or tax-deferred employer plan unless you need the income or for short-term goals (then put them into a taxable account). You’ll pay the income tax at your marginal bracket, either way, it’s just a question of when, and the tax deferral provides a slight benefit.

Treasury Bonds:

Longer-term, higher-yielding treasury bonds fit best in a tax-deferred account, especially if you’re in a higher income bracket or you don’t need the income now. Shorter-term, lower-yielding bonds won’t benefit from the tax deferral since their expected return is generally low, so it matters less where you put them. Since lower-yielding securities are often used to manage short-term needs or for an emergency fund, the added flexibility of a taxable account makes more sense. After all, you don’t want to dip into your retirement account or be forced to sell a highly appreciated security from a taxable account if you’re in a bind.

Municipal Bonds:

Interest from these bonds is generally not taxed at the federal level and sometimes not at the state level either. Because they are already tax-advantaged, there’s no benefit from putting munis in a tax-advantaged retirement account where it will take up room from other securities that would benefit from tax-deferral. Munis are generally lower-yielding securities anyways and are only appropriate if you’re in a high tax bracket (otherwise you’re likely better off with a taxable bond), but keep an eye out for the impact on AMT and other tax thresholds.

REITs:

Investing in a Real Estate Investment Trust is like becoming a landlord for a diversified basket of properties that you don’t have to manage. They are required to distribute 90% of their net income annually, which is generally taxed at ordinary income rates and has lower growth potential than stocks historically, like bonds. Therefore, REITs generally benefit from being held in tax-deferred accounts.  However, distributions from REITs sometimes qualify for QBI (qualified business income) treatment, which can provide a tax deduction if they’re held in a taxable account.

Cash-Like Securities:

Given the lower expected returns for cash-like securities such as money market funds and short-term bonds, there’s generally little benefit to be had by holding these in a tax-advantaged account, especially if they take up room from higher returning securities.

The below chart provides a visual for where each of these securities fall on the earlier Tax Efficiency vs. Expected Return asset location chart.

Parting Thoughts:

Keep in mind, these are not hard and fast rules. Based on your desired investment allocation (i.e. the mix of different security types according to your goals and risk tolerance) and the limitations imposed by your current mix of account types and their balances, you may not have room to put everything into its “optimal” location, so you’ll have to prioritize to get the greatest benefit available within your constraints. Also, we rarely have the benefit of starting an asset location strategy from scratch. You may be sitting on a large capital gain in a taxable account, and it may not be to your advantage to realize it now (i.e. pay the taxes) just to shift certain exposures to another account type. As with most things, this is a balancing act, and there are few hard rules (except for never holding tax-exempt bonds in a tax-advantaged retirement account!).

Lastly, these general asset location strategies are only applicable to middle and high-income individuals and families, who pay capital gains taxes at a 15% rate or higher (i.e. taxable income above $89,251 in 2023 for married filing jointly). If you fall into one of the lower tax brackets, you’ll pay a 0% rate for long-term capital gains, which changes the optimal asset location tradeoffs considerably.

If you’d like to go farther down the rabbit hole and look at some more advanced concepts in asset location strategy, I highly recommend reading The Kitces Report from March/April 2014 by Michael Kitces, to whom I’m indebted for some of the material in this article, particularly the ideas for the visuals.

If all of this is more than you want to understand or undertake, I would be happy to advise you on a strategy that works for your situation and goals.