You're paying more in taxes than you need to. Not because you're doing anything wrong with your investments, but because of where you're holding them.
This is the retirement planning mistake that costs investors thousands of dollars every year, yet it's rarely discussed. Financial advisors spend hours helping clients choose the right investments, but many overlook the equally important question: which accounts should hold those investments?
Asset location—the strategic placement of investments across different account types—can add meaningful value to your after-tax returns over time. Research suggests that thoughtful asset location strategies can boost after-tax returns by 0.1% to 0.3% annually. That might not sound like much, but compounded over decades, it can add tens of thousands of dollars to your retirement savings.
The Three Account Types You Need to Understand
Most retirees have access to three types of accounts, each with distinct tax characteristics:
Traditional Tax-Deferred Accounts (Traditional IRAs, 401(k)s)
Contributions may be tax-deductible, investments grow tax-deferred, and withdrawals are taxed as ordinary income. Every dollar you take out gets added to your taxable income for that year.
Roth Accounts (Roth IRAs, Roth 401(k)s)
Contributions are made with after-tax dollars, investments grow tax-free, and qualified withdrawals are completely tax-free. Once you're 59½ and the account has been open for five years, you never pay taxes on that money again.
Taxable Brokerage Accounts
No contribution limits and no withdrawal restrictions, but you pay taxes annually on interest, dividends, and realized capital gains. Long-term capital gains and qualified dividends receive preferential tax rates (currently 0%, 15%, or 20% depending on income).
The key to asset location is matching each investment type with the account that provides the most favorable tax treatment.
Which Investments Go Where?
Tax-Inefficient Investments: Prioritize Traditional IRAs
Some investments generate significant taxable income annually. These belong in tax-deferred accounts where that income can compound without immediate tax consequences.
Taxable bonds and bond funds top this list. They generate ordinary income taxed at your marginal rate, which can be as high as 37% federally. Holding bonds in a traditional IRA shelters this income from current taxation.
Real estate investment trusts (REITs) also belong here. They're required to distribute most of their income, creating significant taxable distributions. High-yield stocks with substantial dividends similarly benefit from tax-deferred treatment.
Tax-Efficient Investments: Use Taxable Accounts
Some investments naturally minimize taxable income, making them suitable for taxable accounts.
Index funds and exchange-traded funds typically generate minimal capital gains distributions because of their low turnover. When you do sell, you'll pay the preferential long-term capital gains rate if you've held the investment for more than a year.
Municipal bonds generate tax-exempt interest, so there's no benefit to holding them in retirement accounts. In fact, doing so can be counterproductive.
Tax-managed funds are explicitly designed to minimize taxable distributions, making them appropriate for taxable accounts.
Growth Investments: Roth Accounts
This is where asset location gets strategic. Your Roth accounts offer tax-free growth and tax-free withdrawals. That makes them ideal for investments with the highest expected growth potential.
Place your most aggressive stock funds, small-cap stocks, and international equities in Roth accounts. These investments might experience the highest long-term growth, and you want that growth completely tax-free.
Think of your Roth as the account you're least likely to need to tap early in retirement. Let it grow untouched as long as possible, maximizing the compounding of tax-free returns.
Real-World Example
Consider a retiree with $1 million split equally between a traditional IRA, Roth IRA, and taxable account, with a target allocation of 60% stocks and 40% bonds.
Suboptimal Asset Location:
Each account holds 60% stocks and 40% bonds—a simple but tax-inefficient approach.
Optimized Asset Location:
- Traditional IRA: $333,000 entirely in bonds (tax-inefficient)
- Roth IRA: $333,000 entirely in stocks (high growth potential)
- Taxable Account: $267,000 in stocks, $66,000 in bonds
This maintains the same overall 60/40 allocation but places each investment in the most tax-advantaged location. Over 20-30 years, this optimization could add $50,000 or more in after-tax value.
Implementation Challenges
Asset location sounds straightforward in theory but gets complicated in practice.
Account Balance Imbalances
What if you have $800,000 in your traditional IRA but only $100,000 each in Roth and taxable accounts? You can't implement perfect asset location with these proportions.
In this case, do the best you can. Place the most tax-inefficient assets (bonds) in the traditional IRA first, then work down the list based on tax efficiency.
Rebalancing Complexity
Asset location complicates rebalancing. You can't simply rebalance each account independently—you need to think across all accounts simultaneously to maintain your target allocation while preserving optimal tax location.
This is where working with a financial advisor becomes valuable. They can model different scenarios and execute trades that optimize both allocation and location.
Required Minimum Distributions
Once you reach age 73, you must start taking required minimum distributions from traditional IRAs. These mandated withdrawals can disrupt your asset location strategy over time.
Plan ahead by understanding how RMDs will affect your portfolio structure and adjust your strategy as you approach RMD age.
Transaction Costs and Tax Consequences
Moving investments to optimize asset location can trigger capital gains taxes in taxable accounts or transaction costs. Don't let the perfect become the enemy of the good.
If you're implementing asset location for the first time with existing investments, consider doing it gradually. Place new contributions in optimal locations first. Then, over time, gradually shift existing investments when you can do so tax-efficiently.
For pre-retirees, start implementing asset location now. The earlier you begin, the more value you'll capture from compounding returns in tax-advantaged accounts.
The Bottom Line
Asset location is the overlooked strategy that can add significant value to your retirement portfolio without taking additional investment risk or changing your asset allocation.
The key is matching investments to the account types that provide the most favorable tax treatment: tax-inefficient investments in traditional IRAs, high-growth investments in Roths, and tax-efficient investments in taxable accounts.
Like most tax strategies, asset location works best when implemented early and maintained consistently over time. If you have substantial savings across multiple account types, it's worth taking the time to optimize—or working with an advisor who can implement this strategy for you.
Because the goal isn't just to build wealth for retirement. It's to keep more of that wealth for yourself and less for the IRS.
This material is for informational purposes only and should not be construed as tax or investment advice. Tax laws are complex and subject to change. You should consult with a qualified tax advisor regarding your specific situation.
Asset location strategies involve tax considerations that may not be appropriate for all investors. Consult with a financial advisor before implementing any asset location strategy.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Great Valley Advisor Group, a registered investment advisor and separate entity from LPL Financial.
Chesapeake Financial Planners | 2402 Scotlon Ct, Forest Hill, MD 21050 | (410) 652-7868 | www.chesapeakefp.com
