If you’ve been investing for a while, you’ve probably spent a lot of time on your asset allocation. How much in stocks, how much in bonds, how much international. People online will argue about this for days, and honestly, so will I.
What gets a lot less attention is asset location, which is the question of which account each of those investments should sit in. If you’ve got money in a traditional 401(k), a Roth IRA, and a regular brokerage account, you get to choose what goes where. Making good choices can lower your tax bill every year without changing how much risk you’re taking.
If all of your money is in one 401(k), you can skip this one. Asset location only comes into play once you have at least two kinds of accounts.
Asset allocation vs. asset location
Your asset allocation is your overall mix. Say you’ve decided on 70% US stocks, 20% international stocks, and 10% bonds. That’s the decision that drives your risk and most of your returns, and you should settle it first.
Asset location doesn’t change that mix at all. You still own 70/20/10 across everything you have. You’re just deciding which pieces go in which account, based on how each account gets taxed. Done right, the IRS ends up with a smaller share of your growth.
How each account is taxed
Traditional 401(k)s, 403(b)s, and traditional IRAs are tax deferred. You get a deduction when you put money in, you don’t pay anything on the growth along the way, and every dollar you take out in retirement is taxed as ordinary income. It doesn’t matter whether that money grew from stocks or bonds. It all comes out taxed at your regular rate.
Roth accounts work the other way. You pay the tax up front, and as long as you follow the rules, the growth is never taxed.
A regular brokerage account doesn’t get any special treatment. You pay tax every year on interest and dividends, plus any capital gains your funds distribute, and you pay capital gains tax on your profit when you sell. The upside is that qualified dividends and long-term capital gains are taxed at 0%, 15%, or 20%, which for most people is lower than their income tax rate.
Because each account treats income differently, some investments are a better fit in one account than another.
What belongs in a taxable account
Broad stock index funds are a great fit for a taxable brokerage account. A total stock market fund or an S&P 500 fund doesn’t do much buying and selling, so it rarely hands you a capital gains distribution you didn’t ask for. Most of the dividends are qualified, so they get the lower rate. And since you decide when to sell, you decide when you pay tax on your gains.
International index funds also do well in a taxable brokerage account. Those funds pay taxes to foreign countries, and if you hold them in a brokerage account you can usually take the foreign tax credit on your return. In an IRA you lose that credit. It’s not a ton of money, but you wouldn’t want to turn it down.
Taxable brokerage accounts are also the only place you can do tax-loss harvesting when the market drops, or tax-gain harvesting if you’re in the 0% capital gains bracket. And if you hang on to investments in a taxable account until you die, your heirs generally get a step-up in basis, so nobody pays tax on all that growth. (I don’t recommend dying for the tax benefits, but it’s good to know.)
If you’re in a high tax bracket and you need to hold some bonds in taxable, municipal bond funds are worth a look, because their interest is generally free from federal income tax.
What belongs in a traditional (pretax) account
Bonds. Bond interest is taxed as ordinary income, so if you hold a bond fund in a brokerage account, you’re paying your full tax rate on that interest every year. Put the same fund in your 401(k) and that yearly tax bill goes away. You’ll still pay ordinary income tax when you withdraw the money, but you were going to pay ordinary income tax on that interest anyway. This way you pay it decades from now instead of every April.
REITs fit here for the same reason, since most of their dividends don’t qualify for the lower rate. So do high-yield bond funds, TIPS, and any actively managed fund that trades a lot and throws off short-term gains.
There’s another benefit people don’t always think about. Bonds tend to grow more slowly than stocks, so a 401(k) full of bonds grows more slowly too. That keeps your required minimum distributions smaller later on, and a lot of FI people are already worried about how big those are going to be.
What belongs in a Roth
Your Roth is the best account you have, because the growth is never taxed. So you want it holding whatever you expect to grow the most. For most people that means stocks, and if you own anything with higher expected returns, like small-cap value or emerging markets, the Roth is a good home for it.
You can hold bonds in a Roth. Nothing bad happens. But you’re using tax-free space on the slowest-growing thing you own, which is kind of a waste.
An example
Pat and Sam each have $1 million. Each has $400,000 in a traditional 401(k), $300,000 in a Roth IRA, and $300,000 in a taxable brokerage account. They both want 60% stocks and 40% bonds, so $600,000 in stocks and $400,000 in bonds.
Pat holds a 60/40 mix in every account. That means $120,000 of bonds in the taxable account and another $120,000 of bonds in the Roth.
Sam puts all $400,000 of bonds in the 401(k) and fills the Roth and the taxable account with stock index funds.
They own exactly the same thing overall. The difference is taxes. If Pat’s bonds pay 4.5%, that’s $5,400 a year in interest. In the 22% bracket, that’s about $1,188 in federal tax, plus whatever the state wants. Add the tax on dividends from Pat’s $180,000 of taxable stock funds, and Pat owes around $1,600 a year on the taxable account. Sam’s taxable account is all stock funds paying about 1.5% in mostly qualified dividends, so Sam’s bill is closer to $675.
That’s about $900 difference a year. Doing some rough math, if Sam invested that $900 every year and earned 7%, it would be worth about $87,000 after 30 years. And that doesn’t count the bigger difference, which is that Sam’s whole Roth is in stocks and growing tax free, while $120,000 of Pat’s Roth is sitting in bonds.
How much is it really worth?
Vanguard has estimated that good asset location adds somewhere between 0% and 0.75% a year to after-tax returns. Where you fall in that range depends on your tax bracket, how much you have in each type of account, and what you own.
On a $1 million portfolio, 0.75% is $7,500 a year. That adds up quickly.
You’ll get the most out of asset location if you have a big taxable account, a high tax bracket, and a decent amount in bonds. If you’re 100% stocks, there isn’t as much to gain, because your investments are already pretty tax efficient no matter where they sit.
The catches
Your 401(k) might not have good options. If the only bond fund in your plan charges 0.9%, the fees can wipe out the tax savings. In that case it can make more sense to hold the plan’s cheap S&P 500 fund in your 401(k) and keep your bonds somewhere else.
Rebalancing takes more thought. When the market drops, your Roth and taxable accounts take the hit while your bond-heavy traditional account barely moves. You have to look at all your accounts together to know where you stand. When you do rebalance, try to make the trades inside your traditional retirement accounts so you don’t owe capital gains tax.
Your accounts will look lopsided. After a good run in the stock market, your Roth will be way up and your 401(k) will look like it’s asleep. That’s expected. Look at the total of your investments, not each account on its own.
Not every dollar is worth the same. $100,000 in a traditional account isn’t really $100,000, because you still owe tax on it. $100,000 in a Roth is all yours. Some people adjust their allocation for that. Most people don’t need to, but it’s good to keep in mind.
Early retirees should think about their spending plan. If you’re leaving work before 59½ and living off your brokerage account for a while, you may want some bonds or cash in that account to cover the first few years. You don’t want to be stuck selling stocks in a down market to pay your bills.
Things change. Tax rates change, laws change, and you might move to a state with no income tax. Check your setup every so often, especially around big life changes.
Getting there without making it worse
If you already have bond funds in your taxable account, don’t sell them all at once just to get organized. You could owe capital gains tax that wipes out what you’d save. Instead, send new money in your brokerage account to stock index funds, and do your rebalancing inside your pretax accounts, where trades don’t create a tax bill. Over time you’ll get where you want to be.
Also, don’t let asset location talk you into a worse allocation. If you want 30% bonds but only have room for 10% in your 401(k), you still need 30% bonds. Hold the rest in your Roth or taxable account. The allocation always comes first.
The bottom line
Asset allocation is about how much risk you take. Asset location is about how much of your return you get to keep after taxes. The basic approach is stock index funds in taxable, bonds and other tax-heavy investments in your traditional pretax accounts, and your highest-growth investments in your Roth. From there, adjust for your 401(k)’s fund menu, your tax bracket, and when you plan to start withdrawing.
It’s not exciting, and it won’t double your money. But it’s one of the few changes you can make that improves your returns without adding any risk, and that’s worth an afternoon with a spreadsheet.
Leave a Reply