If you’ve ever worked with a financial advisor or tax professional, you’ve probably talked about asset allocation, the mix of stocks, bonds, and other assets in your portfolio. However, asset location is another concept that rarely gets the same spotlight and can significantly impact your after-tax returns.
Asset location is one of the few ways to improve net returns without increasing market risk. It doesn’t require market timing, stock picking, or a change to your overall allocation. It involves a simple shift in where you hold your investments across different accounts: taxable, tax-deferred, and tax-free.
It’s an elegant strategy that works quietly in the background to help you keep more of what you earn.
Understand the three account types
To understand how asset location works, it helps to first break down the three main account types from a tax perspective:
Taxable accounts: These include brokerage accounts not held in retirement plans. Interest, dividends, and realized capital gains are taxed in the year they’re received. Qualified dividends and long-term capital gains are taxed at lower rates, but interest income and short-term gains can be taxed as high as your ordinary income tax rate.
Tax-deferred accounts: Traditional IRAs, 401(k)s, and other retirement plans fall into this category. You defer taxes on contributions and investment growth until you withdraw funds. Distributions are taxed as ordinary income.
Tax-free accounts include Roth IRAs and Roth 401(k)s. Contributions are made with after-tax dollars, but qualified withdrawals are tax-free. This makes them highly valuable for investments with strong long-term growth potential.
Each account type carries its tax implications. That’s where asset location comes in.
The principle behind asset location
Asset location is about matching investment tax efficiency with account tax treatment. The goal is to place tax-inefficient assets in tax-advantaged accounts and tax-efficient holdings in taxable accounts. This alignment can reduce your tax bill and increase your portfolio’s after-tax value.
Here’s how the strategy typically breaks down:
Hold bonds and REITs in tax-deferred accounts (except municipal bonds, better suited for taxable accounts). These asset classes generate income that’s taxed at ordinary income rates. Housing them in a traditional IRA or 401(k) shields that income from immediate taxation.
Hold tax-efficient stocks, like broad index funds and ETFs, in taxable accounts. Stocks often generate qualified dividends and long-term capital gains, which receive favorable tax treatment. You can harvest losses to offset gains, a benefit unavailable in retirement accounts.
Consider placing high-growth stocks, like tech companies or innovative startups, in Roth accounts. Since Roth withdrawals are tax-free, any gains from these investments can grow without tax implications.
This framework is a good starting point for most investors.
The surprising tax impact of poor asset location
Here’s why asset location matters.
Suppose you have a $1 million portfolio split evenly between stocks and bonds. You also have three account types with $333,000 in each. One strategy would be to replicate the same 50/50 mix in each account. That feels balanced and easy to maintain.
But it could be costly.
Assume your stocks return 8% annually and your bonds return 4%. Stocks are more tax-efficient, while bonds generate ordinary income. If you keep bonds in the taxable account, you’ll pay higher taxes yearly than if you’d held them in a tax-deferred account. Meanwhile, if stocks grow in your Roth IRA, you’ll never pay taxes on those gains.
Charles Schwab found that following an asset location strategy can boost annual after-tax returns by 0.14 to 0.41 percentage points for conservative investors in the mid- to high-income tax brackets. Compounded over decades, those savings become meaningful.
Why your risk profile is unchanged
It’s easy to confuse asset location with asset allocation, but they are distinct strategies.
Asset allocation determines your risk and return profile. A 70/30 portfolio (70% stocks, 30% bonds) has a different risk level than a 40/60 mix. Asset location doesn’t alter your total stock-to-bond ratio. It simply changes where each component resides for tax purposes.
You’re still holding the same total amount of stocks and bonds. You’re just doing so more efficiently.
If your portfolio target is 60/40, that ratio stays intact. Whether those bonds are in your Roth, traditional IRA, or taxable account won’t change your risk profile, but it will impact your tax liability.
Factors that can influence your strategy
While the principles of asset location are straightforward, the implementation can be complex. Here are a few factors that might impact your approach:
Your time horizon: Consider prioritizing flexibility in your taxable account for near-term expenses or gifting strategies. Keeping more liquid, lower-volatility assets in taxable accounts may be appropriate.
Tax bracket differences now vs. in retirement: If you expect to be in a lower tax bracket later, you might prioritize tax deferral now. If Roth conversions make sense, you can maximize growth in your Roth account.
State income taxes: If you live in a high-tax state, you may benefit even more from placing taxable bonds and REITs in tax-deferred or Roth accounts.
Availability of asset types in certain accounts: Not all investments are suitable for all account types. Municipal bonds are tax-exempt and generally belong in taxable accounts, and certain private investments may not be allowed in IRAs.
Rebalancing and transaction costs: Over time, asset values drift. Rebalancing to your target allocation can trigger taxes in a brokerage account. Housing more volatile assets in IRAs can give you room to rebalance without tax consequences.
Common mistakes
Asset location is a powerful concept, but there are pitfalls.
Liquidity: Keeping too many volatile or illiquid assets in retirement accounts could leave you scrambling for cash in a downturn. Always consider your short and medium-term cash flow needs.
Treating asset location as static: Your ideal asset location strategy can change over time. Major life events, changes in tax law, and evolving retirement timelines can all prompt a reevaluation.
When to get help
Getting asset allocation right requires a deep understanding of tax treatment, portfolio construction, and future planning needs. You should consider working with a financial advisor to build and maintain an efficient structure.
The best advisors use specialized software to model asset location strategies across accounts, taking into account your tax rate, retirement date, and required minimum distributions. The goal is to capture every available tax advantage without compromising your investment goals.
Final thoughts
Most investors focus on returns and risk, but returns come before taxes. Asset location takes the same portfolio and helps you keep more of what you earn without changing your overall strategy or exposing you to more risk.
It’s not flashy. You won’t see the effects in a single month or quarter. Over time, smart asset location can make a meaningful difference in your financial outcome.
