Understanding the Importance of Asset LocationAsset location is a key and often overlooked aspect of smart investment planning and tax minimization strategies for high-net-worth investors. Many investors do not put much thought into which types of investing accounts they should use nor do they consider how to divide their assets among various account types, and that can be a costly mistake in the long run. This article will break down the basics of asset location, discuss why it matters, and explain how you can begin to make strategic asset location decisions to lower your tax burden and set yourself up for greater financial success.
What Is Asset Location?
“Asset location” refers to how a person’s investments are distributed across the various investing accounts available to them. The three main investment account categories are tax-deferred (traditional), tax-exempt (Roth), and taxable accounts. The breakdown of which accounts you use and in what amounts and how you divide specific types of investments among the accounts is your asset location. For example, an investor might invest 60 percent of their assets in a tax-deferred traditional 401(k), keep 20 percent in a tax-exempt Roth IRA, and keep 30 percent in a taxable brokerage account.
Some people may confuse the term “asset location” with the related concept of “asset allocation,” but the two are completely different portions of a multifaceted, overall investing strategy. Asset location deals with what kinds of investing accounts you use and how your investments are distributed within those accounts, whereas asset allocation refers to the types of investments you decide to purchase within those accounts and how much of each type of investment you purchase. As an example, whether you buy stocks or bonds and how much you buy of each are questions of asset allocation, but which account you use to make those investments is a question of asset location.
Why Does Asset Location Matter?
Each type of investing account has different rules, regulations, and tax implications. Money that goes toward taxes is money you cannot designate for another purpose, and where you choose to invest makes a difference in the returns you can expect to receive after all tax liabilities have been paid. Asset location is particularly relevant to high-net-worth investors because tax-advantaged and tax-free accounts have maximum yearly contribution limits restricting how much money can be put into each account. As of 2024, the maximum 401(k) employee yearly contribution limit for a person under 50 is $23,000, and the maximum yearly contribution limit for an IRA for a person under 50 years old is $7,000. (Individuals older than 50 have slightly higher contribution limits because of their proximity to retirement.) If you want to invest more than the limits for these accounts, you will have to make decisions about how many types of accounts you will use and which of your investments will go into which account.
Additionally, asset location is vital to consider when you plan to take money out of an account because the accounts can have restrictions and may be better suited for different uses. For example, a health savings account offers tremendous tax advantages, but it will not be the best account to draw from first if you are looking to fund an early retirement because of the penalties associated with withdrawing money for nonmedical expenses.
What Are Some Asset Location Best Practices?
A person’s ideal asset location strategy will be strongly influenced by the total amount they want to invest each year. For example, if you wanted to invest $5,000 for retirement in 2024, you could choose to use only one account, but if your goal were to invest $50,000, you would need to split that amount up between several accounts. Asset location strategies are also influenced by your current income tax rate, your expected future income tax rate, your intended uses for invested assets (e.g., are you saving for retirement or for another goal), and the types of investment products that make up your asset allocation (e.g., mutual funds, exchange-traded funds, stocks, bonds, or real estate investment trusts).
Generally, it is best to max out tax-exempt or tax-advantaged accounts before investing any surplus funds in a taxable account, especially when investing over the long term for retirement planning. If your asset allocation includes a mix of investment products, some of your investments will likely be more tax-efficient than others. When deciding which account should hold which investments, it is wise to place more tax-efficient investments (e.g., index funds, exchange-traded funds, or municipal bonds) in taxable accounts while reserving investments that are less tax-efficient (e.g., actively managed mutual funds or real estate investment trusts) in tax-advantaged or tax-exempt accounts to mitigate the tax implications associated with those types of investments.
Effective and tax-efficient long-term investing can be complex because it requires an in-depth understanding of both your current financial situation and your long-term financial goals so that you can identify and implement the most appropriate asset location strategy for your needs. Moreover, strategic investing requires knowledge of the various investing accounts and investment products available to you along with a multifaceted approach to crafting an investment portfolio that meets your needs and moves you closer to achieving your goals. That’s why it can be beneficial to work with an experienced and trusted financial advisor who specializes in working with high-net-worth and high-income individuals.