Implementing an asset location strategy can help lower your tax burden.
Different types of assets and investment accounts are taxed differently.
Asset location can be an important step in maximizing long-term gains.
If your investment portfolio includes a variety of assets in different accounts, including traditional brokerage, IRAs or 401(k) accounts, asset location optimization may be an investment strategy worth learning more about.
Most of us know that with real estate, it’s all about location. Similarly for investments, asset location determines how investments are taxed, and can have a significant effect on the long-term growth. Leveraging the location of your investments is called asset location strategy. This advanced investment practice is a tax-minimization strategy that takes advantage of the different tax treatments applied to different asset and accounts.1
If your investment portfolio includes fixed-income assets and equities, you may benefit from understanding more about asset location. Keep in mind this strategy is not the same as asset allocation, which is the process of deciding where to put money in the market. Let’s take a deeper look at what asset location is, and how it can be applied.
What is asset location optimization?
Asset location optimization is a strategy that allows investors to minimize their tax burden by taking advantage of how different types of investments are taxed. As a result, investors can choose the asset location that aligns with their goals and circumstances. The three primary types of accounts for investments are taxable, tax-deferred, and tax-exempt accounts.
Understanding taxable and tax-advantaged accounts
When it comes to investments, there’s no shortage of options to choose from. With so many choices, it’s important to understand the tax implications of the investments in your portfolio. While paying taxes on your investments may be unavoidable, you do have some control over when you pay taxes.
Here’s a more in-depth overview of the three main investment account types and what makes each one unique.
Taxable accounts – Traditional brokerage accounts allow investors to buy and sell a variety of securities including stocks, bonds, and ETFs. Dividends, interest, or short-term gains from investments held in taxable accounts are then taxed annually according to your ordinary income tax rates.2 It's important to understand the difference in how short-term capital gains are taxed so you choose the option that is best for you.
Tax-deferred accounts – Traditional 401(k), 403(b), nonqualified annuities, and traditional IRAs are all considered tax-deferred because they allow for delayed taxation. That means taxes aren’t paid until withdrawals are made, which often occurs once an investor reaches retirement and may be in a lower tax bracket. However, any withdrawal of taxable amounts made before age 59½ would be subject to ordinary income tax and might incur an additional 10% federal tax. It's also important to note that these retirement accounts have contribution limits. Once limits on tax-deferred retirement accounts are met, annuities may be another option for tax-deferred growth.3
Tax-exempt accounts – This category includes Roth IRA, Roth 401(k), and Roth 403(b) accounts. With these accounts, contributions are made with after-tax income. Investment growth isn’t taxed, and neither are withdrawals made after age 59½.3
Many investors have an assortment of asset classes in their investment portfolio. It’s important to note that investments have different purposes and can help achieve different goals. Tax-advantaged accounts can be a great tool to work toward achieving long-term goals and growth.4
Putting asset location strategy to work
Let’s look at how asset location might be put into action for an investor with a balanced portfolio focused on long-term capital gains looking to diversify their investments.
Let’s say Susan, age 45, has a portfolio that includes assets in a traditional brokerage account, as well as in her tax-deferred traditional 401(k) account through her employer. Susan always contributes to her 401(k) at least up to her company match, and has some uninvested funds in the account. She wants to diversify her portfolio by investing in a taxable mutual fund. If she plans not to touch the fund until retirement, which account should she choose for this fund?
Susan chooses to invest in the fund through her 401(k), because she will avoid annual taxes for the fund, and so her money can be invested pre-tax and grow tax-free until she elects to start making withdrawals in retirement (age 59½). Plus, if she waits until retirement, she’ll pay fewer taxes on the money she does take out because she’ll be in a lower tax bracket.
On the other hand, if Susan were to invest in the fund within her taxable brokerage account, she would pay annual taxes on the amount invested based on her current tax rate, which is likely to be higher than it will be once she’s retired. This means she would pay taxes annually, and the long-term growth of her investment would be stunted.
Who benefits from asset location strategy?
Asset location strategy can be a powerful tool for any investor with taxable and tax-advantaged accounts. Those with a mix of equities and fixed income investments, however, stand to gain the greatest tax advantages.4
If asset location optimization seems right for you, speak with your financial professional. The benefits can be substantial depending on your short- and long-term goals, but it’s best to let a professional help you execute this strategy correctly.
*Securities include investment risks, which includes possible loss of principal.
Things to consider
Understand the right mix of investments for your short- and long-term goals.
Optimize your long-term gains by leveraging asset location strategy.
Asset location is an advanced strategy, so speak with your financial professional to find out if it’s right for you.
Transamerica Resources, Inc. is an Aegon company and is affiliated with various companies which include, but are not limited to, insurance companies and broker dealers. Transamerica Resources, Inc. does not offer insurance products or securities. The information provided is for educational purposes only and should not be construed as insurance, securities, ERISA, tax, investment, legal, medical or financial advice or guidance. Please consult your personal independent professionals for answers to your specific questions.
