You’ve probably heard plenty about what to invest in: stocks, bonds, index funds, and so on. However, there is another question that doesn’t get nearly the same attention: Where should those investments be placed? The strategy that addresses this question is called asset location. Asset location could quietly save you thousands of dollars over the course of your life by improving the tax efficiency of your investments.

What Is Asset Location, and Why Does It Matter?

Asset location is a tax-planning strategy that matches assets and investments to their most tax-efficient accounts. The goal is simple: Match tax-inefficient assets with tax-efficient accounts and keep tax-efficient assets where the tax laws already work in your favor. This strategy will look different for everyone depending on the assets held, the different account types available, the amount of money in each account, and the individual’s investment goals.

When investments are in the “wrong” accounts, you end up paying more in taxes than necessary over the course of many years. This is referred to as tax drag. Tax drag is the reduction in returns caused by taxes on dividends, interest, and realized capital gains. It is a slow leak on your wealth and can cost you thousands of dollars over the course of your investment time frame. Asset location helps seal this leak and protect your returns.

This strategy is particularly helpful if you:

• Are currently in a high marginal tax bracket

• Expect to be in a different tax bracket in retirement

• Have significant assets in accounts that are taxed annually

• Hold high balances in pre-tax accounts and are at risk for “tax bombs” during retirement

• Are investing for the long term (10+ years)

Understanding the Three Tax Buckets

Think of your investment and retirement accounts as buckets. Each of the buckets has its own rules about what can be held in it and how it will be taxed. There are three buckets you can place your assets in: taxable, tax-deferred, and tax-free.

Bucket 1: Taxable Accounts

Taxable accounts (e.g., brokerage and savings accounts) will be taxed on any gains, interest, or dividends annually. There isn’t any tax deferral on realized income throughout the year. The money you invest is already taxed, and then subsequent dividends, interest, and capital gains are all taxed again when you sell the assets. However, investments held for longer than a year receive preferential tax rates; something to keep in mind for these accounts, as it’s their only “special” tax treatment.

These accounts should house your most tax-efficient assets, such as:

• Growth index funds and ETFs (low turnover with mostly long-term gains)

• Municipal bonds, especially if you are in a high tax bracket (federally tax-free and sometimes tax-free at the state level)

• International equities (due to the Foreign Tax Credit)

• Emergency funds (not tax-efficient but the money needs to be easily accessible)

Bucket 2: Tax-Deferred Accounts

In tax-deferred accounts, which are your traditional IRAs and 401(k)s, you contribute pre-tax dollars and the investment grows without being taxed annually. Pre-tax dollars refer to contributions to these accounts that give you a tax deduction today but are taxed when you withdraw the money later. When the money is withdrawn, it will be taxed at ordinary income tax rates. So, assets can essentially grow tax-deferred until you want to withdraw them, usually in retirement and at a lower tax rate. You must start taking required minimum distributions (RMDs) from these accounts in your later years.

The main thing to remember is that you will likely want to keep lower-return, tax-inefficient assets in your tax-deferred accounts. These assets, when placed in tax-deferred accounts, help shelter your investment income from taxation while mitigating your future RMDs. This allows faster-growing investments to be located in a better-suited account, like your brokerage account or Roth IRA, to avoid ordinary income taxes as much as possible.

Tax-deferred accounts are great buckets for slower-growing investments that have less risk. I’m sure you’re asking yourself, why would I want to have slower-growth or lower-return assets in the first place? Well, having a mix of riskier higher-return and safer lower-return assets helps mitigate risk in your portfolio. These slower-growth assets, such as bonds, are necessary for a good asset allocation strategy. The reason they are so beneficial in tax-deferred accounts is that they keep your balance growing and your overall allocation aligned with your long-term goals, but letting a tax-deferred account be the slower-growing account helps reduce your RMDs and, in turn, your lifetime tax burden.

Assets that best suit this bucket are:

• Taxable bonds and core bonds

• High-yield bonds and emerging market bond funds

• REITs (many distributions are taxed as ordinary income)

• Assets you want in a tax-protected account that may not be suited for a Roth IRA

Bucket 3: Tax-Free Accounts

Tax-free accounts are your Roth IRAs and Roth 401(k)s. These accounts are funded with after-tax dollars but qualified withdrawals are tax-free. The growth and earnings (i.e., dividends, capital gains, and interest) of these assets are similarly tax-free. This is the best place to keep your long-term, high-growth, tax-inefficient assets, as tax-free compounding is most valuable for your fastest-growing assets over the long term.

Good examples of high-growth, tax-inefficient assets are:

• High-growth equities

• Small-cap funds

• Value-oriented equities with both growth potential and steady dividend yields

• Emerging market funds

• REITs

Building Your Asset Location Strategy

If you are just starting to develop your portfolio, this is a great strategy to implement right away. If you already have investments and accounts in place, course correction is very possible but should be done cautiously if there are tax consequences involved with the trades being placed. There are a few steps you can take with your financial advisor to set up this strategy.

Step 1: Prepare

Step 1 is all about getting set up and oriented. Look at how much you have in your taxable, tax-deferred, and tax-free accounts. If you only have one of these accounts, it might be time to consider opening more if you want to implement an asset location strategy. Having more than one account is beneficial because it allows you to diversify the tax impact across accounts and increases the effectiveness of this approach. This would also be the time to see if your tax-advantaged accounts (401(k), IRA, Roth) are maxed out, since you will need space in those accounts for this to work. Be mindful of the income limitations for investing in specific accounts (e.g., traditional IRAs and Roth IRAs).

From there, make a list of all your assets. Ensure that you understand the different tax characteristics of each asset: interest, dividends, capital gains, trading frequency, turnover, embedded tax benefits or drag, return, etc., as you will need to be able to understand their tax efficiency on their own to see how they fit into the whole strategy. This list and your accounts are your home base for the next step.

Step 2: Rank

Once you have your list of assets and accounts, it’s time to rank your assets from most to least efficient. A good rule of thumb is to prioritize moving the most tax-inefficient assets first to minimize the most tax drag. One caveat is that you should also consider the potential effects of growth at this point. Certain assets may be better off in a deferred account vs. a tax-free one if they aren’t expected to grow significantly, as growth can create significant capital gains taxes. High-growth and value-oriented funds, emerging market funds, and small-cap funds should go to your Roth accounts first. Leave or locate growth index funds, municipal bonds, and international equities in taxable accounts, as they are typically the least problematic or get particular benefits from being there. Again, be mindful of any trades placed in your taxable accounts, as these will likely generate taxes from the capital gains. Finally, slower-growing and tax-inefficient assets can then be placed into your tax-deferred traditional IRAs or 401(k)s.

Step 3: Move

Within your tax-advantaged accounts, buckets 2 and 3, you can typically buy, sell, and move assets without triggering taxable events or incurring high costs. However, in a taxable account, selling an investment can create a capital gain, which is taxable. It’s best to move slowly, and sometimes this step can require multiple years and some cost. This step would be best to do with whomever you consult on financial matters, as it will be specific to your goals and circumstances. A couple of good approaches would be:

• Use new contributions to buy the correct assets in the correct accounts.

• Instead of automatically reinvesting dividends and interest, buy more efficient investments with that money.

• Look for opportunities to harvest tax losses to offset any gains you may get when you do sell.

Step 4: Review

Once you have a plan in place, review your strategy at least annually or after big life changes. Job switches, retirement, inheritance, or significant economic changes will all affect your strategy and goals. What was once optimal might change due to circumstances within and outside your control. Safeguard your plans by staying up to date with them.

Common Investment Mistakes

Failing to Manage Taxable Income

Something important to remember is that even if you are going to be in a lower tax bracket in retirement, keeping your taxable accounts tax-efficient is important. Some investors make the mistake of focusing heavily on their Roth accounts for the “tax-free” appeal and end up overlooking their taxable brokerage accounts. Having a lot of investment income in these accounts can impact many areas of your plan, so it’s important to keep that in mind when discussing implementation of an asset location strategy.

Areas of your financial plan that are at risk of being affected:

• Modified adjusted gross income (MAGI) thresholds: Investment income adds to your MAGI, which determines your eligibility for certain tax credits, deduction limits, and contribution limits.
• Net Investment Income Tax (NIIT): The NIIT is a 3.8% surtax that kicks in when your MAGI exceeds $200,000 (single) or $250,000 (married filing jointly (MFJ)).
• Roth conversions: Investments producing excessive ordinary income in these accounts can eat up space in the lower tax brackets that you could otherwise be using for conversions.
• Zero percent capital gains harvesting: If your income is low enough, you may be in the 0% capital gains bracket (up to a taxable income of $49,450 single, $98,900 MFJ), which allows you to realize capital gains from stock sales without having to pay federal taxes. Qualified dividends flow into this bucket as well. Having a taxable account producing too many dividends may impact your ability to harvest capital gains at low to no tax cost.

Treating Your Strategy as a One-Time Fix

The circumstances of your financial and personal life will likely change over time. Don’t be afraid to shift strategies that aren’t working anymore. This isn’t something you can “set and forget”; it will require periodic reviews as your assets grow and your life changes. Annually reviewing your portfolio and strategy with your financial advisor is a good idea to start.

Creating Unnecessary Tax Events While Rebalancing

During relocation and rebalancing, be careful not to trigger capital gains by unnecessarily selling assets in taxable accounts. Work within tax-advantaged accounts first and then use new contributions and cash flows to slowly shift your taxable accounts. Do your due diligence during this process to not get hit by taxable events or surprise costs.

Not Paying Attention to Employer Plan Limitations

Pay attention to your retirement accounts if they are employer-sponsored. Many 401(k) plans offer a limited number of investment opportunities, so you may not always be able to put the right asset in the right account. Be aware of these limitations and do your best with what you have available.

Important Exceptions and Planning Opportunities

Due to the nature of asset location not being a “one size fits all” approach, there are a few situations that could significantly change how you undertake this strategy. If any of these apply to you, it’s worth discussing with your financial advisor how they affect your plan.

Effects on RMDs

When you reach a certain age, the IRS requires you to withdraw a minimum amount from your pre-tax retirement accounts (IRA, 401(k), 403(b), 457(b), TSP, etc.) These amounts are called RMDs. They are taxed as ordinary income using your tax bracket at the time of withdrawal.

RMDs can become problematic for tax planning if your traditional IRA has experienced substantial growth or houses significant assets. You may be forced to withdraw more money than you actually need from these accounts. This can create a few issues, such as:

• Pushing you into a higher income tax bracket than you expected
• Increasing the taxes on your Social Security benefits
• Triggering IRMAA surcharges (described below) on your Medicare premiums
• Generating more tax drag as money gets withdrawn and then reinvested into taxable accounts

Implementing an asset location strategy is pivotal for managing this risk. Holding your highest-growth investments in Roth IRAs instead of traditional IRAs keeps your traditional IRA balance lower. Keeping the traditional IRA balance lower can create smaller, more controllable RMDs for retirement, as mentioned earlier. There are a few strategies to keep in mind for reducing potential RMD burden:

• Consider Roth conversions during lower income years to chip away at the future RMD balances and lock in a lower tax rate on that money while letting the Roth assets grow tax-free. Think about doing this during early retirement, before you begin collecting Social Security benefits.
• Qualified charitable distributions are another great way to reduce your RMD tax burden. After the age of 70½, individuals can directly donate money from their IRAs to a qualified charity. This donation counts toward your RMD for the year without triggering a taxable event.
• Taking money from your traditional IRA before RMDs begin can help reduce the account size and future forced withdrawals. You want to ensure that you are still staying within a comfortable tax bracket and that these withdrawals are strategic.

IRMAA Surcharges

IRMAA stands for income-related monthly adjustment amount. It is an additional tax related to Medicare Part B and Part D premiums for individuals whose income exceeds certain thresholds (these thresholds change with the tax code every year). The amount judged against the threshold is your MAGI from two years prior. So what you are earning today helps determine what you pay for Medicare later on.

Large RMDs are one of the most common ways that IRMAA charges are triggered, as RMDs are taxed as ordinary income and increase your MAGI. IRMAA thresholds are like cliffs, even one dollar over the edge can add hundreds of dollars per month to your Medicare costs. There are a few asset location–related methods for avoiding or minimizing these charges:

• Keeping your high-growth assets in a Roth IRA instead of a traditional IRA, which reduces future RMDs and therefore lowers your MAGI during retirement
• Pulling from a Roth IRA or cash savings instead of a traditional IRA when you need cash beyond your RMDs (does not increase your MAGI)
• Strategically managing withdrawals during early retirement (before Social Security benefits begin) to help smooth out income and stay below IRMAA thresholds

Estate Planning: Step-Up Basis

An important fact about passing assets in taxable accounts: When your heirs inherit these accounts, they receive the assets with a “stepped up” cost basis. This means that heirs don’t owe taxes on gains or growth that occurred within your lifetime.

This can significantly change your asset location decisions. For example, if you have highly appreciated investments that you don’t plan to sell in your lifetime, it might make more sense to keep them in a taxable account rather than selling and relocating them. The potential annual savings to you might not outweigh the benefit your heirs could receive.

International Investments and Foreign Tax Credits

If your portfolio includes international funds or ETFs, there is an additional consideration to keep in mind. Foreign governments often withhold a tax on dividends paid to U.S. investors, which can be anywhere from 0%-30% depending on the country. This happens before the dividends or interest payments reach your account.

This is important because in a taxable account you can usually claim a Foreign Tax Credit on your U.S. return to offset the foreign taxes. This basically recovers most of what was withheld. However, within a traditional or Roth IRA, the Foreign Tax Credit is unavailable. This means that there is no recovery of the withheld taxes and they are lost to you. This distinction matters, as international funds tend to have higher dividend yields than U.S. funds, which increases the tax drag on these investments when they are placed in incompatible accounts.

What does this mean in relation to your asset location strategy? International stock funds with meaningful dividends are often better placed in a taxable account, even though it feels counterintuitive. In this case, your ability to claim the Foreign Tax Credit in a taxable account makes it the more efficient choice for investments that have international income.

This is a complex topic, so there are a few nuances to keep in mind:

• Not all international dividends are considered “qualified.” The rate at which international dividends are taxed depends on whether or not the country is part of the U.S. Tax Treaty and on the corporate structure of the company you are invested in.
• International funds that don’t generate a lot of dividends might be okay to stay in a tax-advantaged account. This is one of those topics to discuss with your financial advisor to see what the best choice is for you.
• It is important to review the fund’s dividend history and qualified dividend percentage to make the best choices for your portfolio.

What to Remember About Asset Location

Here are some key takeaways from this guide:

• Asset location is about where your investments live, not what you invest in. A portfolio that is placed more thoughtfully can generate better after-tax returns.
• Match tax-inefficient assets to tax-advantaged accounts. Keep tax-efficient assets in taxable accounts.
• Municipal bonds belong in taxable accounts, if used at all.
• Prioritize Roth accounts for your highest-growth assets. Tax-free compounding is most powerful when applied to the fastest-growing investments over the long term.
• Manage your traditional IRA balance through Roth conversions and strategic withdrawals to reduce future RMD obligations and the tax implications that ripple from them.
• Don’t rush the rebalancing process. Make slow adjustments in taxable accounts to avoid unnecessary capital gains or taxable events.
• Review your strategy at least annually and after any major life changes that could have a substantial financial impact.
• This strategy works best over the long term and in partnership with an advisor who understands you and your goals for your finances.

Building wealth is not only about earning strong returns but also about protecting as much of those returns as possible. Asset location is a strategy that can make a meaningful difference without requiring you to take on more risk or completely rebuild your portfolio. A few smart adjustments today can reduce tax drag, improve compounding, and create more flexibility later in life.

Asset location is complex but exactly the kind of thing we would love to help you with. If you need assistance with asset location as part of your overall financial planning strategy, please reach out to our team!