The first decision you make with respect to your portfolio is its asset allocation, or the mix of stocks and bonds. This initial step is based on your tolerance for risk and the amount of risk you need to take to achieve your life and financial goals.
Once you’ve selected the appropriate asset allocation for you, the second decision you’ll need to make is one about asset location. Asset location refers to where you will hold various types of assets across your taxable, tax-deferred and Roth accounts.
Asset location is an often-overlooked part of the process, and while it may not be as important as getting your asset allocation correct, it can make a meaningful difference in your after-tax returns. Maximizing your after-tax return for a given asset allocation will increase the odds of achieving your goals.
Asset location matters because different types of investments are taxed at different rates and at different times. For example, interest on bonds is taxed as ordinary income whenever an interest payment is made (typically twice per year). Stocks have two components to their return: dividends and capital gains. Dividends (if they are qualified) are taxed at favorable rates when they are paid. The capital gains tax rate is lower than the tax rate on ordinary income, and taxes on capital gains aren’t paid until the asset is sold.
In general, it makes sense to hold stocks in taxable accounts and bonds in tax-advantaged accounts. The rationale for this is twofold. First, bonds are taxed at higher rates than stocks, so sheltering the assets taxed at the higher rate is advantageous. Second, a significant portion of the return on equities comes in the form of capital gains. It already is tax-deferred, even when stocks are held in a taxable account, because you don’t pay the tax until you sell the asset.
There are other benefits to holding stocks in a taxable account, including:
- If you hold the stocks in your taxable account until death, you get a step-up in cost basis, eliminating capital gain taxes for you and your heirs. This effectively makes the capital gains portion of the return tax-free if you hold the stocks for a very long time.
- If you are charitably inclined, you can donate appreciated shares instead of cash. When you donate appreciated shares, you do not owe the tax on the capital gains.
- Holding stocks in a taxable account also gives you the option to harvest losses. Tax-loss harvesting allows you to use losses to offset current or future capital gains, or potentially to offset $3,000 of ordinary income on annual basis.
While the theory says you should locate your bonds in your tax-advantaged accounts and your stocks in your taxable accounts, real life almost never works out that cleanly. The primary culprit is that it’s unlikely your mix of taxable and tax-advantaged accounts will exactly match your mix of stocks and bonds.
However, we would not recommend altering your optimal asset allocation to fit the optimal asset location. In other words, it is far better to live with sub-optimal asset location for the sake of an optimal asset allocation than vice-versa.
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