Asset location can play a key role in tax-efficient investing

Most investors are familiar with the concept of asset allocation, the strategic mix of stocks, bonds, and other assets held in an investment portfolio based on time horizon, risk tolerance, and goals. It lays the foundation of a portfolio and is the principal driver of an investor’s risk and return outcomes.

Complementary to asset allocation is the related concept of asset location, which focuses on optimizing tax efficiency and enhancing after‑tax returns by strategically selecting the most suitable accounts for holding various investments. It involves the thoughtful placement of assets within taxable, tax‑deferred, and tax‑exempt accounts and creates greater flexibility, opportunities for tax efficiency, and more options for income sourcing during different lifestages and throughout retirement.

Understanding tax‑advantaged and taxable accounts

Asset location goes beyond deciding which investments to include in a portfolio. It involves carefully choosing the types of accounts in which these investments are held, based on the differing tax treatments of income generated by the assets. As a result, investors should understand the differences between account types and their interaction with various investment income.

• Tax‑advantaged accounts: Retirement accounts such as Traditional IRAs and 401(k)s allow for contributions with pretax dollars and defer taxes until withdrawal, which usually occurs in retirement. The tax‑deferred growth allows for compounding of investment returns over time without the immediate tax impact, benefiting a portfolio’s long‑term growth potential. Investors can also lower their current taxable income, which might reduce the amount taxed in a relatively high bracket. This can be especially beneficial if the investor expects to be in a lower tax bracket in the future when the taxes are eventually paid.
  
  Tax‑exempt accounts include Roth IRAs and Roth 401(k)s, where contributions are made with after‑tax dollars. Withdrawals from these accounts, including growth and earnings accumulated over time, are generally tax‑free in retirement, provided certain conditions are met.¹ These accounts can be particularly advantageous for investments expected to appreciate significantly, as the tax‑free withdrawal feature allows investors to benefit from full growth potential without tax reductions.
  
  For many investors, contributing to tax-advantaged accounts is one of the simplest and most accessible options in pursuit of a more tax‑savvy investment approach. Retirement savings accounts provide tax advantages that offer growth potential without the annual drag of taxes on interest, dividends, or realized capital gains.
• Taxable accounts: In taxable accounts, including nonretirement‑related brokerage accounts, realized capital gains (both long and short term), dividends, and ordinary interest income, are all subject to annual taxation, which can impact investment returns, especially for those in higher tax brackets.
  
  There are good reasons to invest in a taxable account, including the flexibility of penalty‑free withdrawals before reaching retirement age and the ability to save beyond the statutory limits of tax‑advantaged accounts. Since tax rates on both ordinary income and long-term capital gains have decreased in recent years, some investors might wonder if a taxable account would be preferable to a tax-advantaged account for long-term goals such as retirement. A Roth account is almost always preferable to a taxable account, given the former’s qualified tax-free withdrawals. A Roth account is also generally preferable to a tax-deferred account if a investor expects his or her tax rate will be higher in retirement. If the tax rate is expected to stay the same or decrease in retirement, a tax-deferred account typically is more appropriate than a taxable account for most investors.

Implementing an asset location strategy

When considering an asset location strategy, a first step includes conducting a detailed analysis of household assets, understanding their income characteristics and whether they generate interest, dividends, or capital gains, and how these assets are taxed.

For example, tax‑efficient assets, such as stocks expected to appreciate, could be placed in taxable accounts where favorable long‑term capital gains tax rates may be leveraged. Municipal bonds and funds offer potential diversification benefits and generate interest income that is exempt from federal taxes and, in some cases, state and local taxes. As a result, they can make more sense in taxable accounts. A taxable account is also a good place for investment strategies in which a professional portfolio manager employs specific strategies to minimize tax liabilities, such as tax loss harvesting and limiting portfolio turnover.

Allocate tax‑inefficient assets, such as taxable bonds and real estate investment trusts (REITs) that generate substantial interest and dividends, into tax‑deferred accounts to defer ordinary income taxes and benefit from compounding. Tax‑exempt accounts could be used for assets such as high‑turnover mutual funds that pursue growth aggressively but may also incur tax‑inefficient short‑term gains.

“In general, mutual funds are often more appropriate in tax‑advantaged accounts, whereas ETFs and SMAs can make sense across account types.”

Considering investment vehicles

This analysis not only involves identifying the types of assets held in a portfolio, but also the different investment vehicles, which can include mutual funds, exchange‑traded funds (ETFs), and separately managed accounts (SMAs). In general, mutual funds are often more appropriate in tax‑advantaged accounts, whereas ETFs and SMAs can make sense across account types.

• Mutual funds: These are professionally managed baskets of individual securities, such as stocks or bonds. The common benefits of mutual funds include the potential for built‑in diversification, allowing investors access to a diversified portfolio of securities rather than a single stock or bond. Passively managed mutual funds—index funds, for example—generally seek to replicate a specific market index by holding the same or similar securities in similar proportions to the index. In contrast, an actively managed mutual fund employs professional fund managers who actively choose and trade securities with the goal of outperforming a specific market index through research, analysis, and judgment. Mutual fund orders are executed at the end of the day, and all investors in the fund receive the same price at the market’s close.
  
  Unless they have tax efficiency as a specific objective, mutual funds are often not particularly tax‑efficient. For example, portfolio managers in actively managed mutual funds typically buy and sell securities in pursuit of maximizing investment returns and generally don’t consider potential tax ramifications. However, buying and selling securities in a mutual fund create taxable events, and investors in the fund are responsible for paying taxes on the resulting capital gains. Additionally, mutual fund managers must sell underlying securities to cover the redemptions when investors sell shares, creating more capital gains that are then distributed to all shareholders.
• Exchange‑traded funds: Like mutual funds, ETFs offer a share of pooled securities, and they can be passively or actively managed. Unlike mutual funds, however, ETF shares trade like stocks on an exchange, and they can be bought and sold throughout a trading day.
  
  Instead of directly dealing with individual investors, ETFs interact with large institutional investors known as Authorized Participants (APs). When an investor purchases an ETF share, an AP can create that share by exchanging a basket of the ETF’s underlying securities with the fund. When an investor sells an ETF share, the AP redeems it by receiving that same basket of securities instead of cash. In these in‑kind transactions, the ETF does not actually have to sell its holdings. Therefore, they are not considered taxable events for the fund itself.
  
  Ultimately, ETFs can be created or redeemed without the portfolio manager selling securities, thereby reducing the distributed gains to ETF owners, which could make them attractive to investors who seek growth and greater control of their taxes.
• Separately managed accounts: SMAs are portfolios of individual stocks or bonds, professionally managed based on the investor’s personal financial goals, risk tolerance, and tax preferences. Instead of holding a slice of a group of securities, like in a mutual fund or an ETF, the investor directly owns the professionally managed portfolio of securities.
  
  The investor can instruct the manager to sell specified portfolio holdings to meet various goals, such as tax management or investment growth. SMAs do not have embedded capital gains. In a mutual fund, there can be a taxable event when the fund manager sells securities to meet liquidity needs. In that scenario, any capital gains are distributed to all shareholders. In an SMA, the investor purchases underlying securities directly. Therefore, an investor is only taxed on gains related to their actions.

The Advantages of Active ETFs

The potential to outperform benchmarks.
Actively managed investment strategies feature professional portfolio management that can adapt to changing market conditions in pursuit of more attractive risk-adjusted returns.

Careful security selection can offer both liquidity and convenience.
Rather than owning thousands of securities to replicate the holdings of a benchmark, professional managers can be more discerning when it comes to security selection.

ETFs offer the potential for greater tax efficiency.
The ETF structure inherently has the potential to reduce capital gain distributions by minimizing the impact of shareholder purchase and redemption activity.

The role of expert advice

Since no two individuals are the same, no single investment approach will work for everyone. Due to the potential for complexity, we recommend investors consult with qualified financial and tax professionals. These experts can provide tailored advice to make sure an asset location strategy is aligned with the investor’s personal financial goals. They can also factor in changing tax situations over time due to life events, such as retirement or income fluctuations over the course of a career.

Asset location can play a key role as part of a comprehensive financial plan, significantly influencing tax efficiency and long‑term after‑tax portfolio performance. By strategically placing assets in the right accounts based on tax treatments, investors can potentially enhance after‑tax returns and achieve financial goals more effectively.