You've heard of asset allocation, deciding what percentage of your portfolio goes to stocks, bonds, and other assets. But have you considered asset location? It's the question of where each investment should live: in your taxable brokerage account, your traditional 401(k), or your Roth IRA. Get it right, and you could add years to your retirement.
The Core Principle
Different investments generate different types of returns, and different accounts have different tax treatments. The goal of asset location is to match investments to accounts in the most tax-efficient way.
The basic framework:
• Tax-inefficient investments → Tax-advantaged accounts (401(k), IRA, Roth)
• Tax-efficient investments → Taxable brokerage accounts
This isn't about which investments to own. That's asset allocation. It's about which accounts to hold them in.
What Makes an Investment Tax-Inefficient?
High income generation: Bonds pay interest, which is taxed at your ordinary income rate (up to 37%). Holding bonds in a 401(k) shelters that income.
High turnover: Actively managed funds buy and sell frequently, generating short-term capital gains taxed at ordinary income rates. Index funds are more tax-efficient.
Non-qualified dividends: REITs and some international funds pay dividends taxed at ordinary income rates rather than the lower qualified dividend rate.
🛠️ Recommended Tool
Morningstar provides "Tax Cost Ratio" data for mutual funds and ETFs, showing how much of a fund's returns are lost to taxes annually. Use this to identify tax-inefficient holdings.
What Makes an Investment Tax-Efficient?
Low turnover: Total market index funds rarely sell holdings, minimizing capital gains distributions.
Qualified dividends: U.S. stock dividends are typically taxed at the lower qualified dividend rate (0%, 15%, or 20%).
Growth orientation: Growth stocks that don't pay dividends generate no annual tax. You're only taxed when you sell.
Tax-loss harvesting opportunities: Individual stocks and some ETFs allow you to sell losers for tax benefits.
The Asset Location Framework
Tax-Deferred Accounts (Traditional 401(k), Traditional IRA)
Best for:
- Bonds and bond funds
- REITs (Real Estate Investment Trusts)
- Actively managed funds
- High-dividend stocks/funds
All withdrawals are taxed as ordinary income anyway, so you're not wasting any tax advantage on assets that would be tax-inefficient elsewhere.
Tax-Free Accounts (Roth 401(k), Roth IRA)
Best for:
- Highest expected growth investments
- Assets you'll hold longest
- Investments with high expected returns
Roth accounts are precious. Every dollar of growth is tax-free. Put your highest-growth investments here to maximize the tax-free benefit.
Taxable Brokerage Accounts
Best for:
- Tax-efficient index funds (total market, S&P 500)
- Tax-managed funds
- Municipal bonds (if in high tax bracket)
- Individual stocks (for tax-loss harvesting)
You'll pay some taxes, but qualified dividends and long-term capital gains get preferential rates.
A Practical Example
Let's say you have a $500,000 portfolio split across:
- $200,000 in 401(k)
- $100,000 in Roth IRA
- $200,000 in taxable brokerage
Your target allocation is 70% stocks / 30% bonds. Here's how asset location might work:
401(k) ($200,000): All bonds ($150,000) + some REIT ($50,000)
Roth IRA ($100,000): Small-cap growth stocks or highest-growth equity fund
Taxable ($200,000): Total stock market index fund
Your overall allocation is still 70/30, but the bonds are sheltered from taxes, the highest-growth investments are in the tax-free Roth, and the taxable account holds tax-efficient index funds.
📚 Further Reading
The Bogleheads' Guide to Investing has an excellent chapter on tax-efficient fund placement, with specific recommendations for different account types and portfolio sizes.
When Asset Location Matters Most
Large portfolios: The bigger your portfolio, the more absolute dollars saved through tax efficiency.
High tax brackets: If you're in the 32%+ brackets, the difference between ordinary income and capital gains rates is substantial.
Long time horizons: Tax drag compounds over time. A 0.5% annual tax drag over 30 years is significant.
Substantial taxable accounts: If most of your money is in tax-advantaged accounts, you have less flexibility for location optimization.
When It Matters Less
Small portfolios: The absolute dollar savings may not justify the complexity.
Low tax brackets: If you're in the 10-12% brackets, ordinary income and capital gains rates are similar.
All money in one account type: No location decisions to make if you only have a 401(k).
Complications and Trade-offs
Rebalancing challenges: If your stocks are in taxable and bonds are in tax-deferred, rebalancing requires moving between accounts or accepting allocation drift.
Bonds in Roth debate: Some argue high-growth assets should go in Roth (maximize tax-free growth), others argue bonds should (because you're converting ordinary income to tax-free). Both have merit depending on assumptions.
International stocks: Foreign tax credits only work in taxable accounts. If you hold international funds in your 401(k), you lose the credit.
The Zen Take
Asset location is real optimization, but don't let it paralyze you. The research suggests it can add 0.2% to 0.5% annually to your after-tax returns, meaningful over decades, but not transformative.
The fundamentals matter more: save enough, keep costs low, stay diversified, stay invested. Asset location is the polish, not the foundation.
If you have significant assets in multiple account types and you're in a high tax bracket, optimize your location. Otherwise, a simple approach (same allocation in each account) is good enough. Perfect is the enemy of good, and a complicated strategy you won't maintain is worse than a simple one you will.