A 66-year-old retiree has learned a lesson many investors miss: where you hold your investments matters just as much as what you hold.
Asset location focuses on the tax efficiency of placing different investment types across various account types. This strategy works alongside asset allocation, which determines your overall mix of stocks, bonds, and cash.
The basic principle is straightforward. Tax-inefficient investments belong in tax-advantaged accounts. Tax-efficient investments belong in taxable accounts. Here's why.
Bonds generate ordinary income through interest payments, taxed at your full marginal rate, sometimes exceeding 37 percent at the federal level. Holding bonds in traditional IRAs, Roth IRAs, or 401(k)s shields that income from immediate taxation. Stocks, particularly those you hold long-term, qualify for preferential capital gains rates, currently 0 percent, 15 percent, or 20 percent depending on income. A Roth IRA compounds tax-free forever, making it ideal for growth stocks.
For taxable brokerage accounts, municipal bonds make sense. Their interest income avoids federal taxation. Individual stocks held long-term create tax efficiency because you control when to harvest gains and losses.
Real-world example: A retiree with $500,000 across a traditional IRA, Roth IRA, and taxable account might place $200,000 in bonds within the traditional IRA, $100,000 in aggressive growth stocks within the Roth IRA, and $200,000 in dividend-paying stocks and municipal bonds within the taxable account.
This arrangement typically saves thousands in annual taxes compared to randomly distributing investments across account types.
The strategy becomes especially powerful in retirement when you're drawing income and managing tax brackets. Each dollar of poorly located investments costs real money that compounds over decades.