Not to be confused with asset allocation, asset location refers to the placement of certain asset types in tax-deferred accounts – IRAs and 401(k)s – and other types of assets in taxable accounts.
The concept is simple: place the most highly taxed assets in tax-deferred accounts, while putting more lightly taxed assets in taxable accounts. This generally means putting bonds and real estate investment trusts (REITs), whose payouts can be taxed at income rates of up to 39.6%, in tax-deferred accounts. Stocks, whose capital gains and dividends are taxed at a top federal rate of 20%, should be invested in taxable accounts.
An example illustrates the tax savings. Consider a portfolio consisting of a taxable account with $1,000,000 and an IRA with $1,000,000, allocated among four funds equally weighted in U.S. stocks, international stocks, REITs, and bonds. Mutual fund database Morningstar provides pre-tax and post-tax data for each of these funds, revealing the average annual “tax cost” of each.
|Vanguard Total U.S. Stock Market||VTI||0.38%||18.86%||18.41%||$500,000|
|DFA International Core Equity||DFIEX||1.02%||14.57%||13.40%||$500,000|
|Vanguard U.S. REIT Index||VNQ||1.52%||16.89%||15.11%||$500,000|
|Vanguard Intermediate Treasury||VFIUX||1.33%||3.00%||1.63%||$500,000|
|Data as of 12/31/2013||$2,000,000|
A common, yet inefficient, approach would be to hold each fund equally in each account, irrespective of the tax costs. Doing so results in a tax bill of $10,625 per year. year (illustrated below).
|Vanguard Total U.S. Stock Market||VTI||0.38%||$250,000||$250,000||$950|
|DFA International Core Equity||DFIEX||1.02%||$250,000||$250,000||$2,550|
|Vanguard U.S. REIT Index||VNQ||1.52%||$250,000||$250,000||$3,800|
|Vanguard Intermediate Treasury||VFIUX||1.33%||$250,000||$250,000||$3,325|
|Data as of 12/31/2013||$1,000,000||$1,000,000||$10,625|
A tax-friendly approach can be implemented by stashing funds with a higher tax cost in the IRA and allowing the more tax-friendly funds to compound in the taxable account. Nothing about the asset allocation has changed, but asset location is much improved. The average tax costs are reduced by $3,625, or 0.36%, per year (illustrated below).
|Vanguard Total U.S. Stock Market||VTI||0.38%||$500,000||$1,900|
|DFA International Core Equity||DFIEX||1.02%||$500,000||$5,100|
|Vanguard U.S. REIT Index||VNQ||1.52%||$500,000||$0|
|Vanguard Intermediate Treasury||VFIUX||1.33%||$500,000||$0|
|Data as of 12/31/2013||$1,000,000||$1,000,000||$7,000|
In this example, the portfolio’s after-tax results are improved by $3,625 per year. While asset allocation, fund choices and percentage of taxable vs. tax-deferred money can vary dramatically across investors, structuring a portfolio in this manner is a relatively simple process that should be used to improve returns.
Despite the logic and simple math behind it, asset location is largely ignored. According to Forbes, a 2004 Federal Reserve study revealed American invest their taxable accounts and tax-deferred accounts almost identically, with roughly 65% of each devoted to stocks. As the example above illustrates, investors who do this leave a lot on the table.
 Carnahan, Ira. “Location, Location, Location.” Forbes. November 15, 2004