Asset Location: Optimizing Investment & Tax Planning
Across the financial planning industry, you always hear the term ‘asset allocation’ as being the core pillar of a sustainable investment plan. Simple stated – asset allocation is the act of diversifying your investment holdings amongst a wide range of asset classes. On the macro level, this is stocks and bonds / cash, on the micro level this could be large cap, small cap, mid cap, international stocks, or domestic, international, inflation protected, floating rate bonds, etc. The list goes on.
What is asset location? Who should take advantage?
While coming up with a proper asset allocation is important, we often find that a client’s asset allocation does not coincide with their ‘asset location’ – which we believe is just as important as an individual’s asset allocation.
In short, asset location is the concept of owning certain assets in specific account types based on the accounts tax treatment, but also the growth potential of the asset. If done properly, this type of planning can allow an individual to minimize their taxes and increase portfolio return potential over their lifetime.
Typically, folks who benefit the most from asset location planning are people with pre-tax accounts, ROTH accounts, and taxable investment accounts (brokerage). While all three are not required, the ultimate efficiency is unlocked when you have all three.
How should the accounts be structured?
As a general statement, utilizing the power of asset location looks a bit like this:
- ROTH Accounts: holds the assets with the highest growth potential
- Aggressive investment allocation = 80% stock / equity or above
- Pre-tax Account: holds the assets that are the least tax efficient, have modern growth potential
- REITs, bond funds, high dividend pay mutual funds or stocks, etc.
- Taxable Investment Account: holds the most tax efficient assets
- Individual stocks, low dividends stocks / funds, ETFs
In our experience, most people have equal asset allocation across all their accounts (i.e. each account is allocated 70 / 30 with the same asset classes held) or have the highest appreciating assets in their pre-tax 401k – where 100% of the distributions will be taxable upon withdrawal.
Rather than owning the most aggressive growth assets in their ROTH 401k or IRA, where the contributions are after-tax, the growth and eventual withdrawal of the assets are 100% tax free as long as the person is over age 59 ½ and the account has been open for 5 years.
Amongst taxable accounts we often find individuals holding mutual funds that pay high dividends or distribute large capital gains, which end of creating large unintended tax implications for the current year.
Furthermore, we are now getting to the place where asset allocation meets asset location. For example, let’s say a client’s allocation should be 70% equity and 30% fixed income / bond, and they have pre-tax, ROTH, and taxable accounts. Here, we will also assume the ROTH account is the ROTH portion of the clients 401k, and the pre-tax is the traditional 401k.
Our goal would be to have an overall allocation of 70 / 30, but each account will have a slightly different allocation. The pre-tax account 401k will hold the client’s high dividend paying equity funds (dividend funds / large cap value equity funds) and bond allocation and - floating rate bond, inflation protected bond, corporate bond etc., with the majority of the 30% allocation will be held in this 401k plan. Next, in the client’s ROTH 401k, we will want to implement an aggressive allocation 90%-100% equity spread across various sub-asset classes – small cap, mid cap, large cap, international, emerging market equities.
Lastly, within the client’s taxable account we will want to fill in the remainder of the fixed income and equity allocation with tax efficient holdings – municipal bond funds (no tax on the federal level and potentially no tax on the state level), individual stocks, ETFs / mutual funds that pay low dividends and do not distribute capital gains – this helps us avoid surprise tax bills.
In essence, employing this type of strategy still allows the individual to hold their goal asset allocation – 70 / 30 – in this example, while now leaving more room for choice and flexibility from a distribution perspective. Read along in the next section.
Why this matters in the long run – withdrawals & estate planning
From here, it is crucial to address how utilizing asset location can assist in efficient withdrawals from these accounts, and in one’s estate plan.
As a general reminder, the following are the tax treatments for each account type:
- Pre-tax
- 100% taxable at your income tax rate upon withdrawal
- ROTH
- 100% tax free upon withdrawal as long as the account has been open for 5 years and over age 59 ½
- Taxable account
- Assets held longer than 1 year then sold are subject to capital gains rates – 15% for most people at the federal level
- Assets held less than 1 year then sold are subject to income tax rates
So, when you begin to take withdrawals during your retirement years it is important to design a plan of attack in regard to which account you choose to tap (or combination of) first. For example, if a client is 60 years old and their Required Minimum Distribution (RMD) age is 75, we need to be strategic about where monies come from to keep the person in as low of a tax bracket as possible. With pre-tax accounts, this person was receiving a tax break today on these contributions through their working years, however, at RMD age the person may be in the 24% marginal bracket.
In simple terms, if they wait to take money out of pre-tax accounts until RMD age, they may be creating a ‘tax bomb’ that could explode down the road. Moreover, an individual’s lifestyle in retirement may allow them to withdraw just enough pre-tax monies to keep them in the 12% marginal tax bracket. In return this would reduce the amount they would be required to take out at RMD age, and potentially withdraw these monies at a lower tax bracket than when they contributed to this account.
The goal here would be to withdraw a good amount of pre-tax assets over the years (until RMD age), and fill in the gaps with ROTH, taxable monies, and cash, as needed. Connecting this back to asset location, since the ROTH and taxable monies are more aggressively invested, the client could benefit long term from letting these accounts grow and withdrawing the more conservative (bond fund) assets from their pre-tax accounts as they need income.
Now, where this connects with their estate plan is how each account is treated when they are inherited (more details on this in my previous article concerning estate planning). For pre-tax accounts, if a non-spouse inherits this type of account, they must withdraw the entire account balance and pay the appropriate taxes on the distributions by the end of the 10th year of inheriting the account – HUGE tax implications for the beneficiary, especially if they are in their highest earnings years.
In more recent guidance from the IRS, if the initial owner was taking RMDs at the time of their death, the non-spouse beneficiary must take a specific amount out each year and still have the account balance be $0 by the end of the 10th year. If they were not taking RMDs, the account just needs to be empty by the 10th year.
With ROTH accounts, the 10 year rule still applies, however, since ROTH monies are all after-tax, there are no tax implications upon withdrawal – this is great for the folks inheriting these accounts. Similar to inheriting a ROTH account, inheriting a taxable investment account as a non-spouse can be advantageous from a tax and flexibility perspective.
Here’s why – for example let’s say Mom and Dad bought XYZ stock back in 2005 for $10,000 – this will be the cost basis in the account – the account grew to $150,000. If Mom and Dad sold the whole account, they will need to assess their capital gains tax liability on the $140,000 gain ($150,000 value - $10,000 initial cost). Let’s say their capital gains rate is 15% based on their total taxable income for the year.
In 2026, prior to liquidating the account, Mom and Dad pass away simultaneously - the $150,000 stock position is now passed to you as the sole beneficiary via transfer on death (TOD) registration. Under current tax laws, when you inherit these shares, ($150,000 in this example) you actually receive a step-up in cost basis on the account position as of the account owner’s date of death. So instead of the cost basis on the account being $10,000, the cost basis is now $150,000, and any gains realized are treated as long term capital gains.
So, you could go sell the $150,000 stock position after your parents pass away and pay $0 in capital gains taxes. Again $0. Not a bad deal – and the asset passes outside of probate with the TOD registration.
Compare this to inheriting a pre-tax account and being required to withdraw the entire balance and pay income taxes at your respective rate (over 10 years) during your highest earnings years!
Therefore, if it makes sense from a tax and retirement planning perspective, I will actually encourage people to withdraw more from their pre-tax accounts – even if they do not need the income – and have them allocate these dollars to their ROTH account (i.e. a ROTH conversion), or to their taxable investment account.
The end result here should be that the client pays less in taxes on the pre-tax account withdrawals than when they contribute, and their non-spouse beneficiaries are better off from an inheritance perspective, as the ROTH account can then be withdrawn tax free, and the taxable account receives a step up in cost basis upon the death of the original owner(s).
While this level of planning does require additional work and further understanding of the tax laws, it can be well worth it for clients and their family members from a tax, investment, and estate planning standpoint.
As a reminder, always consult with your financial planner, qualified tax professional, and qualified estate planning attorney prior to making any planning decisions.
Asset allocation programs do not assure a profit or protect against loss in declining markets. No program can guarantee that any objective or goal will be achieved.