When working with a professional advisor, choosing the appropriate asset allocation to provide the greatest chance of achieving your goals is a key component of any successful investment strategy. This allocation selection process also involves some careful consideration in the location and placement of the investor’s assets. The decision involves selecting which accounts, taxable or tax-deferred, will hold equity assets (stocks) and which will hold fixed income assets (bonds), while attaining a desired overall asset allocation. The placement of assets is an important decision that may have a significant impact on taxes, investment returns, and ultimately the longevity of your portfolio.

There are two basic types of investment accounts: taxable and tax-deferred (such as a 401(k) or IRA). The taxation of each account is different, and knowing the differences can help individuals minimize their tax burden. Income, dividends, and realized gains in a tax-deferred account, such as an IRA or 401(k), avoid capital gains and ordinary income taxes. However, future distributions from tax-deferred accounts are taxed as ordinary income. Investment gains from assets held in a taxable account are generally taxed at capital gains rates in the year of sale. Most income received in a taxable account, such as dividends or interest, is taxed as ordinary income in the year it is received. In some cases a Roth IRA is also a viable option. Unlike traditional IRAs, contributions into Roth’s are made with after tax funds, but all distributions are tax free. If investors will likely be in a higher tax bracket when they make withdrawals or if they may not want to take required minimum distributions once they reach age 70 ½, this account may be a good option.

The ability to invest on a tax-deferred basis is valuable because it allows an investor to shelter realized investment gains and income that would normally be subject to taxation. However, because returns differ in terms of tax liability, the value of tax-deferred investing will depend on which assets are held in the tax-deferred account. Every investor’s situation is different so there is no universal answer in deciding where to hold assets. However, the ultimate goal is to increase the value of your portfolio while keeping tax liabilities to a minimum.

If you have both account types, it is typically more tax efficient to hold income-producing securities (bonds) in your IRA or 401(k) accounts, while using taxable accounts for growth-oriented assets such as stocks. This strategy can help defer current taxation on the interest income and focuses the taxable portfolio on growth-oriented assets that are subject to advantageous capital gains rates. For example, consider using a taxable account to house municipal bonds and growth-oriented stocks, while placing taxable bonds and funds that produce short-term gains in an IRA account. When stocks are held inside a tax-deferred account, the tax advantages of capital gains may be lost and ultimately turned into ordinary income upon withdrawal.

The asset allocation decision will also depend on the amount of money you hold in each type of account. If your overall portfolio value is $500,000; consisting of a $475,000 IRA and a $25,000 taxable account, you will likely have less flexibility in how your assets are held compared to someone with the same portfolio value, but who has an equal split between the amount in their IRA and taxable account.

In order to maximize the after-tax return it is important to view your investment portfolio in aggregate. Rather than having different allocations for each account, it is more efficient to view the accounts in aggregate and manage them on a consolidated basis. This reduces costs associated with purchasing the same investment in multiple accounts and it supports placing investments in the most tax efficient accounts.

For additional information and customized guidance regarding the location of your assets, please contact your advisor. The information is not intended to be a specific recommendation and does not constitute investment advice or legal advice. If you are interested in exploring these strategies to see if they are applicable to your specific situation, please contact us.