Asset Location: How Do You Decide on Which Account to Invest?

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Asset location may sound similar to asset allocation, but they are very different concepts.

Asset ALlocation describes the overall strategy of your investments, such as what percentage your total investment is in the stocks.

Asset LOcation is where your asset is located. For example, if you are buying $10,000 of Vanguard Total Market Fund today, what’s the best account to put this investment in? Your 401k or your Roth IRA? The answer of this question is what I’m going to discuss in this post.

Why does the location of your asset matter? Let’s start by talking about what kind accounts there are for most of investors.

There are three major types of asset locations:

  • Pre-tax accounts: this category includes your traditional 401k, 423b, traditional IRA, etc. In these accounts, your contributions are tax deductible on the year of contribution, i.e. the contributions are pre-tax, the growth as well as the contribution principals will be taxed at the time of withdrawal at the rate of federal income tax.
  • Post tax retirement or tax free accounts: Post tax accounts are your Roth 401k and Roth IRA. In these accounts, your contributions are not tax deductible i.e. the contribution is already taxed, the principal contribution as well as all its growth will be tax free on withdraw. Tax free accounts the likes of 529 and HSA accounts: they are pre-tax in contribution (tax deductible on the year of contribution) and the principal as well as its growth are tax free on withdraw for college tuition and medical use, respectively. These post tax retirement accounts and the tax free accounts have the similarity in that they are both tax free on withdrawals of both principal and growth.
  • Taxable accounts: This is your normal brokerage investment accounts or bank accounts where you use your post tax dollars (likely from your monthly paychecks) to buy stocks, bonds, mutual funds, index funds or CDs. You paid tax on this money already. You can invest this money on whatever you like. You may withdraw your investment at any time. However, if you made gains with these investments, you gains will be taxed at short or long term capital gains tax rate (a lower rate than your marginal income tax rate) depending on how long you held on the investment.

Of course, there are many other types of accounts and retirement plans (e.g. government pension plans, social security, etc), the three types accounts listed above are the most frequently encountered retirement investment accounts that you can manage on your own. So understand their characteristics is the first step in understanding how you can take advantage of the system.

The next we should talk about why various assets need to go into different accounts. Let me start with a few rule of thumb when it comes to asset location:

  1. Assets with high turnovers should go into pre-tax or tax free account. For example, small cap funds by definition is a collection of smaller companies which tends to be more risky to fail than large companies like Apple or Wal-mart. Conversely, small companies tend to have higher rate of growth and more room to grow. If a company grows larger than the defined size of small cap company or if it fails altogether, a turnover is created within the small cap fund. This company’s stock will need to be liquidated from the fund and a new stock will be recruited into the fund. This process creates a taxable event which means your small cap fund will generate taxable income which you don’t want to see during your peak earning years. You want to keep these funds in your pre-tax or tax free accounts so they don’t make an impact on your yearly tax calculations.
  2. Assets qualifies for “Foreign Tax Credit” should go into taxable account. I will write an article specifically on this “Foreign Tax Credit” some day. For the purpose of this article, it means you should keep your Vanguard Developed Market and Vanguard Emerging Market Funds in your taxable account.
  3. Assets generating a lot dividends/interests should maybe go into a pre-tax or a tax free account. When your asset generates dividends and interests, it is a taxable event. It means your taxable income will be increased by the amount of your dividends/interests over that given year (unless the dividends are Qualified in which case it’s taxed at capital gains tax rate). Most of bonds and REIT are assets in this category and should be placed in the pre-tax accounts. However, there is a fierce ongoing debate here regarding this point. It is highly contentious whether to place bonds in pre-tax or taxable accounts. On one hand, bonds are highly tax inefficient that placing them in taxable accounts increase taxable income paid at marginal income tax rate. On the other hand, there are decisive advantages to place bonds in a taxable account:
    1. Lower returns than stocks, hence lower tax cost. It is argued that it’s more efficient to save the pre-tax investment space for stocks (esp for super savers or high retirement users with high retirement marginal tax rates.)
    2. Switching holding to a different types of bonds will not incur large capital gains tax unlike switching a stock fund.

After calculating my for own benefits and risks, I bought bonds in my taxable accounts. I started with Vanguard Total Bonds (VBTLX) which I switched to Vanguard intermediate-term tax exempt bonds (VWIUX) after a tax loss harvesting in 2016.

So in summary: Tax inefficient assets should take priority in asset location of pre-tax or tax free accounts whereas tax efficient assets can go in any of your accounts. Here’s my list of assets in three classes: tax efficient, somewhat inefficient, tax inefficient.

  1. Tax efficient (put it anywhere)
    1. Low yield Money Market Fund or cash
    2. Tax managed funds: stocks, bonds, etc
    3. Large cap/total market funds
  2. Somewhat inefficient (prefer to put in pre-tax or tax free accounts):
    1. Small cap funds
    2. Value index funds
    3. Total market bond funds
  3. Tax inefficient (Pre-tax and tax free accounts):
    1. REIT
    2. High turnover funds
    3. High yield corporate funds

What do you think about all this tax location strategies? Is this worth your while? Do you have a different strategy in placing your assets in various accounts? Write me in the comment section below.

Interested in some more reading on personal finances? Click here to read more of my posts.

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