The science of asset allocation gets a lot of attention in the personal finance realm, but it only tells part of the story. In an ideal world, there would be no taxes or transaction costs, so that asset allocation would be the only game in town. You’d simply divide your portfolio between the various asset classes and forget about it.
Rebalancing would be a non-issue because there would be no tax consequences, and you wouldn’t have to worry about which account is most suitable for your small-cap value fund. If you have all of your retirement savings in your 401K or an IRA substantially, you can get away with doing that. Unfortunately for the rest of us, Uncle Sam wants his cut.
Nobody Loves The IRS
Excepting congress, which needs enormous sums of tax dollars for important projects like building bridges to nowhere and llama farms for orphan llamas, nobody likes the IRS. I am no exception, and if you too share my raw hatred of the IRS, you would be wise to think long and hard about asset location.
Asset location is the art of placing different asset classes in various types of accounts, depending on a combination of the tax-efficiency of that asset class and the tax characteristics of the kind of account in question.
Here’s an example to make what I just said make sense.
Suppose you have a target asset allocation for your retirement portfolio of 50% stocks and 50% bonds. Furthermore, about half of that portfolio is in your 401K at work, and half is in either a regular taxable account or a Roth IRA. The best course of action would be to put the bonds in your 401K and stocks in your taxable account or Roth. The reason for this is that bond interest is taxed as regular income and stock dividends, and long-term capital gains are taxed at lower capital-gains rates. Since everything in your 401K will eventually be taxed at standard income tax rates when you liquidate, putting stocks in it would amount to intentionally paying more taxes than necessary.
In contrast, bond interest is taxed as income, so you lose nothing by putting them in your 401K. Proper asset location can make a huge difference in your long-term returns, so it’s well worth paying attention to.
Here is a list of asset classes and the optimal type of account they should be placed in, if possible.
Least tax-efficient
place in a tax-deferred account (401k, traditional IRA, etc.)
High-yield bonds
TIPS
Taxable Bonds
Medium tax-efficiency
place in a tax-free account (Roth IRA, Roth 401k)
REITs
Balanced Funds
Small-cap stock funds
Actively-managed stock funds
Value stock funds
International Stock funds
Most tax-efficient
fine to place in a taxable account
Broadly diversified stock index funds
Tax-managed stock funds
I/EE savings bonds
Tax-exempt municipal bonds