In wealth management, we hear a lot about asset allocation—the art of spreading your investments across different asset classes to balance risk and return. But there's another, often overlooked concept that's just as important: asset location. If asset allocation is about what you invest in, asset location is about where you invest.

Let’s break down what asset location is, why it matters, and how it can help maximize your after-tax returns.

What is Asset Location?

At its core, asset location is a tax-efficiency strategy that involves placing different types of investments in accounts where they’ll be taxed the least. When done right, this approach can help you keep more of your returns after taxes, helping you reach your financial goals sooner.

Understanding Your Account Types

To get the most out of asset location, it’s helpful to first understand the three main types of accounts where assets are held:

1. Taxable Accounts: These are accounts like brokerage accounts where you pay taxes each year on income, dividends, and capital gains. There are no tax benefits here, but they do offer flexibility since you can withdraw funds at any time.
2. Tax-Deferred Accounts: Contributions to accounts like 401(k)s and traditional IRAs grow tax-free until you withdraw them, which is typically in retirement. At that point, withdrawals are taxed as ordinary income. These accounts are great for compounding returns without paying taxes year-to-year.
3. Tax-Exempt Accounts: Accounts like Roth IRAs and Roth 401(k)s allow your investments to grow tax-free, and qualified withdrawals are also tax-free. This makes them ideal for assets with long-term growth potential.

Each of these account types has its own tax rules, and that’s where asset location comes into play. By understanding where each asset type fits best, you can potentially lower your tax bill and boost your overall returns.

Matching Assets to Accounts for Maximum Tax Efficiency

With asset location, the goal is to place investments in the accounts where they’ll get the most tax-efficient treatment. Here’s a general guideline:

1. High-Growth Assets: Stocks and other high-growth investments are often best placed in tax-exempt accounts (like Roth IRAs). Since Roth accounts are tax-free upon qualified withdrawal, you won’t pay taxes on the appreciation, even if the assets grow significantly over time.
2. Income-Generating Assets: Investments that produce regular income, like bonds and real estate investment trusts (REITs), might be better suited for tax-deferred accounts (e.g., traditional IRAs). This way, you don’t pay taxes on income until withdrawal, allowing more compounding in the meantime.
3. Tax-Efficient Assets: Investments like index funds or ETFs, which tend to generate minimal taxable income, can be a good fit for taxable accounts. Since these assets naturally produce fewer taxes each year, the tax impact is lower, making them more suitable for accounts that don’t provide tax deferral.

Why Asset Location Matters for Your Bottom Line

Asset location can seem complex, but the value it adds is straightforward: it helps you avoid paying more taxes than necessary. By strategically placing investments based on their tax characteristics, you keep more of your returns.

For example, if you hold high-dividend stocks in a taxable account, you’ll pay taxes on dividends every year, which eats into your returns. However, if you place those stocks in a tax-deferred account, you delay the tax bill until retirement. That delay allows you to compound more of your returns, increasing your wealth over time.

Putting Asset Location into Practice

Effective asset location requires a balance between tax savings, investment goals, and liquidity needs. A thoughtful strategy considers your entire financial picture, including your goals, income needs, and risk tolerance. This strategy works best as part of a customized wealth plan that takes into account not only what you invest in, but where those investments are held.

Final Thoughts

Asset location is a powerful but underused strategy that helps you optimize your wealth plan for tax efficiency. While it might seem technical, its purpose is straightforward: keeping more of what you earn by avoiding unnecessary taxes.