Asset Site: What is it and How Does it Work?

Definition of Asset Location and Examples

Asset location is a strategy that matches the type of investment with the best type of account for the purpose of minimizing taxes. Asset location may seem similar to “asset allocation,” but these two terms are not the same. Asset location means placing the investment in a taxable or tax-protected account in a way that achieves the best tax treatment. Asset allocation, on the other hand, refers to how assets are mixed and spread across a particular account.

How Asset Location Works

There are three basic types of investment accounts:

• Standard brokerage account: Capital gains, interest income, or earnings from dividends are taxed. Taxes are assessed on the net asset value of mutual funds.
• Tax-deferred account: The way taxes are imposed on tax-deferred accounts differs significantly from the taxation of standard brokerage accounts. Selling mutual funds in a tax-deferred account, such as an IRA or 401(k), will not trigger capital gains taxes. In fact, selling funds in a tax-deferred account does not incur any immediate taxes at all. Other fees may apply to mutual funds, but income from distributions is not taxed in IRA or 401(k) accounts until you withdraw the money later, such as after retirement.
• Tax-exempt account: In a tax-exempt account, investments are made using income that has already been taxed, meaning you pay taxes on the income before you invest it in the account, so it won’t be taxed again. Any money you earn inside this type of account grows tax-free, as long as it stays in the account for a specified period. The IRS imposes restrictions on the amount you can invest in a tax-exempt or tax-deferred account. For example, for 2021, the minimum income threshold for eligibility to contribute to a Roth IRA starts at $125,000 for single individuals and reaches $208,000 in certain cases for married couples. In 2022, these limits increase: the minimum income threshold for eligibility to contribute starts at $129,000 for single individuals and $214,000 for married couples.

Types of Funds Suitable for Asset Location Strategy

In a brokerage account, it makes sense to use the most tax-efficient funds. These may include municipal bond funds or funds that do not generate income from distributions, such as some exchange-traded funds (ETFs), index funds, or growth equity funds.

Reasons to Use Asset Location

The primary reason for using asset location is clear: why lose money to taxes if you don’t have to? To keep taxes low on mutual funds, it is beneficial to be smart about where to hold your assets. The taxes paid on earnings can be one of the biggest hurdles impacting the fund’s performance as an investment.

To summarize, income-generating funds (like most bond funds and income-targeted equity funds) should be held in tax-deferred accounts. An IRA or 401(k) will work well. Tax-efficient funds should be kept in a taxable account, such as an individual or joint brokerage account. Capital gains should also be monitored. If you expect to buy or sell or exchange funds multiple times a year, try to do it in your IRA or 401(k), where capital gains taxes will not be incurred.

Main Takeaways

Asset location is a strategy that matches the type of investment with the best type of account for the purpose of minimizing taxes. It should not be confused with asset allocation, but both can be used together to enhance long-term return opportunities. Investments likely to produce income should be placed in tax-deferred accounts, such as IRAs and 401(k)s. Tax-efficient funds are suitable for a standard brokerage account.

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Sources:

• Internal Revenue Service. “Publication 550 (2020), Investment Incomes and Taxes.” Accessed Nov. 11, 2021.
• Internal Revenue Service. “Amount of Roth IRA Contributions That You Can Make For 2021.” Accessed Nov. 11, 2021.
• Internal Revenue Service. “Amount of Roth IRA Contributions That You Can Make for 2022.” Accessed Nov. 11, 2021.

Source: The Balance

Source: https://www.thebalancemoney.com/what-is-asset-location-2466642

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