What on earth is Asset Location and why do I care?

So what does Asset Location mean?

So let’s jump right in. Asset Location refers to ensuring you have a mix of assets in your net worth / portfolio that is going to allow you to have the option of paying the least amount of taxes you possibly can. So ultimately, this is all about paying less taxes. Well, whenever we talk about paying less taxes, ears tend to perk up. So hopefully that caught your attention. 

While this article gives examples from common types of accounts from the United States, the concept is absolutely valid anywhere in the world. The options that exist in other parts of the world will be different of course. 

To go into it a bit more, it typically refers to having your assets in different types of accounts with different tax treatments. Most generally, it refers to having your assets in 3 different types of accounts:

1. Taxable accounts – this is your traditional brokerage account like your schwab or Robinhood or e-trade or wherever you might be buying and selling stocks and bonds. What is different about this is that it does not offer any tax advantages whatsoever like your 401K or Roth accounts. 100% of what you invest into it is after-tax, the dividends you earn from it are taxed, any proceeds you get from selling stocks or bonds from the account is 100% taxed. You may wonder why even bother with such an account but I will get to that later.
2. Tax-deferred accounts – this is the gamut of the alphabet soup of accounts including 401K or Solo 401K, traditional IRAs, 403(b) etc. 100% of what you invest in this account is not taxed at the time of you putting money in. The money grows tax free, dividends are not taxed. BUT, when you withdraw the money, you will pay regular income taxes. There are rules like in the 401K that stipulate that if you withdraw money before age 60, you pay a penalty. So these are tax-deferred – meaning, you pay taxes later. 
3. Tax-exempt accounts – these are the accounts where you invest money into it after-tax. But once you invest into it, you never have to pay taxes on the growth, dividends from the account. There are some rules around this that I won’t go into now. But these include your Roth IRAs, HSAs (Health Savings Accounts) and 529 College savings accounts. 

Side note: Your portfolio can be in assets beyond pure stocks and bonds like Real Estate, Cryptocurrency, small businesses etc. They don’t fall neatly in the above buckets, but I will touch on it toward the end in terms of how to think about it.

That’s all great but why am I so concerned about the mix of assets in these accounts?

The reason as I mentioned above is to do with the tax treatment. I will explain specifically with 3 scenarios but I personally think it’s more critical for the average person to think about the 2nd and 3rd scenarios and that is what I would like to spend more time on. 

Scenario 1: Current time when you are still working and building up your assets. 

This is the common use case for optimizing your asset location, depending on your income level. And to be honest, this scenario matters the most only for people in higher income brackets. The intent is to put most of your high growth/high taxed assets in the tax-deferred or tax-exempt accounts. Let’s look at a few examples:

• High growth stocks – that nvidia or apple stock that has been appreciating rapidly. If you sell this when it’s in a tax advantaged account like a 401K or a Roth account, you don’t pay taxes on it right now or ever (if it’s in a Roth). You get to decide when to pay the taxes on it. 
• Low-cost ETFs / index funds – these tend to be tax efficient generally because they don’t generate very high dividends. Lots of times people will consider putting these in a taxable brokerage account. 
• Municipal bonds – these are very tax friendly where you don’t pay any federal income. These are perfect in a taxable brokerage account. 

Above examples are not comprehensive, but just to give you an idea of how to think about this. 

Scenario 2: At a future time when you are ready to retire early before age 60

This is the scenario I have been thinking a lot about lately. Let me explain why. A lot of people’s net worth tends to be concentrated in a tax deferred account like a 401K and/or in their personal residence. That’s not a bad thing per se, but it is a challenge if you wish to retire before you turn 60. While I am not sure I will be mentally ready to completely stop working before 60 (or possibly even after), I certainly want to build the flexibility to do so. Life can happen and I want to have the option to do so. 

So then, here is the issue. If you wish to retire at age 50 or 55 for example and all your net worth is in a 401K and in your personal residence, you cannot typically tap into it until you turn 60. There is a way to tap into your 401K at 55 but it’s complicated and frankly sub-optimal in my opinion. 

Therefore, if you have money in a taxable brokerage account and/or cash, you have a tremendous amount of flexibility on how much to withdraw and when. Money contributed into a Roth account also can be withdrawn after 5 years of contribution (only the contributions, not the actual growth because Roth accounts have different rules). This was the big takeaway for me that my financial advisor told me. He said we had very little money sitting in accounts that could be tapped into prior to 60. So I have now started building this up. 

If you have been wondering why I have been going on about planning for this retirement phase, it’s because I probably don’t have a lot of time left for this money to grow, depending on when I wish to retire early (I am already 45 years old at the time of writing this article) but better late than never. If you are even younger than I am now, you have the opportunity to have time on your side to allow the money to compound. 

One note here – if you have investment real estate assets like rental properties, those would be something you could tap into anytime obviously. I have talked about in my blog about how they can be tax advantaged (though not tax free). This would be the same situation if you owned a business that was generating cash flow. 

Scenario 3: At a future time when you ready to retire at age 60 or later:

This is a scenario all of us will face at some point or another. But this use case for having money located in different types of accounts is different. This use case is all about minimizing taxes in general post-retirement. To explain this, let’s assume your plan is to retire at age 60. I won’t go into explaining the implications of RMDs (Required Minimum Distributions) and strategies on how you minimize that because that is a blog post on its own. 

If I kept you reading on the previous scenario and now, you are like why on earth is he talking about an age time frame that feels like a million years away, stay with me. This is one of those things you will be thankful for, with advance intentional planning. 

So, to explain the first item above around generally minimizing taxes, let’s use a simple example with hypothetical numbers:

• Let’s assume two groups of retirees in the same state are aged 60 and retiring this year in 2025. Their annual expenses are about $100,000 but they also plan on making some major repairs to their homes that are going to cost around $20,000. 
• Both these sets of retirees are filing taxes as ‘Married filing jointly’. 
• Retiree couple A has $3M in their 401Ks and nothing much else in assets (outside of their home).
  Retiree couple B has $2M in their 401Ks and $1M in their Roth IRA accounts. They also have equity in their personal home like couple A. 
• So both retiree couples have a net worth of $3M + whatever equity they have in their homes. 
• Retiree couple A has no choice but to withdraw their entire expenses of $120,000 from their 401K account and pay ordinary income taxes on the entire amount. 
• Retiree Couple B has a choice here – they can withdraw up to $94,300 from their 401K and pay the taxes to reach the 12% tax bracket and for the rest of the $25,700 in expenses withdraw from their Roth accounts which is 100% tax free. Below table shows the difference in taxes paid by both couples.

I over-simplified the above example. Frankly, there are other factors that will impact this even more. If you happen to be in a down-market year and you don’t want to withdraw so much from your 401K or Roth IRA, and you have money sitting in cash, you can tap into some of that cash for your expenses without over-withdrawing from your portfolio. This is called the Safe Withdrawal Rate – SWR  you can read more about this here and is frankly a huge topic of its own: Safe Withdrawal Rate (SWR) Method: Calculations and Limitations

So you can see how having a good mix of accounts gives you flexibility at this time to minimize your taxes, but also to not over-withdraw during down markets. But the reason I am asking you to think about this NOW is because specifically for Roth accounts, there is a limitation on how much you can put into it each year. So frankly you need a lot longer to build this up. The backdoor ROTH IRA (if you are a high income earner – otherwise you can do a regular Roth IRA) allows you to contribute $7000 per person in 2025 and you also have the Mega Backdoor Roth IRA allows you to contribute upto $70,000 (but that is including your 401K pre-tax contributions and employee match so in effect you will end contributing a lot lesser).

Of course, you can also create this flexibility with taxable brokerage accounts or basically simple high yield savings accounts or money market accounts. Of course, there are also scenarios where you can pay zero taxes as I have outlined in an earlier blog post ‘How do I pay Zero Income Taxes.’

Concluding thoughts

Asset location is really about tax optimization. You achieve this tax optimization by locating your assets in different accounts/areas that have different tax treatment. 

While this is not overly complicated, it does require you to do some intentional planning with this. You don’t need a financial advisor to do all this but if this is overwhelming for you, certainly work with a financial advisor. 

Thank you for reading! I wish you good luck in your financial journey!