Introductory Guide to Asset Location

Everything in its place…

Asset location is the process of determining which investments to keep in which accounts. That is, after you’ve determined your appropriate asset allocation, how should you divvy that up between your tax-sheltered accounts and your taxable accounts?

Example: Let’s say that you decide that your appropriate asset allocation is a simple 70/30 stock/bond split. You currently have $100,000 in your 401(k), $50,000 in a Roth IRA, and another $100,000 invested in taxable accounts.

So your grand total is $250,000, and you would like $175,000 (70%) invested in stocks and $75,000 (30%) invested in bonds. A few potential asset location options would be as follows:

• Split each account up so that it’s allocated 70/30,
• Invest $75,000 of your taxable account in bonds and invest everything else in stocks,
• Invest $75,000 of your 401(k) in bonds and invest everything else in stocks, or
• Invest all $50,000 of your Roth in bonds, $25,000 of one of your other accounts in bonds, and everything else in stocks.

Option 1: Shelter those bonds!

From a tax standpoint, it makes a great deal of sense to put all of your bonds in tax sheltered accounts. Why? Because they pay the most taxable income.

In contrast, stock income comes in the form of either dividends (which, for the moment, are taxed at a lower rate than interest income) or capital gains (which, if the holding period for the stock was greater than one year, are also taxed at a lower rate than interest income). As a result, you stand to benefit more from tax sheltering your bonds than you do from tax sheltering your stocks.

Option 2: Split everything equally.

Rick Ferri in his All About Index Funds argues that, from a psychological point of view, each account should be split up so that it has the same asset allocation as your whole portfolio.

Ferri makes the case that, if one account were to be entirely bonds and another entirely stocks, many investors would have a hard time considering them as part of a broader portfolio, rather than separately. (And, therefore, rather than deriving the psychological comforts that usually come with having a diversified portfolio, the investor would be watching whichever account is comprised entirely of stocks and panicking whenever it goes down.)

Ferri’s viewpoint makes sense to me. I certainly see a potential psychological benefit to having a mix of asset classes in each account. However, I suspect that the value of that benefit depends largely on the individual.

Which approach is best?

Anytime there’s a math vs. psychology debate, I’m reluctant to declare one option as “best.” As for my own portfolio, however, the entire bond portion is located in my Roth IRA.

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