Your investment portfolio may be missing out on tax optimization opportunities.

• Typically, investors concentrate on the right combination of stocks and bonds in their portfolio, known as asset allocation.
• Experts advise that both wealthy individuals and many others should be mindful of asset location.
• Strategically holding stocks and bonds in specific account types, such as taxable brokerage accounts and Roth or pre-tax retirement accounts, can increase after-tax investment returns.

A lack of attention to taxes may be costing investors big bucks.

The idea of asset allocation, which involves choosing the optimal combination of stocks and bonds (e.g., 60/40), is likely known to many investors as a way to manage investment risk and increase return.

The location of assets, specifically the types of accounts where stocks and bonds are held, is crucial for wealthier investors, according to financial advisors.

This strategy minimizes taxes to increase after-tax returns for investors.

"Ted Jenkin, a certified financial planner in Atlanta and a member of CNBC's Advisor Council, stated that wealthier individuals should prioritize tax allocation as much as asset allocation, but they often neglect this aspect."

According to Jenkin, founder of oXYGen Financial, the asset location "really starts to make sense" once investors' income is high enough to put them in the 24% federal marginal income tax bracket.

In 2024, the 24% tax bracket will apply to single filers with taxable income above $100,000 and married couples filing jointly with taxable income above $201,000.

Why asset location works

According to Connor McGuire, a CFP at Vanguard Personal Advisor, asset location employs two fundamental principles.

For one, not all investment accounts are taxed the same way.

There are three main account types:

• These are traditional (pre-tax) individual retirement accounts and 401(k) plans, where investors defer taxes on contributions but pay later upon withdrawal.
• Roth IRAs and 401(k) plans are tax-exempt, meaning investors do not pay taxes on their contributions or withdrawals.
• These traditional brokerage accounts are taxable, and investors pay tax when earning dividends or interest, or upon sale if there's a profit.

McGuire stated that the taxation of investment income varies based on the type of asset.

Interest income is subject to taxation at the investor's ordinary income tax rates, with the highest earners potentially paying 37% or more.

Capital gains tax rates on investments held for more than one year are generally lower, with many investors facing a 15% rate and the highest earners paying 20% (plus any surcharges), according to McGuire.

It can save you lots of money

Investing in high-tax or tax-inefficient assets in tax-advantaged retirement accounts like 401(k)s and IRAs is a strategy known as asset location.

Investors typically prioritize investments with more advantageous tax rates and tax efficiencies in taxable accounts.

Robert Keebler, a certified public accountant in Green Bay, Wisconsin, and partner at Keebler & Associates, stated that it's crucial because you want to minimize your tax burden.

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According to a 2022 Vanguard analysis, employing such a strategy can increase after-tax returns by 0.05% to 0.3% a year.

An investor with a $1 million portfolio split equally between stocks and bonds and spread across all three account types (traditional, Roth and taxable) could save $74,000 after 30 years by implementing asset location, McGuire stated.

How to do it

Advisors suggest that investors should incorporate asset location within their asset allocation framework, such as a 60/40 stock-bond mix.

Bonds and bond funds are typically better suited for tax-deferred or tax-exempt accounts, according to them.

"Bond investments typically generate earnings through interest, which are taxed at ordinary income tax rates, resulting in a potential tax rate of 37% plus any additional taxes for high-income investors. To minimize this tax impact, it is important to shelter these bonds."

Super-actively managed stock funds that generate significant short-term capital gains should typically be held in tax-preferred accounts, according to Keebler.

Investments held for one year or less are subject to short-term capital gains tax, which is taxed at the ordinary income rate rather than the preferential long-term tax rates.

According to Keebler, high-growth investments are best placed in a Roth account rather than a pre-tax account, as investors won't have to pay taxes on their earnings in the future, assuming they follow the appropriate Roth withdrawal rules.

It is generally recommended for investors to buy and hold individual stocks for long-term growth and opt for stock funds with less frequent internal trading, such as index funds, in taxable accounts, according to advisors.

Municipal bonds are typically better suited for taxable accounts, as their interest is not subject to federal tax, according to advisors.

Additional things to consider

It may be more challenging to withdraw funds from a retirement account before age 59½ compared to a taxable account, and investors must consider these differences when choosing an account type.

The benefits of diversifying across different account types go beyond investing, too.

Withdrawing from pre-tax 401(k) plans and IRAs may increase Medicare premiums, while withdrawing from a Roth account could prevent this increase.

Jenkin stated that it is impossible to predict the tax rates and account taxation that will be in effect decades from now.

He stated that having money in multiple accounts would offer tax flexibility in the future.