Asset location: which investment belongs in which account

Asset Location: Which Investment Belongs in Which Account

A $10,000 bond holding can be worth $24,117 after twenty years or $14,258, depending on nothing except which account it sits in. Same fund, same 4.5% yield, same period. One version sits in a Roth IRA, the other in a taxable brokerage account, and the difference between them is $9,859 that nobody ever sees as a line item.

That is asset location: the decision about which asset goes inside which account wrapper. Asset allocation — 80% stocks, 20% bonds — gets all the attention. Location sits next to it, costs one hour of work, and pays a few tenths of a percent every year for as long as you invest.

Tax is charged by type of income, not by size of account

The rule that makes location work is simple: different kinds of investment income are taxed at different rates, and accounts differ in what they shield.

A bond fund pays interest, and interest is taxed as ordinary income — 24 cents on the dollar in the bracket used here. An equity index fund pays qualified dividends taxed at 15%, and it distributes little else as long as it holds its positions. A REIT distributes most of its income as ordinary dividends, which lands back at 24%.

Inside a traditional 401(k) or IRA, none of that is charged this year. Nothing is taxed while the money stays in the account. Inside a Roth account, nothing is taxed on the way out either, provided the rules are followed. A taxable brokerage account shields nothing, so whatever it holds is taxed annually.

That last line is the whole argument in one number. Hold a bond fund paying 4.5% in a taxable account and the government takes a slice of the interest every single year, whether you spend it or not. Hold it in a Roth and the same interest compounds untouched for twenty years. Nothing was earned differently. One version simply kept the pieces.