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.

The order that does the most work

Rank assets by how badly a taxable account punishes them, then fill the tax-sheltered space from the top of that list.

The sequence follows: bonds and REITs into the 401(k) or a traditional IRA, the broad index fund into the taxable account, and the highest-expected-return holding into the Roth. A Roth is the only wrapper where decades of growth are never taxed, which makes it the wrong home for the asset that grows slowest.

What twenty years of good location is worth

Take $10,000 of pre-tax money earning 4.5% for twenty years, and put it in three places in turn.

In a Roth IRA, $7,600 of take-home pay becomes $10,000 inside the account and grows, untaxed at both ends, to $18,329. In a traditional 401(k), the full $10,000 goes in, grows to $24,117, and is taxed on withdrawal at 24% — leaving the same $18,329. In a taxable account, the money starts at $7,600, loses about 1.3 percentage points a year to tax on the interest, and ends at $14,258.

The two identical lines are the point worth pausing on. A traditional 401(k) and a Roth IRA produce exactly the same result when your tax rate today matches your rate in retirement — the 401(k) taxes a larger balance, the Roth taxes a smaller contribution. The taxable account is the only one of the three that loses ground every year, and it loses it quietly.