Tax Efficient Portfolio Design: Asset Location vs Allocation
How placing the right investments in the right accounts can boost after-tax returns without increasing risk.
If you’ve ever sat through an investment review and heard terms like asset allocation and asset location, it’s easy to assume they are the same. They sound similar, and both affect your portfolio’s performance. But they are two very different tools in the tax and investment toolbox—and understanding both can make a meaningful difference in your after-tax returns over time.
Asset Allocation: The “What” and “How Much”
Asset allocation determines what types of investments you own and in what proportions. It acts as the blueprint for your portfolio. A classic example is a 60/40 portfolio — 60% stocks and 40% bonds — but allocation can be much more detailed. You might diversify across:
US large-cap stocks
Mid-cap and small-cap stocks
International equities
Fixed income (corporate, municipal, Treasury bonds)
Alternative investments (REITs, commodities, private equity)
The right allocation is driven by your goals, risk tolerance, time horizon, and income needs. Allocation decisions are the primary driver of portfolio volatility and long-term returns.
Key point: Asset allocation is about risk and return balance, not taxes.
Asset Location: The “Where” — and Why It Matters for Taxes
While allocation answers what you own, asset location answers where you own it — and this is where the tax savings happen. Most investors have money spread across three types of accounts:
Taxable accounts — Individual or joint brokerage accounts. Gains and income are taxable in the year they occur.
Tax-deferred accounts — Traditional IRA, 401(k), or similar plans. Taxes are deferred until withdrawals, and withdrawals are taxed at ordinary income rates.
Tax-free accounts — Roth IRA or Roth 401(k). Contributions are made after-tax, but qualified withdrawals are tax-free.
Different investments generate different types of income, and not all income is taxed the same way:
| Investment Type | Common Income Type | Tax Treatment (if in taxable account) |
|---|---|---|
| Bonds (Treasuries, corporate, CDs) | Interest | Ordinary income rates (up to 37% federally) |
| Municipal bonds | Interest | Generally federal tax-free; may be state tax-free if in-state |
| US stocks | Qualified dividends & capital gains | 0%, 15%, or 20% long-term capital gains rates |
| REITs & some alternatives | Non-qualified dividends | Ordinary income rates |
| International stocks | Dividends (may be partially non-qualified) | Eligible for foreign tax credit in taxable accounts |
The goal is to match the investment’s tax efficiency with the right account type. For example:
High-tax-cost assets like taxable bonds, REITs, and high-turnover funds are often best in tax-deferred accounts to shelter ongoing income from annual taxation.
High-growth assets like small-cap stocks or aggressive equity funds may be best in Roth accounts so future growth can be withdrawn tax-free.
Tax-efficient assets like broad-market equity ETFs or municipal bonds can be comfortably held in taxable accounts without significant tax drag.
Why It Works
When you shelter tax-inefficient income inside an IRA or 401(k), you delay or avoid paying high ordinary income rates every year. That means more money stays invested and compounds over time. Conversely, putting tax-efficient investments in taxable accounts allows you to take advantage of:
Lower capital gains rates
Tax-loss harvesting opportunities
Step-up in basis at death (for taxable holdings)
Even though the overall asset allocation doesn’t change, the after-tax return can improve noticeably.
Advanced Moves for Asset Location
For more complex portfolios, asset location can also include:
Pairing Roth conversions with location strategy — Converting pre-tax dollars to Roth and placing your highest-growth investments there to maximize tax-free compounding.
Using municipal bonds strategically — Holding munis in taxable accounts when you’re in a high tax bracket, freeing up space in IRAs for higher-yield taxable bonds.
Placing international stocks in taxable accounts — So you can use the foreign tax credit, which you lose if they’re in an IRA.
Rebalancing with new contributions instead of sales — This keeps location optimal without triggering unnecessary taxable events.
Putting It Together: A Simple Example
Let’s say your desired allocation is 60% stocks, 40% bonds and you have $1 million split evenly between a taxable account and a traditional IRA.
Without tax-efficient location:
Each account holds 60% stocks, 40% bonds.
Bond interest in the taxable account is taxed at ordinary income rates every year.
With tax-efficient location:
Put most or all bonds in the traditional IRA (tax-deferred).
Hold more of the stocks in the taxable account, benefiting from lower capital gains rates and tax-loss harvesting opportunities.
The allocation across all accounts is still 60/40 — you’ve just rearranged where the assets live to minimize the tax drag.
Why This Matters
Studies by Vanguard have found that a thoughtful asset-location strategy can add 0.05% to 0.30% in annual after-tax returns. Over decades, that’s a meaningful boost to your wealth without taking more risk.
It also helps in other planning areas:
Roth conversion strategies — placing high-growth assets in Roth accounts can increase long-term tax-free compounding.
RMD management — holding slower-growth, income-producing assets in pre-tax accounts can help control future required distributions.
Charitable giving — appreciated stock in taxable accounts is more valuable for gifting than bonds.
Common Pitfalls
Chasing perfection — Don’t overcomplicate it. Minor deviations aren’t worth big transaction costs or rebalancing headaches.
Ignoring changes — As tax laws, yields, and your personal circumstances change, your asset location strategy should too.
Mixing the concepts — Allocation and location are different levers. You don’t want tax efficiency to compromise your overall investment risk and return targets.
Bottom Line
Asset allocation gets the headlines, but asset location quietly works in the background to keep more of your returns in your pocket. A thoughtful combination of both can improve your portfolio’s efficiency without increasing risk — and when it comes to long-term investing, small tax savings compounded over decades can be a big deal.
Sources:
Vanguard Research. Revisiting the Conventional Wisdom Regarding Asset Location. 2022.