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By Christine Benz | 03-06-2013 02:00 PM

Asset Location: Not So Black and White

Investors need to rethink rules of thumb about asset location and understand the interplay between tax efficiency and expected returns, says financial-planning expert Michael Kitces.

Christine Benz: Hi, I'm Christine Benz for Deciding which asset types to place inside which types of accounts is an important consideration. Joining me to discuss this topic is financial-planning expert Michael Kitces. Michael, thank you so much for being here.

Michael Kitces: My pleasure.

Benz: So most investors have heard of asset allocation and understand its importance. There's another area of planning called asset location. Let's discuss first of all what that means?

Kitces: So most people are familiar with this asset-allocation concept: We're going to own different investments of different types; hopefully they will be well-diversified with low correlations; some things will zig, while others zag. So the whole idea of asset location is to say, "Great, we've got all these different investments, but we also have a lot of different types of accounts, particularly in the individual world." So we've got brokerage accounts, then we've got IRAs, and we've got Roth IRAs. Each of those has different tax treatments. So the whole principal of asset location is to say, "Once we've allocated our assets, in which accounts do we put which investments?"

Now the starting point for this was pretty straightforward. Stocks have preferential long-term capital gains treatment; we're going to buy and hold them for a really long period of time. So let's take that in the brokerage account …

Benz: Taxable.

Kitces: Yeah, taxable account because we're not planning on paying taxes on it for a long time anyway, since we're just going to hold on to that investment as a core, and beyond that we get these favorable, capital gains rates. Then let's take the bonds, which churn off all this ordinary income that they kick out every single year because we get paid bond interest, we will put those inside of the IRA and let those compound inside the IRA. We are going to get ordinary income treatment no matter what, whether it's bond interest or inside of an IRA, but at least, if it's inside the IRA, we can let it compound inside, get a little bit better tax-deferred compounding, and then at some point down the road, we will pull the money back out and pay the taxes.

So that was sort of the basic principal of asset location. The problem is as the environment shifts, it doesn't necessarily work as well as a rule of thumb for where we are today.

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