Why where you hold investments matters

Matt: Okay, when it comes to investing, it's not just what you invest in, it's where you hold it.

This morning in Matt on the Money, we're talking about tax-efficient investing and a strategy called asset location.

Dan Bennett from Lakewater Advisory is back with us. Dan, I want to start simple for this one. What does asset location mean, and why does it matter for everyday investors?

Dan: At a very high level, you've got stocks and bonds, for example, and then you have different account types: traditional 401(k)s, tax-deferred accounts, Roth accounts, and taxable accounts.

Matt: And this is when you get taxed on those accounts?

Dan: Right. Asset location is simply where those types of investments are being held within those different account types in order to minimize taxes and maximize after-tax returns.

Matt: I think that's so hard for people to game out because they don't necessarily know what income bracket they're going to be in when they get to retirement. They can look at what they're earning right now and know what tax bracket they're in, but what do you tell people when they're not sure how much they'll be bringing in 30 years from now?

Dan: I think that's where tax optimization planning within your investment accounts becomes so important.

There's a term called tax drag. If you have a taxable brokerage account and you're holding assets like taxable bonds that might yield 4% or 5%, you're being taxed on that interest every year even though you're not selling anything.

We want to make sure that if you're going to hold bonds, those are being held more in tax-deferred accounts so you're not artificially increasing your taxable income today when you don't necessarily need to.

Matt: Okay. So how should people think about what belongs in a taxable account, like a brokerage account, versus a traditional 401(k) or IRA versus a Roth?

Dan: In my opinion, taxable brokerage accounts should be the most tax-optimized.

That means avoiding things like dividend-paying stocks, high-yield bond funds, or certain real estate investments that may generate taxable income.

For tax-deferred accounts, if bonds make sense within your overall asset allocation, that's where those should generally be held.

Tax-free accounts should typically be your most aggressive investments. So your Roth IRA or Roth 401(k) might hold stocks, international stocks, or small-cap investments because you have years and years of potential tax-free growth.

Matt: For people who have a goal of retiring 10 or 15 years early, is the brokerage account where you tend to tell them to focus?

Dan: It's your Swiss Army knife account.

It doesn't have to be used for just one purpose. It can be used for college education for your children, retirement, early retirement expenses, COBRA insurance premiums, or other medium- and long-term goals.

Matt: Medium-term goals, right?

Dan: Yeah. Medium- or long-term goals depending on how you want to structure it.

Matt: Are there certain types of investments, like dividend-paying stocks or bonds, that really benefit from being in the right account?

Dan: Yes. That's where tax-deferred accounts can really play an important role.

If we look at asset allocation, which is how your money is invested, let's say you're following a traditional 60/40 portfolio, with 60% stocks and 40% bonds.

You may have three different account types. One approach is a mirrored allocation where every account is invested 60% in stocks and 40% in bonds.

Another approach is to optimize where those assets are held.

For example, if you have $300,000 total, with $100,000 in a brokerage account, $100,000 in a 401(k), and $100,000 in a Roth account, you could allocate them differently.

You might have 100% stocks in the brokerage account, more bonds in the 401(k), and perhaps an 80/20 mix in the Roth account.

You still maintain the same overall 60/40 asset allocation, but you're optimizing where those investments are located.

Matt: So it sounds like if your tax situation is that complicated and you have that many accounts, it's probably a good idea to meet with somebody.

Dan: I think so.

Asset allocation is going to be the most important factor for most investors. Asset location is more of a fine-tuning strategy that can help improve tax efficiency around the edges.

Matt: Such a smart way to think about investing and something a lot of people overlook. Dan, thanks as always. We'll have you back soon.

More Good Day after a quick break.