What is Asset Location and why is it Important?
I heard on a podcast recently that personal Finance is more personal than finance. I cannot agree more with this statement. Many decisions and questions in personal finance come down to “it depends”. Sure, there are some things that have an objective answer, but there are probably more questions that are subjective and personal and do not have a single answer.
Should I spend less than I earn? Yes, you should.
Should I put the savings in bonds, a saving account or invest in index funds, ETFs or stocks? It depends on your risk appetite.
Should I carry credit card debt? No, you should not.
Should I have a traditional IRA or Roth IRA account? It depends.
Should I have an emergency fund? Yes, you should
Should I have a 529 account, HSA account and/or a custodian brokerage account for my kids? It depends.
Should I contribute to my 401K to get the free employer match? Yes, you should.
Should I max out my 401K or invest in a brokerage account instead? It depends.
Should I pay-off my mortgage early or keep making the payments since the interest rate is so low? It depends.
As you can see, there are so many things in personal finance that are not set in stone and are unique to individual circumstances. The topic that I am writing about today is one of these subjective decisions. What is Asset Location and should you care for it? It depends. First, let's try to understand what asset location is.
I talked about a hierarchy of accounts that you can use for investing in the stock market in this article. Once you have these investment accounts open, the question becomes what to buy in each of these accounts. This is a good problem to have since that means that you have all the right accounts open. You are just trying to decide which assets to buy in each account. This is called Asset Location.
Now that you understand what is asset location, let’s talk about why asset location is important. So let’s say you have a 401K account, a traditional IRA or a Roth IRA, Health Savings account (HSA) and a taxable brokerage account. You should think about an optimal allocation of assets in these accounts. Remember that whatever happens in a 401K/IRA/HSA account stays out of your tax return. In other words, any capital gains/losses or dividends in these accounts do not enter in your taxable income calculation. So, ideally, if you want to invest in a stock/fund that pays dividends, it makes sense to buy that in a tax-deferred account like 401K/IRA/HSA. If you instead bought a dividend paying stock/fund in a taxable brokerage account then that dividend will get added to your taxable income and you will need to pay income tax on those dividends.
The bad news is that if you invest in the stock market, it is inevitable that some of your investments will not pan out and you will lose money on those stocks. As I wrote in this article, it is totally expected and every investor will experience some losses on their investments. The good news is that if those losses happen in a taxable brokerage account, you will be able to offset your capital gains using those losses and only pay taxes on the net amount. However, if those losses happen in a tax-deferred account like 401K/HSA/IRA, you will not be able to use those losses to offset your gains because transactions in those accounts never enter your taxable income. Therefore, in my opinion, it is a good idea to buy only those stocks/funds in tax-deferred accounts that you have high-conviction on. If you are just buying a starter position in a stock/fund that you are not sure about and you want to learn more about that company before you commit additional funds, it is a good idea to do that in a taxable brokerage account because if you decide to exit that position at a loss, you can use that loss to reduce your taxable income and pay lower taxes. For simplicity purposes, I am assuming that you hold your investments for at least 12 months and therefore qualify for long-term capital gains rates.
So, if you think about it, you can use a brokerage account like a tax-deferred account. Buy positions that don’t pay dividends and hold them for long-term and rarely sell. You won’t have to pay any taxes on dividends and if you let compounding work for you, you don’t have to worry about paying taxes on your gains if you don’t sell often. This topic of asset location is a bit tricky and requires a change in mindset and as I mentioned at the beginning, is a good problem to have.
In the second-half of this article, I want to talk about my first webinar that is scheduled for tonight at 7 PM Central Time. If you would like to attend that, you can register here or just email me at gauravkumar08@gmail.com. There is no cost to attend this webinar. More information about this webinar is available here.
My second webinar which is scheduled for next Wednesday (Nov. 4th) at 7 PM Central Time. I will cover these topics in that webinar: Save to Invest: How much money you should save before you start investing? You can register for my second webinar here
How saving and investing work together?
The concept of emergency fund: How much do I need?
Invest only that money that you don’t need for the next 2-3 years.
What is your holding period?
What is dollar-cost averaging and how does it benefit you?
How often should I invest?