The importance of asset location in wealth planning

When it comes to building and preserving wealth, most investors understand the importance of asset allocation — determining the right mix of stocks, bonds and other investments based on their risk. But there’s another layer of strategy that often gets overlooked: asset location.

Asset location refers to strategically placing different types of investments across different account types to minimize taxes and maximize after-tax returns. This is particularly important for New Hampshire business owners and investors with multiple accounts — taxable investment accounts, IRAs, Roth IRAs, 529 plans and trusts, to name a few. The question isn’t just what to invest in, but where to invest it. Understanding the three main buckets of investment accounts can help you keep more of your wealth working for you.

Taxable brokerage accounts — funds held outside of any tax-advantaged retirement or education account — represent the foundation of many investment portfolios. In these accounts, you pay federal income taxes on dividends, interest and capital gains each year. This ongoing tax liability makes taxable accounts less efficient for high-turnover trading or income-generating investments. However, there are no contribution limits, no age restrictions on withdrawals, and no required distributions.

The key to optimizing taxable accounts is recognizing which investments create the most favorable tax outcomes when held here. Non-dividend–paying stocks are ideal candidates for taxable accounts. Since these investments generate returns primarily through capital appreciation rather than ongoing income, you defer taxation until you sell, and then you benefit from long-term capital gains rates (significantly lower than ordinary income rates, which can reach 37%).

Holding appreciated stocks in a taxable account allows them to grow with minimal annual taxes unless the stocks are sold. Similarly, you can also donate appreciated stocks to charity to avoid capital gains taxes and get a charitable deduction. However, if you need to rebalance or make changes, selling appreciated investments may trigger capital gains taxes if not offset by losses. The tax costs, however, can be stepped up to date of death value on securities on the death of the owner potentially eliminating all capital gains tax when the securities are sold by the beneficiary.

Tax-deferred accounts like Traditional IRAs and 401(k)s allow your investments to grow without annual tax liability; you only pay taxes when you withdraw funds, presumably in retirement when your tax bracket may be lower. This tax-free compounding can strengthen long-term returns, especially for investments that generate ongoing income.

High-dividend–paying stocks, bonds and fixed-income investments all generate ordinary income, taxed at your full tax rate.

These investments are prime candidates for tax-deferred accounts. It’s crucial to understand that tax-deferred accounts come with constraints: required minimum distributions beginning at age 73, potential early withdrawal penalties before age 59 ½, and eventual taxation at your full ordinary income tax rate when funds are distributed. Still, they remain valuable for investors anticipating lower tax brackets in retirement, or those pursuing active trading strategies where avoiding short-term capital gains taxation gives significant tax savings.

Roth IRAs, 529 education savings plans and certain other tax-exempt accounts operate on a fundamentally different principle: Contributions are made with after-tax dollars, but all future growth is tax-free, and qualified distributions carry no tax liability whatsoever. This makes these accounts exceptionally valuable, especially for younger investors. Over decades, tax free compounding can result in substantially larger after-tax wealth compared to taxable accounts.

Because there’s no future tax on distributions, Roth and tax-exempt accounts that have long investment horizons should be considered to hold your highest-growth-potential investments with a more aggressive asset allocation. For younger investors, this might mean an aggressive allocation of growth stocks and equity-focused mutual funds. For education savings through 529 plans, similarly aggressive allocations early on can build substantial education funds without tax consequences when the funds are distributed for educational expenses. High-turnover mutual funds — which generate frequent short-term capital gains normally taxed as ordinary income — are excellent candidates for these accounts. Inside a Roth IRA, a fund’s active trading creates no tax liability. The compounding effect is dramatic: An investment that doubles in a taxable account incurs capital gains tax if liquidated; the same investment doubling in a Roth IRA has no tax consequence.

Susan Martore-Baker is president of Cambridge Trust Company of NH, and Brian Bickford is senior vice president, director of client portfolio management, with Cambridge Trust Wealth Management.