Asset location (AL) is a term used in personal finance to refer to how investors distribute their investments across savings vehicles including taxable accounts, tax-exempt accounts (e.g., TFSA, Roth IRA, ISAs, TESSAs), tax-deferred accounts (e.g., Canadian RRSP, American 401(k) and IRAs, British SIPPs, Irish Personal Retirement Savings Accounts (RPSA), and German Riester pensions), trust accounts (e.g., grantor retainer annuity trusts, generation-skipping trusts, charitable remainder trusts, charitable lead trusts), variable life insurance policies, foundations, and onshore vs. offshore accounts.
While asset allocation (AA) determines what assets to own and in what proportions, AL determines where those assets are held. While the objective of AA is to create portfolios with the greatest return for a level of risk, and to optimize individuals' risk exposure according to their risk tolerance, goals and investment time frame, the objective of AL is to maximize the benefits of different account-types - usually to minimize taxes. There are other objectives that can be personal (e.g., the liquidity of the wealth, the expected use of the funds, privacy, etc.).
In the discussion below the effective tax rate for any asset depends on a personal tax bracket, different countries' treatment of different types of income, personal frequency of realizing the tax liability (e.g. capital gains only taxable when sold after a multi-year holding period), the mix of income-types generated by an asset, and the net tax effect that includes both tax debits and credits (e.g. the treatment of dividend income in Canada and Great Britain).
Location Choice Methodology
Tax Rates
Although there is no academic support, it is common (now declining) to hear that assets with the highest effective tax rates should be prioritized in tax-shelter accounts. This will have been broadly appropriate over the 30 years from the 1980s to the 2000s in North America, as interest rates declined and debt's total returns matched the returns of equity. The rule is dependent on the assumption that total returns from different asset-types are equal. When interest rates are low and expected to rise that assumption will not be valid.
Tax Efficiency
Another common metric to decide which assets should be prioritized is tax-efficiency. This equals the dollars of tax payable per principal invested - the multiple of the asset's rate of return by its effective tax rate. Another way to look at the same metric is as the difference between the asset's nominal rate of return and its after-tax rate of return.
This metric measures the tax-sheltering benefits of the first year only. Reed finds that this metric fails over the life of the accounts. Given two assets with the same tax-efficiency, the asset with the larger rate of return will always create larger benefits in tax-exempt accounts. Even when a high-return asset has a lower tax-efficiency, given enough time it creates more benefits.
It is only when the effective tax rate is very low that its importance relative to the rate of return is equally strong or stronger.
Cumulative Benefit
Reed calculates the cumulative tax savings over varying time spans from tax-free growth. For tax-deferred accounts there may be an additional bonus (or penalty) from a lower (or higher) tax rate on withdrawal vs. contribution. Assets with the largest benefits are given priority into tax shelters. He points out that re-balancing to some asset allocation will reduce the benefits from asset location.
He concludes that 'it all depends' and general rules of thumb are not valid. For example, given enough time high return assets create the largest benefits from tax-free growth, but there may not be enough time, or the high return asset may result in a portfolio large enough to create a penalty from higher withdrawal tax rates.
Asset Types
Common advice is to locate tax-inefficient assets (such as bonds and real estate investment trusts) in the tax-advantaged accounts. This is to fully utilize any long-term capital gain, or capital gains allowances available in taxable accounts. Place income-generating investments into tax-deferred or non-taxable accounts, and place equity investments into taxable accounts. The deciding factor is apparently the effective tax rate on the asset's income.