Key Takeaways

• Investors may spend a lot of time thinking about what investments to make and not enough about where they should be kept.
• Taxable, tax-deferred and tax-free accounts each have a role to play when it comes to reducing taxes for you and your heirs.

Most investors understand the concept of asset allocation. It’s how they divvy up their savings—among stocks, bonds, annuities, cash, real estate, etc.—to manage risk and improve long-term returns.

But asset location—a similar-sounding term with a very different meaning—is no less important, especially when it comes to saving on taxes. Asset location is a tax-minimization strategy for determining which types of investments are best suited for which types of accounts. One way to think of it: You wouldn’t store eggs in the freezer. Similarly, you shouldn’t put tax-exempt municipal bonds in a regular Individual Retirement Account (IRA)—because a tax-deferred IRA is one place where tax-exempt income is not actually tax-exempt.

Problem is, investors tend to be more focused on the what than the where. “They’re always thinking about asset allocation and not giving any thought to asset location,” says Joe Goldgrab, a TIAA executive wealth management advisor based in New York City. "It’s one of the biggest pain points I have when I meet with clients."

There are three main types of investment accounts—taxable, tax-deferred and tax-free. Our general rule of thumb with asset location: The more tax-efficient an investment is, the better-suited it is for taxable accounts. The less tax-efficient an investment is, the better suited it is for tax-deferred and tax-free accounts.

Below is a detailed breakdown of which assets belong where:

• Taxable accounts are conventional brokerage accounts that can hold stocks, bonds, mutual funds, exchange traded funds (ETFs) or really any type of security. They are taxed when you earn interest and dividends or when you sell investments at a profit, generating capital gains.
  
  Which investments are best suited for taxable accounts? As we said before, tax-exempt municipal bonds and municipal bond funds are an obvious choice because the income is generally tax-free. If you held the same bonds in a tax-deferred IRA, you or your heirs would pay ordinary income tax on all the amounts distributed once you start taking required minimum distributions (RMDs).
  
  Taxable accounts are also ideal for any individual stocks, index funds or ETFs that are purchased with an eye toward leaving them to heirs. (Actively managed equity funds with high turnover rates are a different story—more on those in a moment.) One of the advantages of holding such assets held in taxable accounts is, under IRS rules, they get a step-up in cost basis after you pass away. “That makes them great assets to inherit,” says Evan Potash, a TIAA executive wealth management advisor in Newtown, Penn. Say you buy shares of a blue-chip stock today for $100,000, and their value soars to $600,000 by the time of your death. Thanks to the step-up in cost basis, your heirs won’t pay any tax on the $500,000 gain—whereas had the shares been held in a tax-deferred account, all withdrawals would be taxed at your beneficiaries' ordinary income tax rates.

• Tax -deferred accounts, such as traditional 401(k)s, 403(b)s and IRAs, allow investments to grow tax-deferred, with no taxes owed until you withdraw funds (which are then taxed at ordinary income tax rates). Because holdings are not subject to capital gains taxes, these accounts are ideal locations for actively managed equity funds that distribute lots of short- and long-term capital gains to fundholders due to high turnover rates.
  
  For mutual fund investors, it can be frustrating to pay capital gains taxes on profits that were earned before you bought the fund. “Suddenly the fund manager sells Apple stock that he’s owned since 2006,” says Goldgrab. “You didn’t own Apple in 2006, but now you’re getting a 1099 form at the end of the year with these large capital gains. If you own the fund in a tax-deferred IRA, you don’t have to worry about that.”
  
  Taxable bonds, taxable bond funds and fixed annuities are also well suited for tax-deferred accounts. Taxes are deferred until you start withdrawing money in retirement. Not only will that allow your fixed-income holdings to grow faster, but your tax bracket might be lower in retirement than before retirement.
  
  There’s a similar argument for holding high-dividend stocks. In a taxable account, qualified dividends are taxed at rates up to 20%. In a tax-deferred account, you don’t owe dividend taxes, which means dividends can be reinvested (and can keep growing) with no taxes owed until you make withdrawals. That said, consult with a tax professional or your TIAA financial advisor before investing; for some investors, it is possible the difference between a lower tax on dividends now versus a higher tax on withdrawals at ordinary income tax rates later will supersede the value of tax-deferred growth.
• Tax -free accounts, such as Roth IRAs, Roth 401(k)s and Roth 403(b)s, are funded with after-tax dollars. As with tax-deferred accounts, the investments grow tax-free. Unlike with tax-deferred accounts, the withdrawals are generally tax-free too—for you or for your heirs. One limitation of Roth IRAs: You cannot contribute to one unless your income falls below certain thresholds. Tax-deferred IRAs can be converted to Roth IRAs, but you’ll owe ordinary income taxes on the amount converted—which puts a premium on proper asset location. Whatever assets you keep in a Roth account should have enough appreciation potential to justify the cost of the conversion. Thus, the assets well-suited for tax-free accounts include equities with high earnings growth as well as equity mutual funds and equity ETFs with a similar growth trajectory.
  
  With this in mind, Potash suggests considering Roth conversions as an estate planning tool. Not only will the conversion reduce your taxable estate by prepaying future income taxes, but it may allow your heirs to inherit highly appreciated assets without an accompanying tax bill. Says Potash, “All of the growth is tax-free to the heirs.”

If you need help understanding asset location and how it can benefit your retirement plan, talk to your TIAA wealth management advisor. Don’t yet have an advisor? Schedule an appointmentOpens in a new window.