Best for: Anyone who’s maxed out their 401(k) and Roth IRA and is wondering if it matters which funds go where.
Asset allocation is about how much you own of stocks versus bonds. Asset location is about where you hold them.
It matters because the IRS taxes different accounts differently. Put the right assets in the right accounts and you keep more of your money. Mess it up and you’re paying taxes you don’t need to pay.
The Tax Treatment of Your Accounts
Traditional 401(k) and IRA: Every dollar you pull out is taxed as ordinary income. Doesn’t matter if it’s from stocks, bonds, or cash. It’s all ordinary income when it comes out.
Roth IRA: You already paid taxes going in. Everything that comes out is tax-free. Growth, dividends, capital gains. All tax-free.
Taxable brokerage account: You pay taxes on dividends each year. You pay capital gains taxes when you sell. Long-term capital gains (held over a year) are taxed at 0%, 15%, or 20% depending on your income. Short-term gains are taxed as ordinary income.
Those different tax treatments mean some investments work better in some accounts than others.
What Goes Where
Traditional 401(k) and IRA: Put bonds here.
Bonds pay interest. That interest is taxed as ordinary income. If you hold bonds in a taxable account, you’re paying taxes on that interest every year.
In a Traditional 401(k) or IRA, that interest grows tax-deferred. You don’t pay taxes until you pull the money out. And by then, you might be in a lower tax bracket in retirement.
Bonds also don’t grow as fast as stocks. If you’re going to hold something that grows slowly, put it in the account where it gets the tax advantage.
Roth IRA: Put your highest-growth stocks here.
Everything in a Roth grows tax-free forever. If you’re going to hold something that might 10x or 20x, you want it in the Roth so you never pay taxes on those gains.
Individual stocks, growth funds, small-cap funds, international stocks with high growth potential. These all belong in the Roth if you have room.
Taxable brokerage: Put tax-efficient stock funds here.
Index funds like VTI and VXUS are extremely tax-efficient. They don’t generate much in taxable dividends. They don’t have a lot of turnover triggering capital gains.
If you have to hold stocks in a taxable account (because you maxed out your 401(k) and Roth), these are your best options.
You can also hold municipal bonds here if you need bonds in taxable accounts. Municipal bond interest is exempt from federal income tax, which makes them more efficient than regular bonds in taxable accounts.
What About REITs and Other Special Cases?
REITs (Real Estate Investment Trusts) throw off a lot of taxable income. They’re required to distribute 90% of their income to shareholders. That income is taxed as ordinary income.
If you hold REITs, keep them in your Traditional IRA or 401(k). Same goes for any other investment that generates a lot of ordinary income.
Don’t Overthink This
Asset location is nice to have, but it’s not make-or-break.
If you have $50,000 in bonds and only $30,000 of space in your Traditional IRA, just put $30,000 of bonds in the IRA and the rest in your taxable account. It’s fine. You don’t need perfect optimization.
The gains from asset location are real but relatively small compared to the gains from just investing consistently and not panicking during downturns.
The One Thing You Should Never Do
Don’t hold municipal bonds in a Traditional IRA or Roth IRA.
Municipal bonds are tax-exempt. That’s their entire advantage. If you put them in a tax-advantaged account, you’re wasting the tax exemption because everything in that account is already tax-advantaged.
It’s like using an umbrella indoors. Technically you can do it, but why?
The Bottom Line
Bonds go in your Traditional 401(k) and IRA where the interest grows tax-deferred.
High-growth stocks go in your Roth IRA where gains are tax-free forever.
Taxable accounts can hold tax-efficient stock index funds or municipal bonds if needed.
Don’t stress if you can’t optimize perfectly. Close enough works fine.
And whatever you do, don’t put muni bonds in an IRA. That’s just wasteful.