Maybe you’ve heard it before when buying a home. Maybe I’m just thinking of this because I’ve heard it in the movies. But I picture the deal-making real estate agent extolling, “Location, location, location!”

Location may indeed be important when buying real estate, but it’s also important within your investment portfolio. While you may be familiar with asset allocation, asset location is similar in name but different in implementation.

Asset location is the process of determining which investments belong in which accounts based on the tax implications of those investments and the account types. For account types, think about a taxable brokerage account, an IRA, or a 401(k). Each has its own unique treatment for tax purposes, and you should make your investment decisions within each accordingly, if possible.

An asset location example

Like many topics, an example should help you understand the concept of asset location more clearly.

For simplicity’s sake, let’s say you have a taxable brokerage account and a Traditional IRA with equal dollar amounts in each. For your overall portfolio, you’ve decided on a 50/50 split between Investment A, which is growth orientated and does not pay a dividend or other income disbursement, and Investment B, which pays  monthly income. For the former, you receive a return on investment if its price increases and you sell it at a gain. For the latter, a large portion of the return on investment is the income disbursement that it pays.

When you hold investments in a taxable brokerage account, almost all income that you earn in a given year is taxable to you, even if you reinvest it. In a Traditional IRA, taxation on investment income is deferred and you do not pay taxes on the account until you begin to receive distributions from it.

You also would pay taxes on capital gains, aka selling an investment for more than you bought it for, in a taxable brokerage account but not in an IRA. However, long-term capital gains, aka holding for more than 12 months, currently receive preferential tax treatment and are taxed at 15% or less for most taxpayers. “Qualified” dividends also receive this preferential treatment, but not all investment income is a qualified dividend — corporate bond coupon payments would be one example that is not.

With these circumstances in mind, you would apply the concept of asset location by owning Investment A in the taxable brokerage account, and Investment B in the IRA.

In the taxable brokerage account, you would cap your tax exposure at 15% — or 20% if you’re in the highest regular income tax bracket — of any gain you realize on Investment A if you own it for one year or more. Since Investment A doesn’t pay an income disbursement, you will not have to pay taxes on payments like you would if you held Investment B in the account. If things go south for Investment A, you could cut your losses and sell it for a capital loss, which you could then use to offset other capital gains, or up to $3,000 of ordinary income, with carry-forward.

In the IRA, Investment B’s income disbursement is a moot point. No matter the amount of income you receive and reinvest from Investment B, you will not owe income taxes on the payments, because you own it in an IRA. If you held Investment A in the IRA, while it is true that you could avoid paying capital gains tax if you sold it at a gain, you would also remove the possibility utilizing the capital loss, if you had one, on your tax return.

There are unique circumstances where all of this can be turned on its head. Owning certain income paying investments, like Master Limited Partnerships, in an IRA can actually create Unrelated Business Taxable Income (UBTI), which would be taxable to you, in the year earned. It’s best to consult with your financial and tax advisor when considering your asset location.