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Asset Allocation - Location Matters

Taxes Taxes (Photo credit: Tax Credits)

Asset Allocation is an investment strategy that attempts to balance risk and reward by allocating a certain percentage of each asset in accordance to an investors risk tolerance, goals and investment horizon.

What is often overlooked is the importance that taxes will play in this decision making process and the location of those assets. Here are a few basic guidelines.

Tax Deferred Accounts: Hold assets with a higher tax costs in your tax deferred accounts. In general, government or corporate bonds and bond funds may be a better fit for tax deferred accounts (like IRAs and 401(k)s) than for taxable accounts because their payouts are taxed at an investor's ordinary income tax rate.

If you need to hold bonds in your taxable accounts, a municipal bond or municipal bond fund might offer you a better after-tax yield than a taxable bond investment, because income from municipal bonds is exempt from federal income taxes.

Taxable Accounts: Hold assets with low tax costs in your taxable accounts. By contrast, stocks and stock funds may generally be a better bet for taxable accounts. Long-term capital gains, which is what you have when you sell a stock that you've held for at least a year, are taxed at a much lower rate than bond income (however, these favorable tax rates are set to expire at the end of 2012).

Regardless of your investments you need to understand their risks. Stocks are not guaranteed and have been more volatile than the other asset classes over time. Dividends are not guaranteed. Bonds are subject to credit/default risk and interest-rate risk. Municipal bonds may be subject to the alternative minimum tax (AMT) and state and local taxes, and federal taxes apply to any capital gains distributions. Retirement accounts are tax-deferred vehicles designed for retirement savings. Any withdrawals of earnings will be subject to ordinary income tax and, if taken prior to age 59½, may be subject to a 10% federal tax penalty. This should not be considered tax or financial planning advice. Please consult a tax and/or financial professional for advice specific to your individual circumstances.