Portfolio Building: Diversification and Asset Allocation

Where you hold each fund changes what you keep after tax. Place funds by account, set a three-fund mix, and rebalance without a tax bill.

By Michael Hewitt, Founder & Editor-in-Chief. Updated September 28, 2026.

Allocation is what you own. Location is where you keep it. Most portfolio advice stops at the first, but once you have a taxable account next to a 401(k) or IRA, putting each fund in the right account costs nothing but an afternoon. On the worked example below, it cuts the yearly tax bill by $135 on a $100,000 portfolio and $675 on $500,000, before the larger effect of letting stocks compound untaxed in the Roth. Bonds go where their interest is sheltered, broad stock index funds go where tax is lightest, and the fastest growers go in the Roth. The allocation itself takes three funds, or one.

Asset Location: Where to Hold What

Asset location (also called tax location) starts to matter once you have more than one kind of account. Bonds, REITs and actively managed funds pay out income taxed at your ordinary rate every year. A broad stock index ETF pays little beyond qualified dividends, which are taxed at a lower rate. Put the heavy payers where tax is deferred or gone, and the light ones in taxable.

• Taxable brokerage: U.S. and international stock index ETFs (VTI, VXUS), plus municipal bonds if bonds have to live there.
• Roth IRA: the highest expected-return assets, such as small-cap and emerging-market stocks, because that growth is never taxed.
• Traditional 401(k) or IRA: taxable bonds, REITs and anything else that pays ordinary income.
• A target-date fund cannot do any of this, because it holds the same mix in every account. That is fine with one account or a small taxable balance, and a reason to move to separate funds as the taxable account grows.

Asset Location: Two Worked Portfolios

Assumptions: a 70/30 stock/bond allocation split 40% taxable, 30% Traditional 401(k) and 30% Roth IRA; 24% federal plus 6% state on ordinary income; 15% on qualified dividends and long-term gains; bonds yielding 4.5%; stocks paying 1.5% in qualified dividends plus 5.5% in price growth; 30 years. "Mirror" holds 70/30 in every account. "Located" holds only stocks in taxable and the Roth, and only bonds in the Traditional account.

• Portfolio A, $100,000 ($40,000 in taxable). Mirror: $12,000 of bonds in taxable pay $540 of interest and $162 of tax, and $28,000 of stocks add $63 of dividend tax, for $225 a year. Located: $40,000 of stock ETFs pay $600 of dividends and $90 of tax. Saving: $135 a year on the tax bill alone.
• Portfolio B, $500,000 ($200,000 in taxable). Mirror: $2,700 of bond interest taxed at $810, plus $315 of dividend tax, for $1,125 a year. Located: $450 a year. Saving: $675 a year.
• The annual tax bill is the visible part. The rest comes from the stocks compounding untaxed in the Roth while the slower-growing bonds sit in the Traditional account, where every dollar withdrawn is taxed.

When Asset Location Backfires

"Bonds in the Traditional account, stocks in the Roth" is a default, not a law. Four situations change it.

• A small taxable account (under $25,000): the dollar drag is trivial and the extra funds are not worth managing. Hold a target-date fund everywhere until balances grow.
• The Roth is your only tax-advantaged account and bonds end up in taxable: municipal bond funds (VTEB, VWIUX) often beat taxable bonds after tax for anyone in the 24% bracket or higher. A 3.5% muni yield matches a 5.0% taxable yield at a 30% combined rate.
• International funds: the foreign tax credit (worth 0.15-0.40% a year) is lost inside a Roth, because there is no U.S. tax for it to offset. Hold international index funds in taxable and claim the credit on Schedule 3 of Form 1040, even though emerging markets otherwise suit the Roth.
• High-yield dividend ETFs (SCHD, VYM): at 2.5-3.5% yields they carry more tax drag than broad-market funds. Hold them in the Roth or Traditional account, not in taxable.

The 3-Fund Portfolio

Location only pays once the allocation is set, and the allocation needs three funds, not thirty. Together they cover almost the entire global market:

• Total U.S. Stock Market Index (VTI, FSKAX): 50-60% of the stock allocation.
• Total International Stock Index (VXUS, FTIHX): 30-40% of the stock allocation.
• Total Bond Market Index (BND, FXNAX): the whole bond allocation.
• For the stock/bond split, "110 minus your age" in stocks is a rough starting point (80/20 at 30, 50/50 at 60), not a plan. The next section shows what each split has cost in its worst year.
• The one-fund version: a target-date retirement fund holds all three and shifts toward bonds as you age. With a single account, it is all you need.

How Allocation Changes Returns and Volatility

The stock/bond split sets two numbers: the long-run return and the worst year you will have to sit through. The second is the one that makes people sell. Historical figures, 1970-2024:

• 100% stocks: about 10.2% a year, worst year -37% (2008). For horizons of 30 years or more.
• 80/20: about 9.5%, worst year -29%. The classic aggressive mix.
• 60/40: about 8.7%, worst year -20%. The standard balanced benchmark.
• 40/60: about 7.5%, worst year -12%. Suits the approach to retirement.
• 20/80: about 6.2%, worst year -6%. Capital preservation.
• On $100,000 over 30 years at these returns, 100% stocks grows to about $1.84 million, 60/40 to $1.23 million and 20/80 to $612,000. Choose the most aggressive mix whose worst year you could watch without selling.

Rebalancing Without a Tax Bill

Markets change your allocation without asking: after a strong run for stocks, a 70/30 portfolio drifts toward 75/25 and carries more risk than you chose. Check once a year on a fixed date (January works), treat all your accounts as one household portfolio, and act only when an asset class is more than 5 percentage points off target.

How you rebalance matters more than how often, because a sale in a taxable account can cost you tax and a trade inside a 401(k) or IRA costs nothing.

• Worked example: Portfolio A from above, located (stocks in taxable and the Roth, bonds in the Traditional 401(k)), is worth $100,000 and has drifted to 77/23. Getting back to 70/30 means moving $7,000 from stocks to bonds.
• Sell in taxable: selling $7,000 of the stock ETF realizes the gain on those shares at the 15% long-term rate, or $150 per $1,000 of gain. If the shares have doubled since you bought them, $3,500 is gain and the bill is $525. The proceeds then buy bonds in taxable, undoing the location above.
• Trade inside the Roth: sell $7,000 of the stock fund and buy $7,000 of a bond fund in the same account. No tax at all.
• Send new money to bonds: $10,000 of new contributions into the bond fund brings 77/23 back to 70/30 ($33,000 of $110,000) without selling anything.
• The order: new contributions first, trades inside tax-advantaged accounts second, sales in taxable last.
• The exception runs the other way: shares in taxable worth less than you paid. Selling them realizes a loss that offsets gains, plus up to $3,000 of ordinary income a year. Do not buy a substantially identical fund within 30 days either side of the sale (the wash-sale rule).

Key Takeaways

• Asset location costs nothing and cuts the yearly tax bill: bonds and REITs in the Traditional account, broad stock index ETFs in taxable, the highest-growth funds in the Roth.
• Three total-market index funds cover nearly the whole global market; a target-date fund does it in one but holds the same mix in every account, so it cannot do asset location.
• Pick the most aggressive allocation whose worst year you could sit through, and treat "110 minus your age" as a starting point rather than a plan.
• Rebalance when an asset class drifts more than 5 points from target, using new contributions first, trades inside tax-advantaged accounts second, and taxable sales last.