Location optimization, once financial advisors understand it, can be a great tool to save on taxes for clients, adding to their bottom line without taking on additional risk.

Location optimization, in basic terms, is locating specific types of investments in specific types of accounts to minimize taxes.

There are essentially three types of accounts: taxable, non-taxable and tax-deferred.

Taxable accounts are subject to tax as income is realized. Taxable bond interest, non-qualified dividends and short-term capital gains are all taxed at ordinary rates.

Long-term capital gains are taxed at capital gain rates only when sold.

Non-taxable accounts, such as Roth individual retirement accounts, never pay tax.

And tax-deferred accounts, such as IRAs and 401(k)s, are subject to ordinary tax only when distributions are made or when inherited.

Investments can be also categorized according to tax characteristics.

Some investments throw off continuing ordinary income, such as taxable bonds, while other investments are held primarily for appreciation. Still other investments are held for long-term growth.

By correctly matching the investment types to the most appropriate types of accounts, investors can save on both current and future taxes.

Typically, clients should hold tax-inefficient investments, such as bonds, in tax-deferred accounts. The interest won’t incur current taxes, and ordinary tax will only be paid on distribution.

That is OK because if held in the taxable account, it would have been subject to ordinary tax anyway.

Advisors should put clients’ appreciating investments, such as U.S. stock funds, in taxable accounts. They don't pay tax on appreciation until sold, at which point, gains will be taxed at capital gain rates.

If held in an IRA, the tax would eventually be paid at ordinary rates, equating to twice as much tax.

Finally, high-growth investments should be held in the Roth IRA to get the biggest benefit from the “forever” no-tax treatment. Because Roth IRAs are typically the last account to be tapped for distributions, they can ride out the short-term ups and downs.

To summarize the strategy: Hold high-growth investments in Roth IRAs to get the maximum benefit from non-taxable status. Hold appreciating assets in taxable accounts to defer tax on appreciation and only pay capital gains tax when sold, and hold tax-inefficient investments in the IRA to defer tax until distribution.

Location optimization is a win-win strategy, as it can save clients tax dollars and differentiate advisors from the competition.

Sheryl L. Rowling is principal at Rowling & Associates in San Diego.