Any way you can save for retirement will help, right? Well, you are on the right track if you are delaying gratification by socking money away for the future. However, there is a simple way to invest more efficiently. It’s called asset location, which is no more than paying attention to which account you use to buy certain securities. There are 3 major investment account types: tax-free (Roth 401(k) or Roth IRA), tax-deferred (IRA, 401(k), 403(b), qualified annuity, etc.) and after-tax (often called a ‘taxable account’ or ‘non-retirement account’).
I’m always surprised when reviewing a prospective client’s tax return for the first time if I find thousands of dollars in taxable interest and ordinary dividends. These two items are taxed as ordinary income, meaning they are taxed at the taxpayer’s highest rates. Examples include CDs, taxable bond funds, and REITs, which we recommend you should hold in a tax-deferred account, such as an IRA. It makes more sense to hold stocks and stock mutual funds in an after-tax account because long-term capital gains (held more than 1 year) and qualified dividends are taxed at 15% for most taxpayers, and 20% for those in the highest tax bracket. However, ordinary income, can be as high as 39.6%, plus an additional 3.8% surtax for some taxpayers. Also, stocks tend to be the most volatile, and if you experience a loss and sell, you can generally use the loss to off-set gains in other positions. Municipal bonds also fit into this bucket.
IRAs and other tax-deferred accounts are a good place to buy taxable bonds, CDs, and high turnover stock funds. If you enjoy trading stocks, an IRA might be a good place for this because there is no concern for short-term capital gains. In an after-tax account, these same short-term gains would be taxed as ordinary income!
Finally, we get to the Roth — the goose that lays golden eggs. There is just something special about the words ‘tax-free’ that make me smile. If you think about it, $100,000 saved in a Roth IRA is worth $100,000, but $100,000 saved in a traditional IRA is only worth $70,000, if your combined tax rate upon withdrawal is just 30%! Any type of growth investment can be suitable in a Roth, with the goal of maximizing the tax-free growth and compounding over time.
There are many other variables that can play a role in asset location, but being aware of where you put your money greatly impacts how much you keep, and ultimately what you receive when you take it out.