How do I know which of my investments are best in my IRA, Roth IRA or brokerage account? – Peter
It’s great that you are considering this – many people overlook the importance of where to hold different investments. Often, this is due to a lack of awareness of how significantly it can affect returns in general.
Tax treatment is the most important consideration when deciding where to hold your various investments. In particular, you’ll want to consider how different investments create different tax liabilities, as well as the different tax advantages associated with the different accounts you have.
Before diving in I want to clarify that this decision is different from a basic Roth vs. pre-tax account comparison. This choice is about when you prefer to pay income taxes on your pension savings: in advance on your contributions or in the future on your withdrawals.
The question we explain here assumes that we already have money in three types of accounts: a traditional IRA, Roth IRA, and a taxable brokerage account. Your question speaks directly to what it is called active placethe strategic placement of investments in different types of accounts to optimize tax efficiency and maximize after-tax returns.
However, the location of the asset should not be confused asset allocation – an investment strategy that calls for spreading the capital of a portfolio in different asset classes and diversifying into individual asset classes. (And if you need help with asset allocation or asset location, connect with a financial advisor and ask what changes they recommend for you.)
Some assets are better suited for pre-tax accounts like IRAs and 401(k)s, while others may be better suited for Roth accounts.
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Let’s review why asset location matters, starting with the basics.
There are two primary ways to earn returns from an investment: capital gains and cash flows. For example, if the stock price rises from $30 to $40, the $10 increase is known as a capital gain, which becomes taxable on the sale of the stock. Meanwhile, some investments also provide direct payments, such as dividends and interest, which are taxable when received.
These two types of investment returns they are taxed differently, which is a big reason why we want to think about the types of accounts that hold them. (And if you need help selecting tax-efficient investments or managing the taxes generated by your portfolio, consider working with a financial advisor.)
Capital gains are classified as long or short term. You pay a lower tax rate on long-term capital gains than you do on short-term capital gains:
Short-term capital gains: A gain from the sale of an asset held for one year or less. These earnings are taxed to you marginal income tax rate.
Long term capital gains: A gain from the sale of an asset held for more than one year. These earnings are taxed at lower rates than 0%, 15% or 20%depending on your total income.
Meanwhile, ordinary dividends and interest are considered ordinary income and taxed according to your marginal tax rate. Certain dividends, called qualified dividendsreceive long-term capital gains tax treatment. Also, the interest you receive from municipal bonds is tax-free.
However, to simplify so that we can focus on the concept of asset location, we will assume that all your dividends, interest payments and short-term capital gains are taxed as ordinary income.
A man is looking for investment options in his IRA.
Assuming you have a diversified portfolio, you may hold some investments that pay dividends or interest, as well as others that generate capital gains. In general, it’s best to put cash-flow producing investments in tax-advantaged accounts like IRAs and Roth IRAs, and keep investments that pay less cash in brokerage accounts.
You can consider putting your investments that generate taxable income in your Traditional IRA. Remember, traditional IRAs protect you from taxes until you withdraw the money. Since those withdrawals are taxed as income anyway, you don’t lose any benefits by doing so.
Coupon bonds that make regular interest payments or stocks that pay a lot of regular dividends are good examples of investments that you might consider holding in a tax-deferred account like a traditional IRA or 401(k).
Like traditional IRAs, Roth IRAs provide a tax shield on the investments held in the account. You don’t have to worry about taxes on capital gains, dividends or interest with a Roth IRA. However, unlike withdrawals from traditional IRAs, qualified retirees from Roth IRAs are tax free. That’s because Roth IRA contributions are taxed before they go into the account.
To get the most benefit from the tax-free growth that Roth IRAs offer, ideally you hold the assets most likely to earn a higher compounded return over time in your Roth IRA. This would be your equity investments instead of your fixed income assets (which you can hold in your traditional IRA).
Brokerage accounts it does not provide a tax shield like traditional and Roth IRAs. Dividends, interest and earnings are all taxable in a brokerage account even if you don’t withdraw the money. Therefore, it is important to choose more tax efficient investments.
When possible, you may want to avoid holding bonds, stocks that pay dividends and actively managed mutual funds which distribute a lot of short-term earnings into your taxable brokerage account. Instead, consider investments that you can hold for more than a year and that don’t generate much cash flow. These may include stocks that do not pay dividends and index funds. Doing this can help limit the number of taxable events that occur in your account and avoid higher marginal tax rates.
You may also benefit tax loss harvesting in a brokerage account, which can help reduce your rates even more. (If you need guidance on building an investment portfolio outside of your retirement accounts, consider working with the financial advisor.)
A properly diversified portfolio contains a broad mix of investments that provide you with a combination of capital gains, dividends and interest payments. Consider how each of these affect your tax liability and be aware of your overall “asset location”.
Investments that produce taxable income may be better suited for your traditional IRA. Meanwhile, high-growth investments may work better in your Roth account. Finally, consider avoiding dividend and interest paying investments in your taxable brokerage account, and instead focus on investments you hold for the long term that will not produce taxable income.
However, understand that your target asset allocation is not likely to align perfectly with the amount of money you have in each account. You may end up with some bonds in your brokerage account or stocks in your traditional IRA, and that’s fine. The goal is to place your investments as efficiently as your account balances and asset location allow.
Whether your retirement savings are spread across multiple accounts or concentrated in a single 401(k) or IRA, tracking your progress and estimating how much your money will be worth can help you plan more confidently. SmartAsset pension calculator can help you project how much your savings will be worth when you retire and how much income you can expect to potentially generate.
A financial advisor can help you plan and save for retirement. Finding a financial advisor doesn’t have to be difficult. Free tool from SmartAsset puts you with up to three verified financial advisors that serves your area, and you can have a free introductory call with your advisor matches to decide who you feel is right for you. If you are ready find a counselor who can help you achieve your financial goals, start now.
Keep an emergency fund on hand in case you have unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The opposite is that the value of liquid assets can be eroded by inflation. But a high interest account allows you to earn compound interest. Compare the savings accounts of these banks.
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