Most people today have multiple investment accounts to manage as they work toward retirement. In addition to savings and brokerage, it’s common to have a 401(k) plan, a Roth IRA, and a rollover IRA from a previous job. Each of these have unique tax characteristics, and not all accounts are suitable for every investment. Placing your carefully chosen assets in the wrong account can take a big bite out of your expected returns! The practice of strategically placing investments in different types of accounts to maximize their after-tax returns is called tax location, and it’s a powerful technique. The benefits of tax location have been thoroughly cataloged, with studies pointing to a boost of 20+ basis points per year on average.
This extra return doesn’t require any change in your mix of assets, just some attention as to where you put them. In the past year, we’ve seen a few new clients arrive with identical asset mixes in their accounts — regardless of the accounts’ tax status. Unfortunately, it has cost them some return. To help avoid this situation, I’ll explain why tax location works, why it’s advantageous for your portfolio, and how you can go about integrating it into your own portfolio strategy.
Review of Investment Account Types
Your investment accounts fall into three general categories:
1. Taxable: These include Individual, Joint, Trusts, and Custodial accounts. Any gains realized in these accounts will be taxed in the year they were earned.
2. Tax Deferred: These are retirement accounts such as 401(k)s and IRAs. Money goes into these accounts pre-tax, and taxes are not due on principal or earnings until they are withdrawn. As with all retirement accounts of this type, there are tax penalties for early withdrawals.
3. Tax Exempt: Roth IRAs, Roth 401(k)s and some 529 plans make up this group. Money is contributed after tax, but earnings and dividends accrue tax free, though subject to early withdrawal restrictions.