There are 3 main investment account categories:
Asset location in action
Let's look at a hypothetical example. Say Adrian, age 40, is thinking about diversifying his portfolio by investing $250,000 in a taxable bond fund. For this example, we will assume Adrian pays a 35.8% marginal income tax rate on net investment income and the bond fund is assumed to earn a 6% rate of return each year—before taxes.
In what account should he hold the investment? The answer matters, and can mean the difference between paying taxes annually and deferring them until withdrawal.
Suppose Adrian has 2 accounts with sufficient assets to choose between, to hold the investment. One is his taxable brokerage account where interest earned on the investment will be taxed annually; the other is a traditional IRA he has been making after-tax contributions to for many years. Since Adrian began contributing to the IRA midway through his career, he never made any tax-deductible contributions. If Adrian chooses to hold the investment in the tax-deferred IRA, the return on his investment, after-taxes, could be nearly $72,000 greater than it would be in the taxable account when he begins withdrawals 20 years later at age 60, assuming his tax rate remains the same.
Tax deferral has the potential to make a big difference for investors—especially when matched with investments that may be subject to high tax rates, as interest on taxable bonds can be.
In next blogpost, we will discuss if you can benefit from active asset location strategy.
- Taxable accounts such as traditional brokerage accounts hold securities (stocks, bonds, mutual funds, ETFs) that are taxed when you earn dividends or interest, or you realize capital gains by selling investments that went up in value.
- Tax-deferred accounts like traditional 401(k)s, 403(b)s, annuities, and IRAs allow payment of taxes to be delayed until money is withdrawn, when all or a portion of it is taxed as ordinary income.
- Tax-exempt accounts like Roth IRAs, Roth 401(k)s, and Roth 403(b)s, require contributions to be made with after-tax dollars and do not provide a tax deduction up front, but they allow the investor to avoid further taxation (as long as the rules are followed). Fully tax-exempt accounts such as health savings accounts (HSAs), allow you to make pretax or deductible contributions, earnings, or withdrawals, if used for qualified health expenses.
Asset location in action
Let's look at a hypothetical example. Say Adrian, age 40, is thinking about diversifying his portfolio by investing $250,000 in a taxable bond fund. For this example, we will assume Adrian pays a 35.8% marginal income tax rate on net investment income and the bond fund is assumed to earn a 6% rate of return each year—before taxes.
In what account should he hold the investment? The answer matters, and can mean the difference between paying taxes annually and deferring them until withdrawal.
Suppose Adrian has 2 accounts with sufficient assets to choose between, to hold the investment. One is his taxable brokerage account where interest earned on the investment will be taxed annually; the other is a traditional IRA he has been making after-tax contributions to for many years. Since Adrian began contributing to the IRA midway through his career, he never made any tax-deductible contributions. If Adrian chooses to hold the investment in the tax-deferred IRA, the return on his investment, after-taxes, could be nearly $72,000 greater than it would be in the taxable account when he begins withdrawals 20 years later at age 60, assuming his tax rate remains the same.
Tax deferral has the potential to make a big difference for investors—especially when matched with investments that may be subject to high tax rates, as interest on taxable bonds can be.
In next blogpost, we will discuss if you can benefit from active asset location strategy.
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