Why The Location Of Your Investments Matters

Author: Buckingham Strategic Partners, Patrick Kuster, CFP, AIF

Most investors have a process for deciding which investments to buy in their portfolio—with different objectives for building wealth over time. But once you’ve selected your investment mix, have you considered how the account that holds your investments affects what you ultimately earn?

A potential game changer for your expected returns is the amount of tax you’ll need to pay, which may be annually or when you make withdrawals depending on the account type. The type of account also makes a big difference in the amount of tax owed. Thinking about asset location—or being strategic about which account holds each of your investments—can help investors keep more of their income.

Leveling the Playing Field Among Accounts

If you have ever received a Form 1099 from the IRS for investment gains or losses, or if you’ve paid income taxes after taking money from your retirement account, you know that Uncle Sam is your investment partner. Just like you, the government wants these accounts to grow because bigger returns generally mean more tax dollars to collect.

From a tax perspective, taxable brokerage accounts, traditional individual retirement accounts (IRAs) and Roth IRAs are not created equal. To level the playing field, it’s important to consider the after-tax expected return of any investment—the amount we keep. Knowing how an investment is taxed within different types of accounts is critical in determining where to own each of your investments.

Non-Qualified Accounts (Taxable)

  • In taxable accounts, such as a brokerage or joint account, you pay taxes each year you receive dividends and interest payments or when you sell investments for more than you paid for them.
  • Qualified dividends and the capital gains on investments held for at least one year are generally taxed at a preferential rate. This is also known as the capital gains rate, and it is either 0%, 15% or 20% depending on your income bracket.
  • Interest income—such as from bonds—and gains from selling investments held for less than one year are taxed at the ordinary income rate, which ranges from 10% to 37% depending on your income level. So, if you don’t plan to hold your investments for very long in a taxable account, you could wind up paying much more in taxes than if you held them for at least one year.
  • The government bears some of the risk of each investment since it receives a portion of the income in taxes (unless your tax rate is 0%).

Traditional IRAs (Tax-Deferred)

  • Traditional IRAs are tax deferred—there is no immediate tax consequence when you buy or sell investments within the account or when you receive dividends or interest payments.
  • Although you have the benefit of only paying income taxes when taking funds out, you do so at ordinary income tax rates.
  • A good way to think about your traditional IRA is to imagine it is split into two identically invested accounts: one owned by you and the other by the government (the portion of which would equal your tax rate). You’ll receive all of the income from your portion, but you also take on all the risk. Likewise, the government will receive all of the income from its portion and take on all the risk.

Roth IRAs (Tax-Deferred)

  • In Roth IRAs, you make contributions with after-tax dollars, and you don’t pay income taxes on any earnings or when taking funds out as long as you meet certain conditions.
  • Therefore, you can expect to receive all of the income from your returns on investments in these accounts. However, this also means you bear all of the risk on the entire balance.