Most individuals have more than one account for investments, whether for everyday savings, retirement, education, or some other purpose. Retirement and education accounts have tax advantages while others may not have any tax advantages and are simply held in a brokerage account. The goal with these different investment accounts is to match investments with the type of tax treatment of the account that will minimize your taxes on your investment income and growth and, in turn, maximize your wealth.
Accounts with tax-free treatment, such as a Roth IRA, are a great location for investments with the highest expected income and highest yields. Fixed-income investments, such as bonds, often generate regular income in the form of interest that is taxed at the ordinary income rate. If these investments are held in a tax-free account, that income can later be withdrawn with no tax consequence, assuming withdrawals are considered qualified distributions. Accounts with tax-deferred treatment, such as a traditional IRA, are also good candidates for investments with regular income since the deferred taxes on these investments can greatly impact your current cash flow.
Taxable accounts can then be saved for investments with little income and growth or where the growth is due to dividends and capital gains. Little income results in little tax. Additionally, dividends and capital gains are taxed at a preferential rate: 20% for long-term capital gains compared to 39.6% for ordinary income for those in the highest marginal tax bracket (2014 rates). Paying the long-term capital gains tax on these investments results in a lower overall tax liability compared to paying the higher ordinary income tax rate on those same dividends and earnings from a tax deferred account when distributed later.
As an illustration, let’s take a glance at my own accounts. Among my accounts I have a Roth IRA, a 401(k), and a brokerage account. The Roth IRA gives me tax-free growth. Since I do not get a tax deduction on my contributions, I will pay no taxes on the income, earnings, or dividends when I take the money out during retirement (assuming they are qualified distributions). For this reason, I invest in high growth and income generating investments.
The 401(k) is a tax-deferred account. I get a tax deduction on current contributions, but I will pay taxes on the distributions I receive during retirement. Since I will pay the taxes on the distributions, it makes little difference whether these investments have experienced large or little growth as far as my taxes are concerned; I pay the taxes on the distribution amount whether that money was principal contribution invested or earnings from the investments. For this reason, investing in fixed-income within this account allows me to defer the tax until the year I reach age 70 ½.
My brokerage account has no tax advantages. I pay taxes on its income, dividends, and growth as earned. In this account I hold a money market fund that is low risk and serves as a nice place to hold a rainy day fund. A taxable account can also be a good location for mutual funds or stocks where the dividends and capital gains may be eligible for the favorable long-term capital gains tax rates.
The bottom line is that the location of your assets can have a large impact on your tax liability and cash flow, both today and in the future. Planning ahead and structuring your investment portfolios with this in mind can help increase your wealth over time.