Where to put your next investment

Let's say you've decided to add a new investment or two to your portfolio — maybe a stock, maybe a bond, maybe a mutual fund that invests in either or both.

But now you're confronted with another decision: In which account should you buy them? You might have a regular, taxable brokerage account as well as traditional and Roth retirement accounts. Each account has its own tax treatment; the same is true of types of investments. Some are very tax-inefficient, requiring investors to hand over a good bit of the return over to Uncle Sam and Sister State — unless put inside a tax-advantaged retirement account. Other investments have built-in tax advantages, and putting them in an IRA or 401(k) isn't as important.

The trick to smart asset location — the art of putting the different types of investments in the right accounts in order to increase after-tax wealth — starts with ordering your investments according to tax-inefficiency. Then, you consider the expected returns of the investments. Intelligently mixing both of those factors will help you decide which investments should go into your tax-advantaged accounts first.

Boring tax basics

First, some essential facts necessary to understand asset location.

For assets in a regular taxable account, interest and short-term capital gains (profits from investments that are sold within a year of buying them) are taxed as ordinary income, the same rate as a paycheck is taxed. That can be as high as 39.6 percent, though you have to be very wealthy to pay that much. I would guess that most folks who are reading this post are in the 15-25 percent tax brackets.

Long-term capital gains and qualified dividends (according to current law) are taxed at lower rates — as high as 20 percent, with an additional possible 3.8 percent thrown on top of that due to the new Medicare tax. Again, you have to be raking in the dough — to the tune of more than $400,000 in adjusted gross income — to pay a rate that high. Most taxpayers pay rates between 0 percent (yes, zilch) to 15 percent.

As for assets in tax-advantaged retirement accounts, the investments in a traditional account grow tax-deferred until the money is withdrawn; withdrawals are taxed as ordinary income. Distributions from a Roth account are tax-free as long as you follow the rules.

The hierarchy of tax-ification

One of the key strategies to increasing after-tax wealth is filling up your IRAs and 401(k) with the most tax-inefficient investments first, and using money outside those account for investments that aren't heavily taxed or taxed at all.

Here's a very oh-so-general order of investments, according to how much the return you earn is given back on the tax returns you file, if not kept in a 401(k) or IRA. The order will be different for each person, depending on the specific investments owned and how long until they're sold. But this serves as a good starting point.

1. Stocks sold within a year. The gains are taxed as ordinary income.

2. Stocks that pay non-qualified dividends. Most of the payouts from real estate investment trusts (REITs) and some foreign companies do not qualify for a lower dividend rate, so they're taxed as ordinary income.

3. Stocks that pay qualified dividends. The dividends will be taxed at a lower rate than ordinary income, but you're still losing a portion of the return to taxes.

4. Options and shorts. The tax implications of options and shorts are much too complicated to address here. But it starts with the fact that many options strategies are not permitted in an IRA, and shorting is not allowed.

5. Non-dividend-paying stocks held for many years. These have built-in tax-deferral since you won't pay taxes until you sell and then at lower long-term capital gains rates. The longer you hold, the bigger the benefit.

6. Corporate bonds. A mere few years ago, it was considered smart to put most bonds higher up on the list of tax-inefficiency, even ahead of most stocks. However, given today's low rates, there's not as much interest to tax. Also, many bonds these days are selling at a premium (i.e., higher than their issue price and the amount that the investor will get when the bond comes due) because as interest rates have fallen, the prices of existing bonds have gone up. For example, a bond that matures in a few years at $1,000 might be selling for $1,100 today. When it comes to that $100 difference, the investor might be able to use it to offset taxable interest or capital gains. It's actually a bit complicated, but the main point is that you'll lose those tax breaks if the bonds are kept in a tax-advantaged retirement account. All that said, it still might make sense to keep high-yield (a.k.a., “junk”) bonds in a tax-advantaged account.

7. Treasury Inflation-Protected Securities (TIPS). The interest rates on TIPS is very low. However, the inflation adjustments to the principal are taxed every year as “phantom income,” even though you don't realize the gain of that adjustment until you sell or the TIPS mature.

8. Treasuries. The interest is taxable as ordinary income on the federal level, but exempt from state taxes.

9. Municipal bonds. Interest is exempt from federal income taxes and maybe state and local taxes, depending on the bond.

Where do mutual funds and ETFs fall on this list? The investments within a fund are taxed the same as if they were outside the fund, but with an extra layer of complexity because the shareholders are held responsible for the taxable activities of the fund manager. For example, you may hold onto a fund for 20 years, which would qualify any gain for long-term treatment. But if along the way the fund manager is frequently trading the investments within the fund, those short- and long-term gains get passed onto you.

The more tax-inefficient the fund, the more it should be kept in an IRA. Generally, actively traded funds are a bigger tax headache than index funds. But you can learn about a fund's taxable habits at Morningstar.com entering its ticker and then clicking on “Tax.”

The role of expected return and holding period

The other consideration when it comes to asset location is how much you think an investment will be worth in the future. All else being equal, you want the investments that you think will be worth the most in the accounts with the lowest tax implications. That begins with the Roth, since those withdrawals will come out tax-free — and it's always better to have a bigger tax-free account. Of course, knowing ahead of time which investments will have the highest growth can be tricky. But it's a consideration.

Also, it should go without saying, but just in case: Money in retirement accounts is for retirement. Money you need beforehand should not be put in an IRA or 401(k), since withdrawals before age 59 ½ may be subject to taxes and a 10 percent penalty.

It's not what you make, it's what you keep

I've covered asset location, but decades-low interest rates and the increased popularity of more complex strategies such as options and shorting warrant a re-visiting of the topic. In some cases, the choice of which account to put which investments is clear; in others, the decision will not make much of a difference.

But in some ways, you're not the only owner of your investments. Uncle Sam stands to benefit from the growth of your portfolio, too, depending on what you own and where you own it. Everyone should pay their fair share of the “price of civilization” (Oliver Wendell Holmes Jr. called taxes), but there's nothing wrong with legally reducing as much as possible the stake of your co-owner.

More about...Investing, Retirement

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Mike@WeOnlyDoThisOnce
7 years ago

Do you think that shorting represents an essential part of a portfolio, to some?

nicoleandmaggie
nicoleandmaggie
7 years ago

Leight PF had a great post on tax efficient investing today that dovetails nicely with this one.

http://leightpf.wordpress.com/2013/05/28/tax-efficient-investment-placement-over-time/

Jake
Jake
7 years ago

This is a great overview. I don’t think too many individual investors really consider the tax implications of each of their investments, but taxes can be one of the largest factors on how much money you’ll have in retirement. If you can lower your tax rate by 5% by proper allocation then that will give you more money in your pocket.

Kurt @ Money Counselor
Kurt @ Money Counselor
7 years ago

Very important stuff, thanks! Unfortunately we have to take tax implications into account on every investment decision. At the same time though, it’s easy to become obsessed with minimizing taxes and lose sight of why we’re investing to begin with: To grow net worth. Also not a good strategy.

Samantha
Samantha
7 years ago

This was the most boring article I’ve (not) read on GRS. Could have used a cat photo or two, I’m afraid, Robert.

Kyle @ Debt Free Diaries
Kyle @ Debt Free Diaries
7 years ago

Great article! So many people aren’t aware of the different ways certain investments are taxed. Nothing wrong at all with working on lowering your taxable income. Many times the types of investments that lower that liability also work to spur economic growth. Everyone wins!

Derek the Money Saver
Derek the Money Saver
7 years ago

The only tricky thing I see with this is that if you are investing for the next 20-40 years, the field is almost completely wide open as to how tax law could change.

I do like the idea of putting the high growth stocks in the IRA and keep the more boring low-growth dividend type stocks in your personal investment account. That’s a good tip!

Chris @ Stumble Forward
Chris @ Stumble Forward
7 years ago

Great tips I feel the best way to deal with taxes is carry investments that tax your money in different ways. For me I find investing in my companies retirement plan which defers paying taxes now and contributing to my Roth IRA to help pay some of that tax burden now so when I do retire I don’t have to tax every red cent at ordinary income.

My Financial Independence Journey
My Financial Independence Journey
7 years ago

I worry about taxes last. If you pick a solid investment, the only real question remaining is whether it should be in a retirement account or in a taxable account. And that question isn’t really tax question, but more a question about when do you want access to the money.

Peter Voga
Peter Voga
7 years ago

Boring as it might be, tax implications of investments are important to understand. Thanks for making it short and to the point.

deedee
deedee
7 years ago

Some might find this boring, but this is EXACTLY the information I have been trying to find in the last few days! Are you reading my mind somehow, Robert? The only investing I’ve done so far is in a Roth IRA and a company-sponsored pension plan where I’ve never had to really think about taxes. But I’m now at a point where I’m able to start investing on my own outside of retirement, and I’m just beginning to wrap my mind around the fees/taxes that come with it. I’d love to see a post in the future about relatively liquid… Read more »

Tim
Tim
7 years ago
Reply to  deedee

Deedee, There’s a lot of choices between CDs and 100% stock, and I’m happy to provide some info (also, GRS, I can write a guest post on “intermediate” investing options if there’s interest). The most basic options are bonds, and in order of increasing returns it’d probably go: treasury, municipal, corporate, emerging markets. Those can be purchased via mutual fund (usually with a $1-3k minimum, but then can be bought and sold without additional fees) or exchange traded fund (basically a mutual fund that trades on the stock exchanges—typically with lower fees but then you have to pay a commission… Read more »

Izza Carter
Izza Carter
7 years ago

Great post, I’ve learned a lot from this article. Investment is the best way to a better future that is why we must take courage to learn from this topic.

James
James
7 years ago

BITCOIN Mining

Greg
Greg
7 years ago

I always get these confused. It seems to make sense that for a long term strategy, that the Non-dividend-paying stocks would make a lot of sense. Wouldn’t yield any annual income, per se, but the payoff in the long run may be a good investment. Certainly worth balancing the portfolio with.

Camp System
Camp System
6 years ago

This is a keeper! Good info! Robert I hope you keep writing more blogs like this one. Nice work Robert.

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