When getting started with investing, most people tend to focus on vehicles -- ETFs, mutual funds, stocks, and bonds -- versus the location of these investments, in terms of tax-deferred, tax-free, and taxable accounts. Tax management isn't just for retirees, and should be considered by any investor regardless of wealth. A more appropriate plan of action would include first determining your risk tolerance, followed by formulating an asset allocation, selecting investments, and ensuring these investments are held in a tax-efficient manner.
Tax-deferred accounts
If your asset allocation calls for an investment that derives most of its return from income, such as bonds or real estate investment trusts, you will be better suited from a tax standpoint to put these investments in a tax-deferred account. Tax-deferred accounts include 401(k)s, 403(b)s, 457(b)s, Traditional IRAs, and any other account containing pre-tax money -- in other words, money contributed to these accounts has not yet been taxed. By holding investments like bonds in these accounts, any income earned will not be taxed in the period earned -- it will only be taxed, albeit at ordinary income rates, when money is actually withdrawn from the account.
Additionally, by keeping stocks out of these accounts, you'll avoid the sting of substantial RMDs (Required Minimum Distributions) once you turn age 72. RMDs have the potential to push you into a higher tax bracket, and require significant planning to optimize throughout your retirement. Stocks held in tax-deferred accounts will drive up the value of your tax-deferred account over time, increasing the probability of large RMDs and, ultimately, a higher tax rate that could affect your broader income.
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Tax-free accounts
There aren't many choices here -- because of course there aren't -- but you do have some recourse. A Roth IRA or, alternatively, a Roth 401(k) through an employer, both contain money that has already been taxed. With that said, absent a change in tax law, money invested in a Roth IRA or Roth 401(k) will never be taxed again, regardless of investment vehicle. These accounts represent opportunities to hold your highest-growth assets, like pure stock index funds or the highest-rated technology stocks. You won't need to worry about withdrawals affecting your future tax bill, as this money has already passed that toll booth. You also won't have to worry about costly RMDs in the future, even after you are long retired past the age of 72.
All things considered, it's now a good time to take advantage of maximizing contributions to and converting to Roth accounts, as tax rates are historically low and plan to stay low through 2024. Roth accounts also provide for peace of mind -- that is, if tax rates stay the same or go up, you've clearly made a good decision by paying tax now; if tax rates fall, then you are still left with a zero tax bill in the future. Psychologically, it pays to get rid of your tax liabilities as soon as you can, unless you truly expect a far lower tax rate in retirement.
Taxable accounts
Taxable accounts refer to your run-of-the-mill brokerage accounts that can be found at any major discount broker or full-service wealth management firm. Here, you're taxed on income as it's earned -- most commonly, this refers to taxable bond interest and stock dividends. Stock index funds, both domestic and international, are great investments for your taxable account, as their primary benefit comes through unrealized price appreciation. In a taxable account, unrealized gains are not taxed at all until the investment is sold, giving the investor more control as to when tax will be triggered. Investments generating high dividends would be considered suboptimal in these accounts, as every dollar is taxed as it's earned.
These accounts also provide for favorable tax rates if investments are held long enough. If a stock is held longer than one year, you'll be able to take advantage of long-term capital gains rates that range from 0% to 20%. These rates are much less aggressive than the ordinary income schedule, and also apply to gains on mutual funds held longer than one year as well as qualified dividends. Additionally, if you have an international fund as part of your asset allocation, you are likely better off keeping it in a taxable account, as you may be eligible to receive a foreign tax credit for international taxes paid -- this opportunity is otherwise lost in a tax-advantaged account.
It's, of course, important to build a financial plan and stick to it over time, but it's also critically important to understand that tax mismanagement has the potential to eat into much of your hard-earned financial fortress. Carefully ensuring your investments are optimized for tax efficiency will not only increase your ability to earn higher after-tax returns; it will also relieve pressure when tax season arrives.
