Where you put your investments can make a huge difference for your after-tax wealth. I want to spark some ideas for your own portfolio with the concept of “asset location”. Let’s dive into it.
We have three main investment accounts:
- Taxable account: A traditional brokerage account is a taxable account where you are taxed when you earn dividends or sell investments at a gain.
- Tax-deferred account: Traditional 401(k), 403(b), and traditional IRAs allow payment of taxes to be deferred to the future—you pay taxes when they are withdrawn.
- Tax-exempt account: Roth IRA, Roth 401(k), and Roth 403(b) allow you to avoid future taxes while providing no immediate tax deduction.
Asset Location in Action
Say, as part of your investment strategy, you want to start putting money in bonds. You have a 401(k), Roth IRA, and a brokerage account. Where do we put them?
> Brokerage account.
When you hold bonds, like BND (Total Bond Fund ETF), you pay taxes on non-qualified dividends (interest from the bond) up to a max rate of 37%. This means that if you receive $1,000 from the bond, you will pay approximately $370 in taxes if you are in the highest tax bracket.
So, is taxable brokerage the right choice? Not really. We would be paying $300+ every year.
> Roth IRA.
When we purchase bonds in a Roth IRA, we will not pay taxes on the interest since it’s a tax-free account! That’s much better than the $370 in taxes we would pay in a brokerage account. But is it the best choice? Well, bonds are considered “fixed income” funds, and they don’t grow much. Since the Roth IRA is a tax-free account (meaning we pay no taxes when we sell these investments), we want as much growth as possible in it. This way, we pay the least amount of taxes later on.
So? Is it better than the brokerage? Yes, but is it the best? No.
> 401(k)/403(b)
By holding bonds in an account like a traditional 401(k)/403(b), the interest income avoids immediate taxation, compounding tax-free until withdrawal.
So, we avoid the $370 of taxes and aren’t sacrificing the tax-free compounding like we are with a Roth IRA. This makes the 401(k) the perfect location for bonds.
Now, the 401(k)/403(b) choices are limited and are provided by your employer. So, if they don’t offer a bond fund, you might not have a choice.
A few more examples:
- REIT stocks/ETFs also pay non-qualified dividends and would follow similar logic like bond funds.
- Actively managed funds (I’m strongly against these, as I believe passive funds are the best & lowest fees) have a lot of turnover, so they shouldn’t be in a brokerage account due to capital gain distributions.
- Stocks that pay 0% dividends (like Netflix) are the most efficient to hold within the brokerage account.
- Foreign funds are best to hold in your taxable account because you may qualify for the foreign tax credit that you wouldn’t otherwise have in your retirement accounts.
I really like this visual from Fidelity to reference:
Overall, I hope you think about all of your investments & how they get taxed. Remember – small decisions can have a lasting impact on your wealth.
Hope you learned something new.
MC, CPA