Where you hold your investments may be just as important as which investments you hold. That’s because where you hold your investments may have major tax implications. Taxes clearly affect taxable and tax-deferred accounts differently. It’s important to take this into consideration when creating your financial plan.
Specifically, you should consider how asset allocation in different investment vehicles affects your taxes. Investing in such a way that you don’t pay more taxes than necessary has the potential to have a large impact on your overall returns. Here’s what you need to know about taxable vs tax-deferred investments.
Asset Allocation
It matters how you divide up your portfolio. When it comes to taxes, it may benefit you to consider your asset allocation within your portfolio as a whole, as opposed to within each individual account. For example, if your goal is to have a portfolio invested in 50% stocks and 50% bonds, it may seem logical to ensure that the investments in each account line up with this asset allocation. But this strategy may not take advantage of all the tax opportunities provided by different types of accounts.
In order to take advantage of every tax opportunity open to you, you may also want to ensure that the funds in each account are invested in order to take advantage of each account’s unique tax benefits. This may mean that one account may have a high percentage of fixed income investments while another may have a high percentage of small and mid-cap stocks. In short, different asset allocations may provide better tax opportunities in different accounts.
Saving for Retirement
Though tax considerations should play an important role in every aspect of your financial plan, they can have an especially large impact on retirement savings. Tax considerations play a significant role in retirement savings for two reasons. First, many types of retirement savings accounts offer tax advantages. This means more options and potential opportunities as far as which accounts to choose from. Secondly, retirement planning has a longer time horizon, which means more time for your money to grow. Therefore, even small tax savings have the potential to impact your retirement nest egg as a result of compounding growth.
Taxable Accounts
Any traditional brokerage account falls within this category. The main point to consider in these accounts is that you’ll be paying capital gains taxes, which are taxes on the income gained off of your investments every year. Taxes on your gains means less money to remain invested and potentially grow. Especially when saving for long term goals, capital gains tax can have a huge impact.
Even though taxable accounts don’t receive the tax advantages of some other accounts, investing certain assets in these accounts may still be beneficial. These accounts can be great places for your lower growth equities since the tax rate on qualified dividends and capital gains in these accounts is taxed at a lower rate than your regular income tax rate.
Tax-Deferred Accounts
Tax-deferred accounts are often those associated with retirement savings such as 401(k)s, 403 (b)s, and traditional IRAs. One of the reasons these accounts are so often associated with retirement is because they provide some great tax advantages. Taking advantage of these tax-deferred accounts can be valuable, but it’s not just about investing money in these accounts. To truly take the most advantage of these accounts, it’s also important to consider how you’re investing your funds.
As a general rule, consider including higher-growth investments in these more tax friendly accounts. That’s because in these accounts, you’re not paying capital gains tax every year. Instead, you’re waiting until retirement to pay taxes on the money. That means money that you would be paying in taxes is instead staying in your account and continuing to grow. During retirement, it’s likely that your income tax rate will be lower. So, it may be better to pay the taxes on the extra income during retirement as opposed to before retirement.
Speak With A Financial Advisor
How taxes affect your investments is just one of many things to consider when building a portfolio. In order to make sure you’re making the most of your money, consider working with a trained professional. The financial advisors at Good Life Financial can help you understand the tax benefits of various accounts and investments so you can build them into your financial plan.
Disclosure
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.