One of the things to keep in mind as you plan your investment strategy is where you want to keep your assets. Since the income from different assets is taxed differently, where you keep your money makes a difference in the long run. As you plan your investment strategy, don’t forget about tax planning.
What assets are already tax efficient?
There are some assets that are already tax efficient, at least at the federal level. These assets don’t need to be kept in a special account, since they come with built-in tax advantages. Municipal bonds are a good example. You don’t pay federal taxes on municipal bonds, so it might not make sense to keep them in a tax advantaged retirement account. It can be a “waste” of tax efficiency to keep assets that are already tax efficient in a tax advantaged retirement account.
Choose the right assets for your tax-advantaged retirement account.
Assets that are tax inefficient should be the ones in your tax advantaged retirement account. Dividend paying stocks can be great in your tax advantaged retirement account where you either pay taxes later (as with a deferred account, like a traditional IRA or 401(k)), or you pay now, contributing with after tax dollars (as with a Roth account).
When you contribute to a tax free account, like a Roth, your earnings aren't taxed. Even with a tax deferred account, you can reap the benefits of using pre-tax dollars for your contribution and boosting the efficiency of your investment. Some investors like to keep stocks, non-municipal bonds, and other assets that are costly in terms of taxes in tax advantaged retirement accounts.
Don’t forget that it’s possible to use a similar strategy with a Health Savings Account. If you are eligible for an HSA, you get a tax deduction for your contribution, and the earnings aren't taxed as long as you use the money for qualified health care expenses. (When you are 59½, you can use the HSA as a traditional IRA for nonmedical costs.)
When do you need the money?
As important as tax planning is, it’s not the only consideration you should worry about when deciding where to keep your investments. You also need to think about when you will need the money. It might be nice to keep dividend stocks in your Roth account and avoid paying taxes on your earnings, but what if you need the income from the stocks before you turn 59½?
Consider your goals for the investment proceeds. While it almost never makes sense to hold tax efficient assets in a tax advantaged account, there are times when it makes sense to keep tax inefficient assets in a nonadvantaged account. If you know you will need the money before you turn 59½ and can take retirement account distributions without penalty, keep the assets in a taxable account. If you are 30 right now, and are building an income portfolio over the next 15 years for the passive income so that you can retire early, you’ll want to keep your assets in a “regular” taxable account. You’ll still have to pay taxes on your earnings each year, but you’ll have access to your money when you need it — without having to pay the 10 percent penalty for early retirement account withdrawals.
Also, don’t forget to consider your future tax situation. If you are deciding between a Roth account and a traditional account, you want to keep your assets in a place that offers you the best deal overall. If you think that your taxes will be higher later on (either because tax rates will rise or because you will eventually enter a higher tax bracket), it can make sense to pay taxes now, at a lower rate, and avoid paying taxes on your earnings later. However, if you think your tax burden will decrease by the time you are ready to withdraw money from a retirement account, you might prefer a tax-deferred traditional account.
Think about your assets and what you want to accomplish, and consider consulting a tax professional as you decide where to keep your investments.
Miranda is a freelance contributor to several investing and personal finance web sites. She also writes for her own blog, Planting Money Seeds.