Asset Location

February 6, 2023

You’ve probably heard the phrase, “The three things that matter in property are location, location, location.” Similarly, when optimizing your investments to maximize after-tax returns, you should emphasize asset location. Today we’ll explore three types of locations or accounts: Traditional IRA, Roth IRA, and taxable brokerage account.

A traditional IRA is funded with pretax dollars, grows tax-deferred, and then is taxed as ordinary income when withdrawn in retirement. People in high tax brackets can take advantage of an upfront tax deduction now while their marginal tax rate is high and wait to pay taxes until they retire when their income will be considerably lower and taxed at a lower rate.

A Roth IRA is funded with dollars that have already been taxed, grows tax-free, and is withdrawn tax-free in retirement. People who are starting their careers and anticipate large raises in their future may want to consider paying taxes now while they are in a lower tax bracket than they will be after receiving raises, and take advantage of the traditional IRA during their peak earning years.

Be careful, withdrawals from either type of account could face a 10% tax penalty if you withdraw before age 59 and a half, with few exceptions. This penalty incentives savers to keep their retirement savings in their retirement accounts. There are also limits as to how much money you can invest in each. A taxable brokerage account, on the other hand, is funded with dollars that have been already taxed, incurs income taxes on interest earned, and triggers taxable events when investments are sold.

When savers sell investments that were held for less than one year, the gains are taxed as ordinary income. When savers sell investments that were held for one year or more at a gain, the gains are taxed at the capital gains rate, which is lower than the ordinary income rate. When investments are sold at a loss, a tax ASSET is created (more on this next month). There are no penalties for accessing the money or limits on dollars invested in taxable accounts.

Savers should also consider the direction of taxes when deciding which location to choose. The conventional wisdom says that the US government will have no choice but to raise taxes to sustain its excessive borrowing and spending habits. This thinking would favor paying taxes now and contributing to a Roth instead of taking a deduction now by contributing to a traditional account.

Of course, your unique situation will dictate the best path forward for you. Talk to your financial advisor about your asset location and ensure you have a solid tax strategy in place.

Put on your overalls and tune in next month to learn about tax-loss harvesting!

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