One of the biggest mistakes I see all the time is that most retirees focus 100% on asset allocation (aka what things they are invested in) and completely ignore asset location (aka strategically putting certain investments in certain accounts).
Because of this, most people end up paying way more taxes in retirement than they have to.
Not to mention, asset location is the easiest way to make more money with your investments without taking any more risk.
Two Types of Taxes
The first thing we have to get straight when talking about asset location is the two main types of taxes you can pay. The first is ordinary income tax and the second is long-term capital gains tax.
Ordinary income tax is the type that most people think of when they think about taxes. In 2021, the tax brackets are anywhere from 0%-37% on the federal level. This means that those with the very lowest incomes pay 0% tax and those on the highest side have a marginal tax rate of 37%.
Any income you make from a job, business, or pension is generally taxed as ordinary income. Any money taken out of a pre-tax retirement account (traditional IRA, traditional 401k, traditional TSP, etc.) is also taxed as ordinary income.
Fewer people know about long-term capital gains tax but it is crucial to understand especially in retirement. In 2021, the long-term capital gains tax rates are either 0%, 15%, or 20% depending on your income level.
And while I won’t bore you with all the details, the one thing to remember is that long-term capital gains taxes are (as the law stands today) always lower than your ordinary income tax rates.
This means that if we have a choice to have ordinary income or long-term capital gains then you should pick the latter every single time. Long-term capital gains taxes come into play most often in taxable accounts which I’ll address below.
But with all that being said, my favorite type of taxes is no tax at all. We will cover this more below.
Best Investments for Your Pre-tax Accounts
The first thing we have to know about pre-tax accounts (traditional IRA, traditional 401k, traditional TSP, etc.) is that whenever money comes out of these accounts it will always be taxed as ordinary income which is the highest tax rate you can pay.
So whenever we have a choice we want to put the more conservative investments that we own into your pre-tax accounts. These more conservative investments won’t grow as fast as others so you will limit how much of your money will be subject to the highest tax rates.
Most of the time, it will make sense to put your more aggressive investments into the accounts I’ll address below.
Best Investments for Your Taxable Accounts
Taxable accounts include any accounts that aren’t retirement accounts. Most of the time this will simply be a brokerage account where you invest money.
The thing to know about taxable accounts is that you have to pay taxes as you earn money in them. In retirement accounts you generally only have to pay taxes either when you put money in or when you take money out. In taxable accounts, you are issued 1099 every year for any earnings you had.
For example, if you own Apple stock in a taxable account and Apple pays you a dividend then you will have to pay taxes on that dividend in the year you earned it even if the money you earned stayed in the account.
Or if you bought Apple stock at $100 and sold it at $150 then you would have to pay taxes in the year that you sold the stock for the gain.
So it is not a good thing that you have to pay taxes every year in a taxable account but the good news is that, if managed in the right way, you can often only pay taxes at long-term capital gains rates.
One strategy to do this is by only having growth-oriented investments in your taxable account.
For example, if you invest in a fund that focuses on growth stocks that don’t pay a lot of dividends then you will probably not have to pay much in tax year to year. And when you do decide to sell this growth fund (as long as you held it for more than a year) then you will owe taxes but it will be at the lower long-term capital gains rates.
Most of the time you will want to avoid investing in bonds or high-dividend paying stocks in taxable accounts to avoid taxes as much as you can year to year.
Best Investments for your Roth Accounts
Roth accounts are certainly my favorite place to have money. Roth accounts include a Roth IRA, Roth 401k, or Roth TSP.
What makes Roth accounts so unique is the fact that these accounts can grow tax-free and when you take money out of them then it generally comes out 100% tax-free.
Because of this tax treatment, we want these accounts to grow as much as possible. Consequently, it generally makes sense to put your more aggressive investments into your Roth accounts.
This way your account that has the best tax consequences will be the one that experiences the most growth over time.
But as always, it is important to note that everyone’s situation is different and your situation may call for different tax strategies.
