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It's one thing to pick out an investment. It's another to pick out where the investment is being held. The main reason? Taxes. Numerous variables can alter your liability, including your current vs. future income, the evolving US tax code, expected income sources, and other financial goals.
Because of this, many try to keep their options open for tax efficiency. To combat this, people like to use multiple accounts for their investments to diversify their tax efforts. This process is also known as Asset Location.
Asset Location involves using multiple accounts to take advantage of their unique tax advantages. The benefits in question typically identify three characteristics:
There are generally three different tax structures:
This account might not be "tax-advantaged," but some underrated perks are worth mentioning. So, how are these treated?
You can find this treatment in accounts like a taxable brokerage account.
They do not have immediate tax features like retirement accounts. However, this also presents an advantage. There are no early penalties or contribution limits. Plus, if the funds have been held for at least one year, they are subject to long-term capital gains treatment, which could be more favorable than your current income tax bracket.
Most retirement accounts have this structure by default. The tax structure is as follows:
Some common accounts of this type are the 401(k), Traditional IRA, SEP IRA, SIMPLE IRA, etc.
From a contribution standpoint, there is an immediate tax benefit. These contributions are also "above-the-line" deductions, so they are separate from your standard / itemized deductions.
As such, those with high incomes or who need less income later may find value in utilizing deductions when they expect to pay the highest taxes today rather than later.
When we hear "post-tax," the immediate phrase we think of is "tax-free." The tax benefits are flipped compared to a pre-tax account:
This is commonly seen in a Roth account, such as a Roth IRA or a Roth 401(k).
Tax-free growth is an opportunity many should not overlook, as few accounts provide this perk. Furthermore, if income is expected to be higher in the future, it's typically better to put your income today into these accounts and apply the tax-free benefit when tax rates are higher.
Since these accounts are after-tax (by simply not taking a deduction like a pre-tax account), there is generally better flexibility with accessing contributions and conversions. Alongside other accounts, this can provide exciting opportunities to keep taxable income low in the future.
When comparing them side by side, it can be not easy to know which one will provide the most significant benefit. Asset location offers more options for improving tax efficiency and choices with it.
For example, tax-efficient investments are usually optimal in a taxable account, while investments that generate tax inefficiencies are better utilized within pre-tax and post-tax accounts.
By creating more options, you can be strategic, use more or multiple to your advantage, and maximize your tax planning efforts. You can get the best of both worlds (or rather, all three).
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