Asset Location – A Way to Improve Your Investment Return, Episode #43
When it comes to investing, there are very few “free lunches.” Asset location is one of them. In basic terms, it’s a way to improve your after-tax investment return (the one that matters) without taking on more risk, simply by being strategic about which investments you hold within which accounts, based on their unique tax treatment. In this episode, we walk through the different investment account types (Roth, pre-tax, and taxable) and explain how to think about which investments to own in each.
Outline of this episode
- The three buckets of investment accounts [1:56]
- Breaking down Roth accounts [5:57]
- Pretax account overview [9:45]
- What to know about taxable accounts [13:01]
- The recap [17:32]
Bucket Account #1 - Roth Accounts
With Roth accounts, you contribute the money initially and don't receive a tax deduction for your contributions. Once the money's in the account, it grows tax-free and you never have to pay taxes on it again. The most common type of Roth account is a Roth IRA. You may have one from making direct or backdoor Roth IRA contributions, rolling over Roth money from an employer retirement account, or maybe you still have Roth money in an employer retirement account from making Roth contributions to a 401k, 403b, or 457b. Regardless of how it got there, it's nice to have money in a Roth account knowing the money will never be taxed again. From an asset location perspective, it's nice knowing that you won't have to pay taxes on Roth money from year to year, and you also won't pay taxes on the growth of that money when you withdraw it in the future.
In your Roth accounts, you want to own your high-growth, tax-inefficient investments. These are the investments that you expect to grow the most and have the highest returns over time, and aren't very tax-efficient year in and year out in terms of the nature of the investments. One of the cardinal rules of asset location is, assuming your target investment allocation consists of a mix of stocks and bonds, you want to avoid holding bonds in your Roth accounts and instead own stocks in them.
Bucket Account #2 - Pretax Accounts
Pretax accounts tend to be the largest bucket or the accounts with the most money for most people because employer retirement accounts tend to be the biggest retirement savings vehicle for people, and since most people are in a higher tax bracket during their working years relative to retirement, they prefer to receive tax deductions along the way, which means making pretax rather than Roth contributions to their employer retirement plans.
Your pre-tax accounts might be a pretax 401k, 403b, or 457b through your employer. If you're self-employed you may have a SEP IRA, individual 401k, or SIMPLE IRA. You may even have traditional or rollover IRAs if you're retired and you consolidated your old employee retirement accounts.
We know it's an alphabet soup of acronyms, but at the most basic level, the way pretax accounts are treated for tax purposes is that when you contribute money to the account you receive a tax deduction. Once the money is in the account it grows tax-deferred, which means you don't have to pay any taxes year-to-year on dividends, interest, or when you sell investments in the account. In retirement (or when you eventually withdraw from the pre-tax account), you pay taxes on each dollar you withdraw at ordinary income rates, which are higher than long-term capital gains tax rates. Because of this taxation, you generally want to own investments that are tax-inefficient and have expected returns that aren't as high as the investments that you hold in your Roth accounts.
Bucket Account #3 - Taxable Accounts
The last account type is taxable accounts where you pay taxes on dividends and interest kicked off by your investments each year. When you sell investments, you also pay taxes on the gains, or the difference between what you bought and sold the investment for. If the investments were held for more than a year, those gains are taxed at long-term capital gains tax rates, which are lower. If you held those investments for less than a year, you would pay taxes on the gains at ordinary income rates, which are higher. For most higher-income households, ordinary income rates are substantially higher than long-term capital gains tax rates. Knowing how taxable accounts are taxed means you want to own high growth and/or tax-efficient investments in your taxable accounts.
Resources & People Mentioned
- Podcast Episode #5: The 80:20 Rule of Investing
- Podcast Episode #19: The “Other 20%” of Successful Investing
- Download our guide: The Toolkit for Optimizing Your Finances as an Employed Physician
- Download our guide: The Financial Checkup
Connect With Trent and Andrew
- https://mdwmllc.com
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