What Is Tax Location?
Tax location is a real thing in my world and it does matter. Plus, it is something that matters more to you! Let me explain why. And here is a video if that is easier.
In its simplest terms, tax location is when you are strategic with which holdings you have in what types of accounts. Basically, you want to get the most tax bang out of your investments. As always, let’s talk specifics.
First, let’s assume your overall investment allocation is roughly 60/40. This means 60% of your holdings are in equities (stocks) and the balance is in fixed income (bonds).
The first type of account we are going to focus on is Roth accounts. These are nicknamed “never-to-be-taxed-again” accounts in my world (Health Savings Accounts also are here). Contributions go into Roths after taxes, with no taxes on growth and none on distributions, assuming you follow the rules. When taking Tax Location into consideration, I lean toward using the “never-to-be-taxed-again” Roth to hold the most aggressive investments in your overall 60/40 portfolio. Simply, place those investments with the highest growth potential within an account that will not tax said higher growth.
Tax-Deferred accounts such as IRAs and 401ks will then go the opposite route. They will hold those investments with lower return potential. This is because at some point you will be taking money out of these accounts and they will be taxed at Ordinary Income rates. Meaning, distributions will be taxed like you just earned that amount of income for the year. You need to have 40% of your investments in fixed income, but these accounts may hold a higher concentration of lower-growth potential investments because of the tax hit down the road.
Finally, let’s talk Taxable accounts. These may be Individual accounts for you or Joint with your spouse. Regardless, the way these accounts work is your contributions go in after taxes and growth will be taxed at Capital Gains rates. Short-term rates are the same as Ordinary Income while long-term rates are typically lower. The big oops I often see here is people assume these accounts are not taxed because you already paid taxes on the money before it went in. Wouldn’t that be nice of Uncle Sam😉 Within taxable accounts you need to pay attention to dividends, yields and distributions. These are tax-creation events. It is why you hear people like me say to be cautious of holding mutual funds and high-dividend investments in taxable accounts. I am not saying you can’t hold them, just be aware of any potential tax landmines.
One final thought with Tax Location. You need to be aware of your Timeframe. I have written about this before and how it is an incredibly important question most advisors and investors overlook. Timeframe does not only include how long you plan to invest, but also when you will start accessing these funds. Before you start making adjustments to have more effective Tax Location, answer the Timeframe question first.
Final Final thought – After reading this you probably know more about proper tax location of your investments than 90% of people out there and sadly a good chunk of financial advisors. Being cognizant of where you hold what investments will help you achieve a goal I have with all clients – Lowest Lifetime Tax Bill Wins!!!