- In taxable accounts, such as a brokerage or joint account, you pay taxes each year you receive dividends and interest payments or when you sell investments for more than you paid for them.<\/li>
- Qualified dividends and the capital gains on investments held for at least one year are generally taxed at a preferential rate. This is also known as the capital gains rate, and it is either 0%, 15% or 20% depending on your income bracket.<\/li>
- Interest income\u2014such as from bonds\u2014and gains from selling investments held for less than one year are taxed at the ordinary income rate, which ranges from 10% to 37% depending on your income level. So, if you don\u2019t plan to hold your investments for very long in a taxable account, you could wind up paying much more in taxes than if you held them for at least one year.<\/li>
- The government bears some of the risk of each investment since it receives a portion of the income in taxes (unless your tax rate is 0%).<\/li><\/ul>\n\n\n\n
Traditional IRAs (Tax-Deferred)<\/em><\/p>\n\n\n\n
- Traditional IRAs are tax deferred\u2014there is no immediate tax consequence when you buy or sell investments within the account or when you receive dividends or interest payments.<\/li>
- Although you have the benefit of only paying income taxes when taking funds out, you do so at ordinary income tax rates.<\/li>
- A good way to think about your traditional IRA is to imagine it is split into two identically invested accounts: one owned by you and the other by the government (the portion of which would equal your tax rate). You\u2019ll receive all of the income from your portion, but you also take on all the risk. Likewise, the government will receive all of the income from its portion and take on all the risk.<\/li><\/ul>\n\n\n\n
Roth IRAs (Tax-Deferred)<\/em><\/p>\n\n\n\n
- In Roth IRAs, you make contributions with after-tax dollars, and you don\u2019t pay income taxes on any earnings or when taking funds out as long as you meet certain conditions.<\/li>
- Therefore, you can expect to receive all of the income from your returns on investments in these accounts. However, this also means you bear all of the risk on the entire balance.<\/li><\/ul>\n\n\n\n
Deciding Which Accounts Should Own What Is a Game of Prioritization<\/h2>\n\n\n\n
When making investment decisions, the first step is to decide what type of investments will meet your personal goals\u2014the accounts you already have should not dictate those decisions. Only after deciding on your overall allocation target can you review your existing accounts to determine the optimal location for each of your investments.<\/p>\n\n\n\n
When considering location, it\u2019s helpful to view all of your accounts as one household portfolio, rather than separately. Although exchanging investments between accounts may lead to differing returns in one account compared with another, the goal is to create more after-tax wealth overall through tax efficiency.<\/p>\n\n\n\n
To make the most of tax treatments, it\u2019s generally favorable for most investors to prioritize tax-inefficient investments in IRAs, either traditional or Roth. As you move these investments to tax-deferred IRAs, you\u2019ll have room in your taxable accounts to take advantage of the preferential rates for tax-efficient investments. Some examples below illustrate how to think about these decisions.<\/p>\n\n\n
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<\/figure><\/div>\n\n\nWhen deciding whether to place your investments in a taxable account or IRA, it\u2019s also important to give the greatest consideration to those investments with higher expected returns\u2014and therefore generally higher risk. For example, it may seem like simple logic to hold investments with the highest expected returns in a Roth IRA because your income won\u2019t be taxed. However, you aren\u2019t always better off taking all the investment risk.<\/p>\n\n\n\n