Location, location, location. That’s the mantra for real estate investing. But location also matters when it comes to asset allocation, how you divide up your investments between stocks and bonds (including mutual funds). A common question we all face: what types of investments belong in taxable accounts, and what types belong in retirement accounts like IRAs, 401ks and 403bs?
The reason that question matters is our wonderful tax code. A brief primer: ordinary income is taxed at rates running from 15% to 35% (at least through 2012, unless Congress changes its mind). Bonds and CDs pay interest, which is taxed as ordinary income. Capital gain income (when an investment is held for at least a year) is taxed at a maximum rate of 15%. Most dividends (paid by stocks) and stocks held for at least a year qualify as capital gain income. So given the choice between ordinary income and capital gain income, you nearly always want capital gain income; you simply keep more after taxes.
That leads back to our asset location question. Where should you hold stocks: in a taxable account or a retirement account? Same question for bonds and CDs. And what about mutual funds?
The ideal holding place for stocks and any type of investment that can be taxed as a long-term capital gain is a taxable account. When you sell a stock held at least a year, you pay (at most) 15% in taxes. The other big plus for holding stock in a taxable account is you can also let the government help pay for your losses. Uncle Sam gives us a tax break on investment losses in taxable accounts. And we know from recent years that stocks can generate losses.
The ideal holding place for bonds and CDs (anything that generates interest) is inside a retirement account. When you take money out of a retirement account, it’s normally taxed as ordinary income. Interest from a bond or CD held outside a retirement account is also taxed as ordinary income. So by putting a bond or CD inside a retirement account, you get to defer any income tax for now.
For mutual funds, it depends on the type of fund. In general, index funds (which are very tax efficient) should be held inside taxable accounts. Actively-managed funds (which can generate lots of dividends and capital gains each year) should be held in retirement accounts, like IRAs.
As you make adjustments to your investments over time, be sure to give some thought to where you put your money. Location really can make a difference for your taxes. And taxes can certainly make a difference in your retirement readiness.