When I started working after college, it was a bit of a stretch to contribute to both my 401(k), to get my employer match, fully fund my Roth IRA, and build up a small cash cushion (I would later learn these are called emergency funds ). I pushed to do it because my parents drilled this lesson into my brain as a young adult – save money today because you never know what will happen tomorrow. (I thought I dodged a bullet by avoiding the dot com boom and bust but I was later rewarded for my diligence with the largest recession since the Great Depression!)
So… what do I do with the money in my Roth IRA or my 401(k)? You will never be able to predict the future with certainty so you will never know beforehand which investments will perform the best. You will, however, know the cost of owning those investments and the cost of taxes if you pick correctly. The best we can do is have a good plan, execute that plan, and pick investments that provide the most value for the price that you pay in fees and taxes.
Tax Advantaged vs. Regular Brokerage
As you save money, you’ll start to have a mix of tax advantaged accounts and taxable brokerage accounts:
- The 401(k) and traditional IRA represent tax deferred retirement accounts, where tax deductible contribution grow tax free and distributions are taxed at your ordinary income tax rate.
- The Roth IRA represents tax free retirement accounts, where you cannot deduct contributions but they grow tax free and distributions are tax free.
- Finally, there are regular taxable brokerage accounts that offer no tax benefits whatsoever but do offer the chance to withdraw your funds without rules or penalties.
Put tax advantaged investments into a taxable brokerage account and put tax disadvantaged investments into your retirement accounts. You only benefit from tax advantaged investments if they’re in a regular broker account because the tax advantaged accounts shield you from those benefits.
Example: If you buy a dividend aristocrat  for the dividend yield, it’s better to buy through your regular brokerage account. Dividends are taxed at the long term capital gains rate (0% or 15), much lower than your ordinary income tax rate . If you bought it in an Traditional IRA, your dividends would be tax free initially but then taxed at the might higher ordinary income tax rate when you take disbursements (the dividends would grow tax free but you lose the initial tax benefit of dividends).
Best Investments for Tax Advantaged Accounts
The general rule is that tax advantaged investments are bad in an already tax advantaged account. Municipal bonds, which are income tax free, make terrible IRA investments because you take an investment that’s federal income tax free and subject it to income taxes. The return on munis is low because of the tax treatment, and lower risk, so you’re not getting the full value.
If you plan on generating a lot of short term capital gains (buying and selling stocks and holding them for less than a year), do so in your tax advantaged retirement account. In a regular account, you’d pay taxes each year. In a tax advantaged accounts, you would only have to pay taxes when you took disbursements, leaving a larger amount in your account to invest in. If you’re to pay short term capital gains anyway, you might as well have them deferred for as long as possible.
The disadvantage of this approach is that you in a regular account you can write-off up to $3,000 of investment losses from your ordinary income. This isn’t possible in a tax advantaged account.
Best Investments for Regular Accounts
On the flip side, the best investment for a regular brokerage account are those that are bad investments for tax advantaged accounts. Any investment that has built-in tax advantages will not be fully appreciated unless they get regular tax treatment. These include long term stock holdings (longer than a year), tax advantaged bonds (or bond funds), dividends, MLPs, Treasuries, and others.
Remember, when you are making retirement and investing decisions, tax considerations should only play a small role in the process. What you invest in and how you setup your entire portfolio is far more important than whether you invested in the right product in the right account. If you took tax advantaged dividends in a tax free Roth IRA, you would surrender only a bit of the tax advantage. If, however, you have everything else under control, then it makes sense to ensure you are being the most tax efficient.
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