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Is Your Retirement Investing Strategy Tax Efficient?

When it comes to retirement, I feel that even though I’ve saved quite a bit into 401k’s and Roth IRAs, I generally don’t have a clear sense of how I should be using these accounts and how much I will need in retirement. My personality is such that I generally try to focus on one area of my personal finances and try to put the others on autopilot until I can give them their due time and concentration. Retirement autopilot consisted of putting away as much as I could into my 401K and contributing the maximum to my Roth IRA, then selecting a nice mix of high growth funds and stocks in both. I thought I was being relatively tax efficient (and I am, relatively), but I wasn’t being the absolute most efficient.

In between your investment income and your pocket is a little organization known as the Internal Revenue Service. The fee the IRS charges for you to keep both of your legs in working order is known as a tax and that tax comes in three forms: tax-free, short term capital gains, and long term capital gains (more on capital gains taxes [3]). In a Roth IRA, you get distributions tax free. In a 401K and Traditional IRA, you effectively are taxed at the short term capital gains rate on withdrawals because the disbursements are treated as income. None of your retirement assets come out as long term capital gains.

So what does this mean? Put your most tax inefficient investments (day-trading, short term holdings) in your 401K because it can’t be taxed more than short term capital gains. Now, that’s a concept everyone understands once they’ve heard it, but it’s also important to understand the other side: don’t put tax efficient investments in your retirement accounts. (Roth excluded, since it’s tax free growth)

What happens with a lot of people is that they see their nest egg as something that shouldn’t be played with so they put it in nice safe index funds and mutual funds. They then have another brokerage account where they’re investing in the latest hot energy stock, IPO, or tech company; which they fund with their “play” money. For sanity’s sake, that may be a good idea but it’s terrible from a tax perspective (which isn’t the only consideration when it comes to investing, but it happens to be the focus of this post).

What should you do instead? Buy those high flying stocks in your 401k and Traditional IRA because no matter what happens you’ll still be taxed at the highest rate (or go with the Roth because you won’t be taxed on it). Save the “safer” investments to your brokerage account where you can benefit from long term capital gains tax rates.