Most people spend a lot of time thinking about what to invest in. But there is another question that can save you just as much money, maybe more: where to hold your investments.
This strategy is called tax location, and it is one of the most underused tools in personal finance. The idea is simple: different types of investments are taxed differently, and by placing the right investments in the right accounts, you can significantly reduce how much you owe in taxes over time.
How Different Accounts Are Taxed
Taxable brokerage accounts are regular investment accounts with no special tax treatment. You pay taxes on dividends, interest, and capital gains in the year they occur.
Traditional IRA and 401(k) accounts are tax deferred. You do not pay taxes on the money going in or on the growth inside the account. You pay taxes when you withdraw the money in retirement.
Roth IRA and Roth 401(k) accounts are tax free. You pay taxes on the money going in, but all growth and withdrawals are completely tax free.
The Tax Location Strategy
Hold tax inefficient investments in tax advantaged accounts. Investments that generate a lot of taxable income, like bonds, REITs, and actively managed funds with high turnover, are best held inside a traditional IRA, 401(k), or Roth IRA. Inside these accounts, the income and gains are either tax deferred or tax free.
Hold tax efficient investments in taxable accounts. Investments that generate minimal taxable income, like broad market index funds and ETFs, are well suited for taxable brokerage accounts. These funds have low turnover and benefit from the lower long term capital gains rates when you eventually sell.
Put your highest growth investments in your Roth. Since Roth accounts grow completely tax free, they are the ideal home for investments you expect to appreciate the most over time. If that investment doubles or triples in value, you pay zero taxes on those gains.
Start With What You Have
You do not need to overhaul your entire portfolio to implement tax location. Start by reviewing what you currently hold and where. If you have highly taxed investments sitting in a taxable account, consider whether they would be better placed in a tax advantaged account. Small adjustments to where you hold your investments can add up to thousands of dollars in tax savings over a lifetime of investing. That is money that stays in your pocket and keeps compounding for you.