Asset allocation is a big picture, holistic view of all your assets. It takes your risk tolerance and time horizon into account but should also consider tax efficiency. These types of accounts that hold your investments matter and you CAN optimize this for tax efficiency.
Understanding Asset Allocation
There are three types of investment accounts or “tax buckets” that hold your assets.
- Income Taxable (after tax investment account)
- Tax Deferred (IRA or other type of retirement account)
- Income Tax Free (Roth IRA or Life Insurance)
A well-designed portfolio will have a planned percentage of stocks, bonds, and other types of investments. Ideally you want to pay the least amount of tax possible across your entire portfolio. Ensure you sell your growth stocks at long-term capital gains rates. This would happen in an income taxable account, or an income tax free account.
In an income taxable bucket, most of your investment income is subject to tax, but not all the income in this account is taxed at the same rate. Interest, some dividends, short-term gains and partnership income are all taxed at ordinary rates, while long-term capital gains are taxed at a more favorable long-term capital gains rate.
Any withdrawal you make from a tax deferred bucket (IRA or other retirement account) will be taxable at the higher ordinary income rate. Long-term capital gains on assets held in your tax-deferred account will be taxed at higher ordinary income rates. These same investments held in a cash account or Roth IRA would produce less tax by paying either a long-term capital rate in an after-tax account, or no tax at all in a Roth.
So, what does that all mean?
Overall, and to the extent that our portfolio will allow it, the best place to hold your growth is in a Roth IRA. Next your growth should be in an after-tax account and lastly in your IRA or other retirement accounts. The same rate will tax your income investments whether held in a retirement account or a cash account. This practical example shows asset allocation spread across different accounts.
For more information on where to put your hard-earned money, request a meeting today.
