Could I have come up with a more vague title? Possibly.
But I am glad that my vagueness has brought you here.
What I am talking about is making sure that you are investing in the right types of investments in the right types of investment accounts.
Below I am going to take some time to give a brief overview of different types of investments and investment accounts, if you already know this information feel free to skip to the good stuff below!
There are so many different types of investments:
- Equities or Stocks: ownership in a company
- Bonds: loans to a company/government
- Cash/Cash alternatives: alternatives being high yield savings, money market, CDs
- Real Estate
- Cryptocurrencies
- There are also mutual funds and ETFs that are sort of like big baskets that hold some of these above investments individually or in combination
- For example: you can have a mutual fund that only hold large company stocks or you can have a mutual fund that holds stocks and bonds as well.
There are also different types of investment accounts. I want to highlight three:
- The pretax account (401k or Traditional IRA): Here you get a tax deferral when you contribute to these accounts and when you take the money out at retirement time the money is fully taxable to you at income tax rates at that time
- Example: If you contribute $5,000 to your 401k when you make $100,000. You will only pay taxes on $95,000 of income (not including all of the other tax pieces, I am oversimplifying to help illustrate). And over time let’s say that $5,000 grows to $20,000 in retirement and you want to take out $10,000 when you retire. That full $10,000 will be taxable to you then at your income tax bracket.
- Roth IRA/401k: with Roth accounts, you contribute money to these investment accounts and when you got to take money out at retirement time the money and its growth are going to come out tax free.
- Example: if you contribute $5,000 to a Roth IRA, you would have already paid taxes on that money. So over time if it grows to $20,000 in retirement and you need to take $10,000 out, that $10,000 will come out tax free
- Taxable brokerage account: This type of account has its own tax structure separate from the two previously mentioned accounts. Brokerage accounts are taxed at capital gains rates (0%, 15% or 20% depending on your income level).
- Example: If you contribute $5000 to a brokerage account, you will have already paid taxes on that money and you don’t get any sort of tax deferral. Now let’s again say many years down the road that this $5,000 grows to $20,000 but in this case we are going to take to full $20,000. In this example you would not pay taxes on the $5,000 you put into the account, this is called your basis. And you would pay the capital gains tax rate on the $15,000 of gains, which a lot of the times can be lower than your income tax rate.
Ok, so now that we have those definitions out of the way let’ talk through why it is so important to have the right investments in the right accounts.
With these different accounts being taxed in different ways, we are able to be strategic with what we put where to take full advantage of the tax advantages of each account.
Let me break that down more.
Historically over time, the S&P 500 (an index representing the stock prices of the leading 500 companies in the US stock market) has returned on average around 10% per year since its inception.
So we would want our stock investments that are likely to grow most, like the S&P 500 index, to be in our investment accounts that allow tax free or tax favored growth. So this would be your Roth IRAs/401k’s and taxable brokerage accounts.
If you are going to have bonds in your portfolio, you would want those to be in your pretax accounts such as your Traditional IRA & 401k. This is because bonds have historically average annual returns in the 4% to 6% range depending on the type of bonds. With bonds and assets similar to bonds having a lower average growth rate than an asset class such as stocks, you would want those bonds to grow within that tax deferred account because distributions from the pretax account are going to come out completely taxable.
Since your Roth accounts are going to grow tax free, you want those accounts to house the investments that are going to grow more
Since your pretax accounts are going to grow tax deferred, meaning you will pay taxes on the money you take out later, you want the pretax accounts to house investments that are not going to grow as much but that do serve a purpose in your financial planning.
This is just one piece to the puzzle as far as how you should be invested. There are many other factors such as your age, risk tolerance, time horizon, level of spending and other things that will factor into how you should be invested.
But don’t overlook the power of aligning your investments with the correct accounts.