Most investors think carefully about which investments to buy. Fewer think about where to hold them. Yet the type of account you use — taxable, tax-deferred or tax-free — can significantly change how much of your investment growth you actually keep after taxes.
Taxable brokerage accounts offer flexibility, since you can deposit and withdraw at any time. However, you may owe taxes each year on interest, dividends and any gains you realize when you sell. Long-term capital gains generally receive more favorable tax treatment than short-term gains.
Tax-deferred and tax-free accounts
Tax-deferred accounts, such as traditional 401(k)s and traditional IRAs, may let you contribute pre-tax dollars and postpone taxes until you withdraw in retirement. Your investments can grow without annual tax bills, but withdrawals are typically taxed as ordinary income.
Roth accounts work in the opposite way. You contribute money that has already been taxed, but qualified withdrawals in retirement can be tax-free. That makes Roth accounts especially valuable for investments you expect to grow significantly over time.
As a general principle, investments that produce a lot of taxable income, such as certain bond funds, are often better suited to tax-advantaged accounts. Tax-efficient investments, like broad stock index funds that generate fewer taxable distributions, may fit well in taxable accounts.
Contribution limits, income rules, employer plan features and your expected tax bracket in retirement all affect the best approach for you. There's no single formula, and the right mix often changes as your income and goals change.
Coordinate your investing and tax plans
Investment and tax decisions work best when they're made together. Reviewing your accounts each year, especially before contribution deadlines, helps you take full advantage of the options available to you.
Optima Finance Wealth coordinates investment and tax planning in one place. Schedule a free tax-efficiency review with our team today.