Huge returns don’t mean much if you are giving most of the profits back to Uncle Sam. Yet, so many investors ignore the impact that taxes have on their planning decisions. Different investments work better in different accounts and different accounts work better for different objectives. That’s why investment location can be just as important as investment selection.
A sports analogy I like to use, is that of a pitching matchup in baseball. Especially with middle relievers, managers will often utilize a pitcher they believe to have a particular advantage over their opponent. The same thing works with the use of specific accounts. Certain accounts match up better against the taxation of investments in order to best grow your money. However, investors, and even many advisors, often overlook or are unaware of the enormous impact taxes can have on generating wealth and the steps they can and should take to reduce the burden.
To help grapple with taxes, the chart below shows some helpful suggestions on where to own what (from Fidelity):
*Tax deferred would typically be a 401k, Traditional IRA, small business plan or annuity. While the tax exempt would be Roth or potentially a foundation.
If you aren’t sure if your mutual fund or ETF would be better suited in a taxable or tax deferred/exempt account, a little-known performance check is available on most investments:
The example above comes from the Vanguard website on one of their better known/performing asset allocation funds. You can see there is a big difference between the pretax and after-tax returns, especially when you consider compounding. To put this into perspective, a 100k investment growing at 7.18% for 20 years becomes roughly 400k. The same investment at only 5.5% becomes roughly 290k. Yikes! This investment likely belongs in a deferred/exempt account so that you aren’t paying taxes each year on the fund’s distributions and you are getting the full power of those returns. If the spread between pre/post tax is tight, like many index funds or ETFs, the position can stay in the taxable account without causing the large tax drag which holds you back.
As a rule of thumb, you should always have a plan for what you own, why you own it, and where you own it. Appropriately planning and utilizing accounts like IRAs, 529 plans, UTMAs, annuities and trusts can be life changing. If you delegate your finances to an advisor, one of the biggest ways we can earn our value is by making sure you are taking advantage of the right accounts. Make sure you are asking your advisor what you can be doing to keep more of your profits.
If taxes aren’t being discussed or even considered, make sure you give us a call!