You may have heard of ‘asset allocation.’ Asset allocation refers to what kind of investments you make. Though the term looks similar, ‘asset location’ means something different. Asset location refers to what type of investment accounts that you use to invest your money. In this article, we will be focusing on retirement accounts (such as IRAs) and taxable brokerage accounts.
Retirement Accounts (IRAs)
These type of accounts are tax advantaged, but you can be penalized if you make withdrawals too early (or in some cases, if you withdraw an amount that is larger than what you put in). These are great for investments if you want are aiming to have more income that you can withdraw without penalty when you reach retirement age. Because of the tax advantages of these accounts, investing in these accounts is more simple.
Taxable Brokerage Accounts
On these accounts, you have to pay taxes on any money you make. You also will report your income to the IRS during tax season. Depending on your investments, you may have to file a 1099 form (this is pretty easy). Depending on what type of investments you have, you may have to file forms such as a Schedule K-1 form. Most investors will only have to file a 1099. Fortunately, most banks will fill the 1099 form out for you (I’m not sure about the Schedule K-1 Form). You only have to relay the information to the IRS. Of course, if you don’t make any money, you do not get taxed on your investments.
Investing in these accounts is more tricky than a retirement account. This is because you have to take another factor into consideration when you invest–you have to consider tax efficiency. For instance, ‘qualified’ dividends are normally taxed at 15-20%. ‘Unqualified’ dividends are taxed at your normal tax rate. Certain investments have lower taxes than others. Turnover rate can also effect how much your investment is taxed.
Which Asset Location is Right for You?
If you plan on retiring at 59 and a half or later and don’t want to withdraw prior to retirement, I recommend a retirement account. If you want to retire earlier than that or if you want to have extra income that you can draw from at will and without penalty, I recommend a taxable brokerage. I do a combination of both. I have a 401k with my employer, a Roth IRA, and a taxable brokerage account.