Obviously, what you invest in can mean the difference between getting rich and losing your shirt. But where you invest can be even more important — especially if you end up picking winners.
Most people have several different ways to put their money to work. If you have a 401(k) or other retirement plan at work, you can have deductions pulled directly out of your paycheck and put toward your long-term savings. Opening an IRA can give you many of the same benefits with even more flexibility. For goals other than retirement, regular brokerage or mutual fund accounts let you have complete control over your money, and you can take it out or move it without any penalties.
But if you have a diversified investment portfolio with a variety of assets — such as stocks, mutual funds, bank CDs or other fixed-income investments, and alternative investments — you may not spend much time figuring out where each investment fits best across all the accounts you have. As a result, you could be missing out on big tax savings.
What should go where?
The right answer depends on your individual situation, but some general rules of thumb apply to many people.
1. Interest-bearing assets belong in IRAs. If you have bank CDs, bonds, or other investments that produce interest income, the best place for them is in a Traditional IRA. The reason is that these assets benefit the most from the tax savings that IRAs provide. Unlike income from stock dividends and capital gains, interest income gets taxed at your higher ordinary rate. Given how low the rates on these investments are right now anyway, the last thing you can afford is to lose a big share of that meager income to the tax man.
2. Save your best ideas for a Roth IRA. A Roth IRA is a special type of retirement account that let’s you withdraw all the income it generates tax-free. Therefore, you should put the investments that have the best chance of soaring in value inside a Roth.
High-growth stocks fit that bill. Think about some of the blockbuster gainers over the years — stocks like priceline.com (PCLN) and Green Mountain Coffee Roasters (GMCR) that have made a bundle for their longtime shareholders. If you’d put those investments in a Roth IRA, you could’ve enjoyed all those profits without paying a penny in tax. That’s why Roth IRAs are so valuable — but since you can only contribute limited amounts to a Roth, you have to use your Roth money wisely.
3. Invest long-term in taxable accounts. Even though stocks give you the best chance to make significant money over the long haul, that doesn’t mean that they aren’t suitable for taxable accounts. Until you actually sell a stock you own, you don’t pay tax on any gains. So plenty of people are still sitting on big gains from stocks like Amazon.com (AMZN) and Apple (AAPL) that they’ve held for years, letting their profits ride — and they haven’t had to pay a dime in tax along the way.
Moreover, as long as you hold onto investments for more than a year, any gains qualify for a tax break. Currently, the maximum tax rate for long-term capital gains is 15%, compared to up to 35% for regular income. So putting stocks and stock mutual funds or ETFs in taxable accounts can be a smart idea — especially when you can’t afford to lock up that money until you retire.
Figuring out what investments to buy may seem hard enough without worrying about which account to use to buy them. But in your constant fight with the IRS, it can make a huge difference — and it’s worth the effort.
For more on smart tax moves:
- 2012 Tax Changes: What You Need to Know
- The Real Reason to Adjust Your Withholding
- Legally Dodge the Tax Man in Retirement
Motley Fool contributor Dan Caplinger learned a lot of tax lessons the hard way. You can follow him on Twitter here. He doesn’t own shares of the companies mentioned in this article. The Motley Fool owns shares of Amazon.com and Apple. Motley Fool newsletter services have recommended buying shares of Amazon.com, priceline.com, Green Mountain, and Apple, as well as creating a lurking gator position in Green Mountain and a bull call spread position in Apple.