You’ve read about diversification — not placing all your eggs in one basket.
Diversification means that your investments are in the mix of stocks and bonds, U.S. and international and big and small companies. Financial Advisors call this asset allocation. It’s how we allocate your money across these different asset classes (the different types of stocks and bonds). Often, this is done by using mutual funds that hold these stocks and bonds, not by owning the individual stocks and bonds.
That’s the basis of modern investing. Diversification allows you to pursue your investment growth goal while not exposing yourself to more risk of loss than you can handle.
Some asset classes generate income, like interest payments from bonds or dividends from real estate and some stocks. This income is taxed just like you earn it, and that can mean a big surprise at tax time.
What if you could own those asset classes, benefit from the income but not pay tax on those earnings each year? By holding “tax inefficient” asset classes in your tax deferred accounts, you are not taxed on the earnings. Your IRA, 401(k), 403b, 457 and some other employer-sponsored retirement plans are all tax deferred accounts. And they are just the place to consider holding these asset classes that pay interest and dividends. (Note, your Roth IRA may be the best place to own different asset classes).
Financial Advisors call this “Location Optimization” or “Asset Location”. It’s a way to use the different types of accounts you have as one more way to diversify. Following the tax laws, a portfolio that pays less in tax means you get to keep more.
Circular 230 Notice: Pursuant to Treasury Department Circular 230, tax advice contained in this communication and any attachments are not intended to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code, nor may any such tax advice be used to promote, market or recommend to any person any transaction or matter that is the subject of this communication and any attachments.
RA, 401(k) and other tax-deferred retirement accounts noted above are subject to required minimum distributions in retirement which are taxed at your marginal tax rate.