Investment Allocation and Investment Location: Both are Important!

As my amount of money invested slowly grows I am paying more attention to where my money is invested and how I invest it. I believe the most important part of investing is diversifying your investments using mutual funds that track the market indices. For me I use a 90% Stock / 10% Fixed Income portfolio that I rebalance yearly. Doing this keeps my risk exposure where I like it and forces me to sell high and buy low.

I further split my stocks portion into 50% US Stock Market Index and 50% International non-US stocks (this goes between International Index and Emerging Markets Index). For now I have all of my fixed income money in US domestic bonds as I have not found an international fixed income fund that I like.

Now that I have a sizable sum invested in the market I am starting to evaluate the investment location. I have to also look at the tax implications of which types of investment I hold in which type of accounts. Currently I have a Roth IRA, SIMPLE IRA (like a 401(k)), and a taxable brokerage account (currently empty).

These are the 3 main choices for all of us in investing. My first choice is to get my employer's match on the SIMPLE IRA. It is also the easiest as it comes out of my pay directly. Second I put whatever I can in my Roth IRA as it is all tax free on the back end. That is as good as it gets! If I max out my limit on the Roth I will add to the taxable account.

With the tools in place I have to decide which investments fit in which account based on tax advantage. It is best to put high income producing assets in the Roth IRA as interest is taxed at your normal income tax rate. Inside the Roth you never pay any taxes ever. Make the most of it!

Next best is to have any low or no income producing asset in a taxable account (once you max out the Roth IRA). If the stock or fund pays a low or no dividend it is best held here because you don't pay tax until you sell the asset. You only pay tax on whatever dividends are paid out. The end gain at time of sale is taxed at a lower long term capital gains rate. If you have a loss you can also use that loss against other gains to avoid tax. An added benefit is that if someone inherits your assets the cost basis resets to the value at the time of your death.

The traditional IRA/401(k) is the worst option in my opinion. You do save a little income tax up front but every cent that comes out of the account later is taxed as ordinary income. You also lose the ability to recover losses from the assets if you have them. The one advantage is that you can possibly wait for a low income year to withdraw from this account to reduce the amount of taxes you pay. You can also convert assets to Roth if you meet the requirements but still have to pay the tax on the converted amount now.

Now that we fully understand the options available we can make decisions accordingly. In my case I put 5% of my income in the SIMPLE and add sporadically to my Roth IRA. As my situation improves I will start a monthly contribution to my Roth to start the habit. I hope as time goes by and I earn more I can max out my Roth IRA and start with my taxable account. I welcome to problem of tax on investment gains!