Investing by tax allocation

You can spend a lot of time and money working with a therapist to learn the powerful lesson, "control what you can control." Much the same applies to financial planning and investing. There is enough research to quote ad nauseam that the great majority of people and money managers cannot consistently beat the overall market. In other words, we don't get to control when a tweet or a new war moves the market, and trying to time such things is folly.

This leaves us with a better question - what do we control in our portfolios? With planning and thought, most can exert some control over how the proceeds of our investments are eventually taxed. There are three flavors to try: pre-tax investments are taxed like a paycheck when the funds are taken out of the account, taxable or non-retirement assets see growth and income taxed as they are realized (interest and dividends annually and gains when you sell), and tax-free or Roth accounts see no tax on any part of your withdrawals so long as you play by the rules of when you can do so.

When we think about a diversified portfolio we quickly see how these three flavors can lead to very different results depending on the account they live in. Take a bond, for instance. It will pay you interest over time which is usually taxed as ordinary income. Inside a non-retirement account you'll owe tax on this income as it's paid to you, regardless of whether you take it out or reinvest it.

The same bond in a pre-tax IRA will accrue the interest at no tax to you, allowing you to reinvest the proceeds over and over and defer all tax until you take funds out in retirement.

That bond has a role to play in your portfolio over time, just as a riskier international stock has its place. You'd expect such a stock fund to be volatile, but offer you a higher return over a long period of time. If it's going to grow, it would be great to have that aggressive growth in a tax-free account. If such a fund grew 500% over 25 years in a taxable account, you would owe considerable capital gains tax when you eventually sold it for spending.

At the end of the day, the money you get to spend in your life is a function of its growth and the tax you'll have to pay on it. Thoughtful planning can put you on the best possible path of growth, but too many people forget the second avenue to portfolio potential.