Investing Tip #5: Location, Location, Location
My mother always told me, “Mack when you buy a house, the three most important things to remember are location, location, location.” Believe it or not, I actually took her advice on this. With three girls under age 4, I’m very happy I listened.
This principle can be applied to investing as well. We’ve already discussed how important it is that you have stocks, bonds, real estate, and precious metals in your portfolio. But just as important is where you have them.
Why is location important? Simply put—taxes. When you make money on an investment, either through interest, dividends, or gains, the tax man wants in on the action. If you have your investments in the wrong location, it will cost you more in taxes.
Following is the general rule of where to house each asset class.
- Treasury or Corporate Bonds. Treasury and Corporate Bond interest is taxable at your tax rate, which is generally between 15 and 33 percent. If you sell the bond at a gain, you also will incur capital gains tax. The tax is the same as your tax bracket rate if you sell the bond within 12 months of purchasing it (short-term capital gains). If you sell the bond after 12 months, it is taxable at long term rates. That rate is 15 percent if you are in the 25 to 35 percent brackets. If you are in the 10 or 15 percent brackets, no tax is due on long-term gains. It’s usually best to hold these bonds in an IRA, 401(k) or other retirement account.
- Municipal Bonds. Municipal bonds are issued by state and local governments, and in most cases the interest is exempt from Federal income tax. Therefore, it makes sense to keep these investments in non-qualified or taxable accounts. Capital gains are still taxable however, so try to hold munis for at least 12 months if you have a gain.
- Stocks. Most stocks generate some dividends, which are usually only taxed if you are in the 25 percent or higher tax bracket. If you have a gain in the stock, try to hold it for more than a year and it will qualify for long-term capital gains rates. If you hold the stock less than a year, you will pay short-term capital gains. For this reason, holding stock in a nonqualified account makes a lot of sense.
- Real Estate. Real estate dividends may either be taxed at your normal tax rate, or if qualified, at long-term gains rates. Gains are taxed at short-term rates if held less than 12 months, or at long-term rates if held more than that. If you own the real estate property directly, it makes sense to hold it in a taxable account. If you own the real estate indirectly through a limited partnership or REIT, it may make sense to hold the investment in a retirement plan.
- Precious Metals. Precious metals are viewed as collectibles by the IRS, and gains are taxed at a flat 28 percent. So for most folks, holding precious metals in a retirement plan is the way to go.
Of course, there are exceptions to every rule.
Taxes can take a substantial bite out of your portfolios returns over time. So it pays to make sure your investments are in the right place.