Asset Location: The Secret to Investment Success

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In December, I introduced a very important investment concept, asset location. The post contained a flowchart, that helped you decide where you should start investing.

The question of where to start investing, is just as important to understand as asset allocation. Different accounts such as a Roth IRA and 401(k) offer advantages that taxable accounts can’t match. An investor who is looking to maximize their after-tax return (which is the goal of investing), will look to invest in these accounts first.

The post I did back in December, was just an info graphic and didn’t explain the reasoning behind my choices?  In this post I wanted to expand on this flowchart, so you can see my rationale.

Assumptions

• You plan on your income increasing and therefore your taxes increasing
• You’re eligible to contribute to a Roth IRA

Are You Employed?

The asset location flowchart starts off with a simple question, “Are you employed?  It depends on where your work, but these plans are generally called 401K’s, 403B’s, Simple IRA’s, or Thift Savings Plans.

If you’re self-employed, you still qualify for certain types of employer-sponsored plans. Therefore, you would answer yes to this question.

Last, don’t factor in employer-sponsored plans that let you purchase company stock. For asset allocation reasons, this is not the best account to begin investing.

Are You Employed? – Yes

The advantage of investing in an employer sponsored retirement plan first, is that your employer might match a portion of your contributions. A matching contribution from your employer, is the highest returning investment available today.

If you’re self-employed you can create a plan where your company matches your personal contributions. There are tremendous tax advantages to creating an employer-sponsored plan if you’re self-employed.

Are You Employed? – No

If you’re not employed, you will not have excess to any employer plans that offer tax-savings.

Are You Employed? – Yes – Matching Contributions?

If matching contributions are available in your employer sponsored plan, you must take full advantage of them before considering investing in any other account.

Are You Employed? – No – Earned Income? – No

If you don’t currently have a job, but have earned income for the year, you’re qualified to start an IRA. The IRS categorizes earned income as wages, salary, and amounts received from professional services.

Income that the IRS doesn’t count as earned income are dividends, interest, capital gains, unemployment compensation, and disability payments.

Are You Employed? – Yes – Matching Contributions? – No – Start a Roth IRA

There are two reasons why you would choose to invest in a Roth IRA over 401K.

1. Roth IRA’s don’t have to be rolled over.
2. You choose the investment provider in a Roth IRA, while in a 401K, the investments are chosen for you.

Are You Employed? – Yes – Matching Contributions? – Yes – Roth Option?

Going Roth has it’s advantages, especially for members of Gen Y. Therefore, if there is a Roth option available, I would recommend taking advantage of it.

Are You Employed? – No – Earned Income? – No – Spousal Income?

If you don’t have any income, but your spouse does, the IRS still lets you contribute to a Roth IRA. If you’re a one income household, this can be an option for you.

More on spousal IRA’s

Are You Employed? – No – Earned Income? – No – Spousal Income? – No – Taxable Account

Unfortunately, you don’t qualify for any accounts set aside for after-tax savings. Hopefully, none of you will be in this situation.

Conclusion

This should clear up a lot of the confusion regarding asset location. Once you have your asset location figured out, you can then move onto asset allocation.

Good luck and if you have any questions, let me know in the comments.

Tagged as: Asset Allocation, investing, Saving