I’m often asked by investors how I should hold my different investments. This appendix will give you a road map on how to start thinking about that.
Imagine two investors.
Both own exactly the same investments.
Both earn the same returns.
Both take the same amount of risk.
Twenty years later one investor has substantially more money.
Why?
Taxes.
The investments were identical. The account structure wasn’t. Many investors spend decades learning about stocks, real estate, and mutual funds while knowing very little about:
- IRAs
- Roth IRAs
- SEP IRAs
- Solo 401(k)s
- HSAs
- Taxable brokerage accounts
- Self-directed accounts
The goal of this chapter is not to provide tax advice. We are not CPAs. The goal is to help you understand the major vehicles available so you can have a more productive discussion with your CPA, financial advisor, or attorney.
First: There Are Two Decisions
Most investors combine these together. They are actually separate decisions.
Decision #1: What should I invest in?
Examples:
- Stocks
- Bonds
- Real estate
- Private equity
- Income funds
- MTI
- REITs
Decision #2: Where should I hold those investments?
Examples:
- Brokerage account
- Traditional IRA
- Roth IRA
- SEP IRA
- Solo 401(k)
- HSA
The investment and the account are two different things.
The Three Sources of Return
Every investment generally creates returns through one of three mechanisms.
1. Income
Examples:
- Bonds
- Preferred stock
- Dividend stocks
- Income funds
- Real estate cash flow
- MTI (Medium Term Income Fund) style investments
You receive cash distributions.
Benefits:
- Predictable
- Can supplement income
- Easier psychologically
Drawbacks:
- Usually taxable (and taxable right away)
- May grow slowly
2. Appreciation
Examples:
- Growth stocks and/or growth-focused mutual funds
- Venture capital
- Some private equity
Little/no current income. Most of the returns arise from future growth.
Benefits:
- Potentially large upside
- Tax efficiency (Usually a lower tax rate, and the tax liability is in the future when you sell).
Drawbacks:
- Volatile
- Can take years to realize gains
3. Hybrid
Examples:
- Rental real estate
- Value stocks
- Some private equity investments
You receive current income plus future appreciation.
Benefits:
- Predictable
- Can supplement income
- Easier psychologically
Drawbacks:
- Usually taxable (and taxable right away)
- May grow slowly
Many investors prefer hybrids because they provide both cash flow and growth.
Which Assets Belong in Which Accounts?
This is where things become interesting. A common principle: Tax-inefficient assets often belong inside tax-advantaged accounts. Following are some examples.
Income-Producing Assets
Investments that may throw off taxable income every year:
- Bonds
- High-dividend funds
- Income funds
Many investors prefer holding these inside:
- Traditional IRA
- SEP IRA
- Solo 401(k)
Why? The annual taxation may be deferred.
Appreciation Assets
Growth assets often generate little current income.
Examples:
- Growth stock funds
- Index funds
These may work reasonably well in taxable accounts because taxes are often deferred until sale.
Roth Accounts
Many advisors argue: Place your highest expected growth assets inside Roth accounts. Why?
If growth occurs inside a Roth, future gains may potentially be tax free if rules are met. Example: $50,000 growing to $500,000. The location matters (a lot!). These rules vary a lot so talk to your advisors.
Understanding the Major Account Types
Taxable Brokerage Account (The simplest)
Advantages:
- No contribution limits
- Full liquidity
- No age restrictions
Disadvantages:
- Ongoing taxation
- Capital gains taxes
Most investors will have one.
Traditional IRA
Advantages:
- Tax-deferred growth
- Often tax deduction on contribution
Disadvantages:
- Future withdrawals taxed as ordinary income
- Required distributions later in life
Roth IRA
Advantages:
- Tax-free growth (subject to IRS rules)
- Tax-free withdrawals (subject to IRS rules)
Disadvantages:
- Income limitations
- No immediate deduction
Many investors view Roth space as extremely valuable because it may never be taxed again. Note that there are some advanced tax management strategies for Roth IRAs that are beyond the scope of this book. See our book, 1031 Exchanges, Private Equity and DST for more information.
SEP IRA
This is the one many business owners discover surprisingly late. SEP stands for Simplified Employee Pension.
Advantages:
- Potentially large contributions
- Easy administration
- Designed for self-employed individuals and business owners
Disadvantages:
- Employer contribution rules
- Less flexibility than some Solo 401(k) structures
For many small business owners, a SEP is one of the first major tax-advantaged retirement vehicles to evaluate.
Solo 401(k)
Designed primarily for self-employed individuals without full-time employees.
Advantages:
- Often higher contribution flexibility
- Loan provisions may exist
- Can sometimes allow larger contributions than SEP structures
- May be able to take advantage of matching to increase contribution
Disadvantages:
- More administration
- More complexity
Many business owners eventually compare a SEP IRA vs. Solo 401(k) with their CPA.
HSA
Often overlooked. Some advisors call it the most tax-advantaged account available. Why? Potentially:
- Tax deduction going in
- Tax-free growth
- Tax-free medical withdrawals
In other words, a triple tax benefit. Not everyone qualifies, but many investors ignore it. Talk to your CPA to see if you can take advantage.
Self-Directed Accounts
A self-directed account is not a different tax structure. It is simply an account that allows a broader investment menu. Instead of:
- Stocks
- ETFs
- Mutual funds
You may be able to own:
- Real estate
- Private funds
- Notes
- Private companies
- Certain alternative investments
Examples include:
- Self-directed IRA
- Self-directed Roth IRA
- Self-directed SEP IRA
- Self-directed Solo 401(k)
The tax structure stays the same; the investment menu changes. That’s an important distinction.
In addition, there are number of trust formations that can solve many different types of problems. They are beyond the scope of what we can cover in a simple introductory book. Be sure to ask your financial advisors about them.
A Simple Framework
Many investors eventually create buckets and often develop them in this order.
Bucket 1: Safety
Purpose: Sleep at night
- Cash
- CDs
- Treasury securities
Bucket 2: Growth
Purpose: Long-term appreciation
- Index funds
- Growth funds
- Equities
Bucket 3: Income
Purpose: Cash flow
- Bonds
- Dividend funds
- Income-producing alternatives
Bucket 4: Alternatives
Purpose: Diversification and non-correlated return streams
- Private equity
- Private credit
- Real estate partnerships
- MTI Medium-Term income fund
Questions to Ask Your CPA
This is a great way to get started. To explore in more depth, see our earlier book, The Complete Guide to Passive Diversified Real Estate Investing.
Before opening any account, consider asking:
- Should I be using a SEP IRA or Solo 401(k)?
- Am I maximizing available retirement contributions?
- Would Roth conversions make sense?
- Which investments belong in taxable accounts?
- Which investments belong in retirement accounts?
- Does a self-directed account make sense for me?
- What prohibited transaction rules apply?
- What are the tax consequences of my investment strategy?
Key Takeaway
Most investors focus entirely on the investment. Sophisticated investors focus on both:
- What they own.
- Where they own it.
The right investment in the wrong account can create unnecessary taxes for decades. The right investment in the right account can significantly improve long-term outcomes without taking any additional investment risk.
Our Investor Relations team has set aside some time for you if you would like to see if our MTI is right for you. Go to IrontonCapital.com/icanalysis to choose your best time for your free portfolio analysis.
