We spend countless hours researching the “what” which stock, which fund, which sector. But people often forget to ask one of the most important questions: where should I invest it?
The account you choose for your investments can be just as important as the investment itself. Here’s why:
Different Accounts are Taxed Differently
Every investment has the potential to generate income (like interest or dividends) or capital gains. The type of account that holds this investment determines when and how you pay tax on that growth. This is crucial because a smarter tax placement strategy could boost your long-term, after-tax returns.
Let’s look at the three main types of investment accounts and how they are taxed:
Account Type |
When are Contributions Taxed? |
When is Growth/Withdrawal Taxed? |
| Traditional Retirement Accounts (Traditional 401(k), IRA) |
Tax-deductible (pre-tax). Reduces your taxable income today. |
Tax-Deferred. All growth is taxed as ordinary income only upon withdrawal in retirement. |
| Roth Accounts (Roth 401(k), Roth IRA)
|
After-tax. Does not reduce your taxable income today.
|
Tax-Free. Qualified withdrawals in retirement are completely tax-free.
|
| Individual/Taxable Accounts
(Standard Brokerage Account) |
After-tax. |
Taxed Annually. You pay tax on interest, dividends, and realized capital gains every year. |
The Private Credit Opportunity in a 401(k)
Recently, regulatory and legislative discussions like the Executive Order titled “Democratizing Access to Alternative Assets for 401(k) Investors” have been aiming to pave the way for more people to access alternative investments in their defined-contribution plans. This includes asset classes like private equity and, more specifically, private credit.
Private credit, which involves non-bank institutions lending directly to companies, has been growing in popularity due to its attractive yields. But from a tax perspective, it presents a challenge.
The Tax Headache of Private Credit in a Taxable Account
Private credit is, by its nature, an income-generating asset. The return you receive primarily comes from interest payments on the loans.
In a standard, taxable brokerage account, that interest is typically taxed as ordinary income, the highest tax rate. This means that every year, you pay a tax bill on the interest your investment generates.
The Tax Shield of the Traditional 401(k)
This is where the power of tax placement comes in. By investing in private credit through a traditional 401(k) or IRA, you gain a benefit: tax deferral.
Why this matters for private credit:
- Shielding Ordinary Income: The interest payments, which would normally be immediately taxed at your top ordinary income bracket, are allowed to compound tax- free within the retirement account.
- Maximized Compounding: Every dollar of growth stays invested, generating a return on the full amount, not just the after-tax remainder. This increases the compounding effect.
- The Lower Tax Bracket Bet: When you eventually take withdrawals from your traditional 401(k) in retirement, you will pay ordinary income tax on the full amount (contributions and all growth). However, most people are in a lower tax bracket in
retirement than they are during their peak earning years. This means you could convert a current, high-tax liability into a future, potentially lower-tax liability.
In short, a traditional 401(k) can act as a powerful tax shield for high-income-generating assets like private credit, allowing the full force of those higher yields to compound for decades.
A Word of Caution
While the tax benefits are clear, it is important to remember that private credit carries unique risks. It is an illiquid investment, meaning you cannot easily sell it for cash like a stock, ETF, or mutual fund. It also often comes with higher fees.
As regulators work to make these products available, a key consideration for investors will be whether the added complexity, illiquidity, and higher fees are justified by the potentially higher yields and powerful tax benefits of placing them inside your tax-deferred retirement account.
This blog post is for informational and educational purposes only and should not be considered tax, legal, or investment advice. Consult with a qualified financial or tax professional before making any investment decisions. A Roth IRA offers tax-free withdrawals on taxable contributions. To qualify for the tax-free and penalty free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59.5 or due to death, disability, or a first-time home purchase (up to a $10,000 lifetime maximum).
Depending on state law, Roth IRA distributions may be subject to state taxes.
