Understanding the difference between taxable, tax-deferred, and tax-exempt accounts may improve portfolio diversification and how much return you earn over time. But often, investors may not fully understand how a strategy called asset location may help improve returns and lower their overall tax bill using these different types of accounts. Each account type has different tax rules and treatments, and understanding each may help you determine which accounts suit your situation. Here, we outline what you need to know about each account type:

Taxable accounts- A taxable account is an account for which the IRS default rules apply, meaning there are no tax benefits. However, taxable accounts often have fewer restrictions and more flexibility when investing and withdrawing from them. Examples of taxable accounts include:

· checking and savings accounts

· money market accounts

· brokerage accounts that hold securities (stocks, bonds, ETFs, mutual funds, private investments)

In a taxable account, earnings such as dividends or interest are taxed yearly (money market, checking, and savings accounts) or when you sell strategies that gain value. Long-term gains on investments sold from taxable accounts are taxed at the 15% capital gains rate, which may be lower than an investor's federal tax rate.

Also, taxable accounts have no contribution limits or age restrictions for withdrawing.

Tax-deferred accounts- Tax-deferred accounts allow the payments of taxes to be delayed until the money is withdrawn. Examples of tax-deferred accounts include retirement savings accounts such as:

· 401 (k)s

· IRAs

· 403 (b)s

· Tax-deferred annuities

· Health Savings Accounts (HSAs)

Contributions into a tax-deferred account are made with money that has not been taxed, and contributions may help lower the investor's taxable income the year they were made. However, once the money is withdrawn from these various accounts, the contributions and earnings are taxed as ordinary income at the investor's current tax rate.

Tax-deferred accounts have contribution limits, age restrictions for withdrawing, or other conditions such as what the money can be used for, such as health care expenses. Tax-deferred accounts are often part of an employer-sponsored retirement savings plan or other employer benefits.

Tax-exempt accounts- Tax-exempt accounts require contributions to be made with after-tax dollars and do not provide a tax deduction on those dollars. However, tax-exempt accounts may not have additional taxation, providing the investor follows the applicable tax rules on these types of accounts:

· Roth IRAs

· Roth 401(k)s

· Roth 403(b)s

Tax-exempt accounts provide future tax breaks since withdrawals at retirement are not subject to taxes; the accumulation is tax-free.

There may be income limits to invest in tax-exempt accounts and age restrictions on the withdrawal age or the tax-exempt status, or a penalty may apply. Your financial and tax professionals can help you understand the rules on tax-exempt status for your situation.

An asset location strategy using these three investment strategies, taxable, tax-deferred, and tax-exempt, may help your tax situation now or later in retirement. A financial professional can help you determine if diversifying your portfolio using all three investment strategies may be appropriate for you.