When it comes to taxes, all investments are different. Everything depends on the character and timing of the investments. So before you sell appreciated stock, buy interest-bearing bonds, or re-balance your portfolio, you’ll want to understand the tax consequences or your investment actions.
Deferring vs. Paying Now
The first distinction to understand is that between taxable and tax-deferred accounts. Retirement accounts such as traditional 401(k)s and IRAs are taxdeferred. This means you make pre-tax or tax-deductible contributions and don’t owe tax on them, or your investment gains, until you take the money out in retirement. Tax-deferred portfolios support — or at least tolerate — investment strategies such as frequent trading activity.*
A taxable account that you fund with post-tax dollars is less amenable to such investment strategies because you’re responsible for the tax on appreciated investments in the year you sell them. This may be less of an issue if you hold an investment for at least one year and it qualifies for the 15% or 20% long-term capital gains rate. But if you sell earlier, you may owe as much as 39.6% in tax on capital gains, depending on your current income.
Taxable accounts make more sense for investments you intend to hold for a long time. Certain types, such as index funds and international funds, which tend to make minimal taxable distributions, are also generally suited to taxable accounts.
The Bond Question
Bonds often present tax complications for investors. Usually, some interestpaying, fixed-income investments need to be in taxable accounts to provide liquidity for trading. But whether it’s better to invest in taxable or tax-free bonds depends on several factors, including your expected return after taxes.
All else being equal, a taxable bond paying 4% and subject to a 40% tax (for a net after-tax return of 2.4%) is less desirable than a tax-exempt bond paying 3%. Your need for current income also affects whether you should hold fixed-income investments in a taxable or tax-deferred account.
Your Alternative Minimum Tax situation should also be taken into account as this may change your marginal tax rate. In addition, interest income from specified private activity bonds is includible in the computation of Alternative Minimum Taxable income.
You may also be subject to the 3.8% Net Investment Income Tax (NIIT), which is in addition to regular income or Alternative Minimum Tax liability. The rules for NIIT are complex, but it generally applies to unearned income and capital gains if your modified adjusted gross income reaches a certain threshold.
Contact us with any questions about how the NIIT and other taxes may affect your tax situation.
*For specific investment advice, you should consult with your personal investment broker or Registered Investment Advisor