As a rule, when you’re investing for retirement or with other long-term goals in mind, using tax-advantaged accounts are a good go-to strategy. Examples of tax-advantaged accounts include IRAs, 401(k)s or 403(b)s. While certain assets are well-suited to being housed inside of a tax-advantaged account, other types of assets are better held in a traditional taxable account.
Some investments, such as fast-growing stocks, can trigger substantial capital gains upon sale. If you’ve owned the position for over a year before you sell it, you face long-term capital gains, taxed at a maximum rate of 20%. Short-term capital gains, assessed on holding periods of a year or less, are taxed at your ordinary income tax rate with a maximum tax of 37%*.
Considering the inherent tax-efficiency of the investment will point you in the right direction as to whether or not you’re better off putting the investments in a tax-advantaged or a taxable account. Generally, the more tax efficient an investment, the more benefit you’ll get from owning it in a taxable account. Investments that lack tax efficiency, on the other hand, are normally best suited to tax-advantaged vehicles.
Municipal bonds – or munis – held either individually or through mutual funds, provide another notable example. Munis are attractive to tax-sensitive investors because the income they throw off is exempt from federal income taxes and sometimes state and local income taxes, as well. However, because you don’t get a double benefit when you own an already tax-advantaged security in a tax-advantaged account, holding munis in your 401(k) or IRA doesn’t serve a beneficial purpose, as that would result in a lost opportunity. Instead, you may benefit more from holding the munis in a taxable account.
Similarly, tax-efficient investments such as passively-managed index mutual funds or exchange-traded funds, or long-term stock holdings, are also generally appropriate for taxable accounts. These securities are more likely to generate long-term capital gains, which enjoy a more favorable tax treatment.
Additionally, securities that generate more of their total return via capital appreciation or that pay qualified dividends are also better taxable account options. When it comes to dividends, though, you need to pay close attention to the tax rules surrounding them. If you own many income-generating investments, you should be familiar with the differences between qualified and nonqualified dividends, as they’re treated differently when it comes to taxation. Qualified dividends are paid by U.S. corporations or qualified foreign corporations. Similar to long-term gains, qualified dividends are subject to a maximum tax rate of 20%, though many investors are eligible for a 15% rate*. At the same time, nonqualified dividends — which include most distributions from real estate investment trusts and master limited partnerships — receive a less favorable tax treatment. Like short-term gains, nonqualified dividends are taxed at your ordinary income tax rate.
Take Advantage of Income-generating Investments
Taxable investments that tend to produce much of their return in income, work best for tax-advantaged accounts. This includes items such as corporate bonds (especially high-yield bonds) as well as Real Estate Investment Trusts (REITs), which are required to pass through most of their earnings as shareholder income. Most REIT dividends are nonqualified and are therefore taxed at your ordinary income rate.
Another tax-advantaged-appropriate investment may be an actively managed mutual fund. Funds with significant turnover — meaning their portfolio managers are actively buying and selling securities — have increased potential to generate short-term gains that ultimately get passed through to the investor. Because short-term gains are taxed at a higher rate than are long-term gains, these funds would be less desirable in a taxable account.
Though this article provides you with some general guidelines in determining which investments make for better tax-advantaged or taxable accounts, it’s always best to speak to your trusted Untracht Early tax advisor to help you craft a strategy that works best with your investment portfolio. Please feel free to contact your advisor for specific advice.