If you have both taxable and tax-advantaged accounts and can choose which securities are held in which accounts, here are some ideas to help you decide where to invest.
Many investors have both taxable accounts, such as bank and brokerage accounts, as well as tax-advantaged accounts like 401(k)s, 403(b)s, and Individual Retirement Accounts (IRAs).
Investors can keep a variety of securities such as stocks, bonds, and money market funds within these accounts. But the allocation can make a big difference in the long run when it comes to taxes. A tax-efficient portfolio may offer investors more money to reinvest and grow over time.
To get started with tax-efficient investing, first look across your entire holdings, including employer plans and your spouse’s portfolios, says Michael Rice, corporate tax director for TD Ameritrade. Tax-efficient accounts such as 401(k)s, 403(b)s, and traditional IRAs allow investors to defer taxes on holdings until amounts are withdrawn during retirement.
Roth IRAs and Roth 401(k)s are also tax-advantaged plans. With Roth plans, investors pay taxes on their deposits, but then the gains grow tax-free. So withdrawals from Roth accounts aren’t taxed, although you will incur an early withdrawal fee if you take funds before age 59.
In a taxable account, holdings are subject to tax. The rates depend on whether the gains are short-term or long-term.
Short-term capital gains (and interest) are taxed at the ordinary income rates that can be as high as 37%. Long-term capital gains (securities held for more than a year) are taxed at a maximum tax rate of 20%, and this is the same rate applied to ordinary dividend payments.
It’s no wonder many investors are confused about which securities to put in which accounts. Rice suggests putting actively managed funds, preferred stocks, and taxable bond funds like junk bonds in your tax-advantaged accounts, especially retirement accounts where the securities are likely to be held for more than one year. Essentially, consider using tax-efficient accounts to hold investments that kick off yearly income.
On the other hand, consider keeping municipal bonds in your taxable accounts only. Municipal bonds typically pay a lower yield because they’re already tax-advantaged. So holding them in a traditional retirement account can actually do more harm than good.
“You’re essentially converting what is tax-free into taxable when it’s withdrawn,” Rice says. “Putting it in a Roth means you don’t fully leverage its tax-free nature because municipal bonds would be tax-free in any event.”
Mutual funds and exchange-traded funds that are designed to minimize taxes should ideally also go into the taxable account. Keep in mind that if you put stock in a taxable account, you might try to hold it for more than a year to avoid the short-term capital gains tax when you sell it. International stock funds are better in a taxable account because they will likely have foreign withholdings, and holding in a taxable account may allow investors to claim foreign tax credits against U.S. taxes, Rice says.
A tax-efficient portfolio can provide more money over the long run. Let’s look at two hypothetical portfolios, Portfolio A (“tax inefficient”) and Portfolio B (“tax efficient”). Both have a starting balance of $100,000 and 7% annual growth. Assume that both accounts are held over 30 years with the gains reinvested.
Let's say Portfolio A’s gains have an effective tax rate of 28% annually before gains are reinvested. Suppose that due to the tax efficiency of Portfolio B, it has achieved an effective tax rate of 15% before reinvestment. Under these assumptions, after 30 years, Portfolio A would have grown to $437,161. Portfolio B would have grown to $566,277, or an additional $129,116.
If you’re ready to make your portfolio more tax-efficient, consider a few key factors. Wash sale rules are still in effect, meaning that if you sell a security at a loss, you can’t repurchase it or a nearly identical investment for another 30 days or else you won’t be allowed to reap the tax benefit of the loss, according to Rice. And although holdings like money market accounts provide ordinary income, many people use them for emergency cash, so the need for liquidity may override the benefits of tax efficiency.
Taxes are complex, so try to speak with a tax advisor before solidifying your plan. And don’t go overboard with focusing on tax efficiency, Rice says.
“Tax efficiency is a tail that should never wag the dog,” he says. “The overall investment philosophy, risk tolerance, and so on is of paramount importance.”
Want to learn more about tax-efficient investing? Watch the video below.