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.
Consider tax-advantaged accounts for many fixed-income investments
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accounts such as 401(k)s, 403(b)s, and traditional IRAs allow investors to defer taxes on holdings until amounts are withdrawn during retirement.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“You’re essentially converting what is tax-free into taxable when it’s withdrawn,” Rice says.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.”
The key to filing taxes is being prepared. TD Ameritrade provides information and resources to help you navigate tax season.
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.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.
Carefully consider the investment objectives, risks, charges and expenses before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an investment company. Read carefully before investing.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC, a subsidiary of The Charles Schwab Corporation. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2021 Charles Schwab & Co. Inc. All rights reserved.