Abstract: When investing for retirement, people usually prefer tax-advantaged accounts, such as IRAs, 401(k)s or 403(b)s. But investments such as municipal bonds and passively managed index mutual funds may be better for traditional taxable accounts. This article unpacks why the more tax efficient an investment, the more benefit investors get from owning it in a taxable account, and vice versa.
Taxable vs. tax-advantaged accounts
When investing for retirement or other long-term goals, people usually prefer tax-advantaged accounts, such as IRAs, 401(k)s or 403(b)s. Certain assets are well suited to these accounts, but other investments make far more sense for traditional taxable accounts. Knowing the difference can help bring you closer to your financial goals.
Understand how they’re taxed
Where you own assets matters because of how they’re taxed. Some investments, such as fast-growing stocks, can generate substantial capital gains, which generally occurs whenever you sell a security for more than you paid for it.
When you’ve owned that investment for over a year, you recognize long-term gains, taxed at a maximum rate of 20%. In contrast, short-term gains, recognized when the holding period is one year or less, are taxed at your ordinary-income tax rate — maxing out at 39.6%.
Meanwhile, if you own a lot of dividend-generating investments, you’ll need to pay attention to the tax rules for dividends, which belong to one of two categories:
Qualified. These dividends are paid by U.S. corporations or qualified foreign corporations. Assuming you’ve met the applicable holding period requirements, qualified dividends are, like long-term gains, subject to a maximum tax rate of 20%.
Nonqualified. These dividends — which include most distributions from real estate investment trusts (REITs) and master limited partnerships (MLPs) — receive a less favorable tax treatment. Like short-term gains, nonqualified dividends are taxed at your ordinary-income tax rate.
Taxable interest (such as from corporate bonds and most U.S. government bonds) also is generally subject to ordinary-income rates.
Finally, there’s the 3.8% net investment income tax (NIIT) for higher-income taxpayers to consider. But the NIIT might be repealed under health care or tax reform legislation. (Contact us for the latest information.)
Generally, the more tax efficient an investment, the more benefit you’ll get from owning it in a taxable account.
Consider municipal bonds (“munis”), either held individually or through mutual funds. Munis are particularly attractive to tax-sensitive investors because their income is exempt from federal income taxes and sometimes state and local income taxes as well. 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 would result in a lost opportunity.
Passively managed index mutual funds or exchange-traded funds, and long-term stock holdings, are also generally appropriate for taxable accounts. Over time, these securities are tax efficient because they’re more likely to generate long-term capital gains, whose tax treatment is relatively favorable. Securities that generate more of their total return via capital appreciation or that pay qualified dividends are also better taxable account options.
Investments that generate ordinary income
What investments work best for tax-advantaged accounts? Taxable investments that tend to produce much of their return in ordinary income, for one. This category includes corporate bonds, especially high-yield bonds, as well as REITs, which are required to pass through most of their earnings as shareholder income. Most REIT dividends are nonqualified and therefore taxed at your ordinary-income rate.
Another tax-advantaged-appropriate investment may be actively managed mutual funds. 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 you. Because short-term gains are taxed at your higher ordinary rate, these funds would be less desirable in a taxable account.
Think beyond taxes
The above concepts are only general suggestions for taxable and tax-advantaged accounts. You may, for example, need more liquidity in your taxable account than you do in your IRA account. In this case, you might decide to hold a high-turnover equity fund or high-yield bond investments in the taxable account because you value flexibility more than favorable tax treatment.
Just keep in mind the benefits and risks — including the risk that your investments will lose value — associated with any investment decision, and know that tax issues can be complex. HK can help you make the best choices for your situation.