While academic research has shown it is difficult or impossible to beat market returns, often we can effectively improve our returns simply by reducing the taxes on our investment income and gains! The first step is to understand how tax treatment differs for each account type, especially when taking retirement withdrawals. To avoid penalty scenarios, assume that all withdrawals occur after age 59 ½.
- IRA/401k/403b/457: Although balances in these accounts grow tax-deferred, all withdrawals are taxed as ORDINARY INCOME — traditionally the highest applicable tax rate an investor will pay.
- Roth IRAs: Grows tax-deferred and withdrawals are TAX-FREE.
- Taxable accounts such as individual, joint, and trust accounts: Taxation on these accounts varies with the security and is assessed annually when gains are realized and/or income is received since the account is not tax-deferred. But investors have the opportunity to receive the more favorable CAPITAL GAINS tax rate on stocks held over one year.
The next step is to understand what rate you will pay for the various types of income you receive if held in a taxable account:
- Ordinary income tax rates (undesirable) apply to interest income from money markets, bonds (other than municipal), and REITS.
- Capital gains rates (desirable) apply to long-term gains and qualified dividends associated with stocks and stock funds.
So putting this information all together, what can an investor do to minimize taxes? Consider these guidelines:
Tax-Deferred Accounts, such as your IRA/401k/403/457, should contain High-Returning Securities with Big Tax Consequences. Clear examples of these assets are junk bonds, junk-bond funds, and multi-sector-bond funds, all of which kick off a higher percentage of taxable income. REITs, whose payouts are generally nonqualified and taxed as ordinary income, also go here. This type of account is also a good home for high-quality bonds and bond funds, particularly when returns are higher. Finally, stock funds that have a high-asset-turnover (thereby creating realized gains, especially short-term gains that are taxed at dreaded ordinary income rates) should go here if you don’t have sufficient space in a Roth account.
Tax-Free accounts, Roths, should contain your Highest Returning Securities. Because the gains are tax-free, you should put your highest returning assets, usually stocks and stock funds, that are in the emerging markets and small cap categories. Because Roths are tax-deferred, this is a great home for high-turnover stock funds.
Taxable accounts, typically titled as individual, joint, and trust, should contain Higher-Returning Securities with Low Tax Consequences. Because these accounts are eligible for long-term capital gains treatment, they are a great receptacle for stocks and stock funds with low turnover. Not only has the capital gains rate been traditionally lower than ordinary income rates, typically the investor can decide when to sell and absorb those taxes. While high-dividend paying stocks with qualified dividends may currently work in this type of account, keep in mind that favorable dividend tax treatment seems to be on the cutting board annually and may easily disappear.
Because tax treatment of investments changes frequently, it’s important to revisit your asset-location framework every few years. Need more information? Morningstar’s Christine Benz has several excellent articles on this topic at Morningstar.com.
