Tax-efficient investing.

Looking for actionable strategies for tax-efficient investing? Tax-smart investors hold tax-efficient investments in taxable accounts and less tax-efficient investments in tax-advantaged accounts.

Strategies for tax efficiency.

Broadly speaking, investments that tend to lose less of their return to income taxes are good candidates for taxable accounts. Likewise, investments that lose more of their return to taxes could go in tax-advantaged accounts. Here’s where you might consider placing your investments:

Where tax-smart investors typically place their investments.
Taxable accounts Tax-advantaged accounts such as Roth IRAs and tax-deferred accounts including traditional IRAs, 401(k)s and deferred annuities
Individual stocks you plan to hold more than one year Individual stocks you plan to hold one year or less
Tax-managed stock funds, index funds, exchange-traded funds (ETFs), low-turnover stock funds Actively managed funds that may generate significant short-term capital gains
Stocks or mutual funds that pay qualified dividends Taxable bond funds, zero-coupon bonds, inflation-protected bonds or high-yield bond funds
Municipal bonds, I bonds (savings bonds) Real estate investment trusts (REITs)

Returns lost to taxes.

Because mutual funds may distribute capital gains throughout the year, mutual fund investors are often concerned about losing investment returns to taxes. But depending on how they manage their investments, individual stock and bond investors are vulnerable to taxes as well.

Returns lost to taxes might be disconcerting, however, you can exercise a good deal of control over them. For example, diversification and asset allocation are great tools that help reduce portfolio volatility. But despite how diligent you might be in setting up your portfolios and selecting your individual investments, you’ll still be subjected to the short-term whims of the market. The greatest degree of control is in the area of expenses and tax-efficient implementation. It makes sense, then, to bring tax-efficiency near the forefront of your investment plan.

Of course, this presumes that you hold investments in both types of accounts. If all your investment money is in your qualified retirement plan, like a 401(k) or IRA, then just focus on asset allocation and investment selection.

Tax diversification.

Tax diversification can be important if you’re uncertain about your tax bracket in retirement, and it can also help with charitable giving and estate planning goals.

Holding your investments in different accounts based on tax treatment (such as taxable and tax-advantaged investments and accounts) adds value during the accumulation phase of your financial life by allowing you to defer taxes (or, in the case of a Roth IRA, entirely eliminate the taxes on investment returns if you satisfy the holding period requirement). It also adds an additional layer of diversification to your portfolio during the distribution phase in retirement. Call it “tax diversification.”

Diversifying by tax treatment can be especially important if you’re uncertain about the tax bracket you’ll be in at retirement. For example, if you’re on the fence, instead of choosing a traditional IRA, 401(k), or Roth IRA, why not split your contributions between two accounts? When you start withdrawing money in retirement, you’ll be able to manage your income tax bracket with more flexibility as you choose which types of accounts you take your cash from. For example, you may want to focus on tax-free municipal bond income, qualified dividends, and long-term capital gains from your taxable accounts; tax-free income from your Roth accounts; and only enough from taxable IRAs to keep you from moving into the next highest tax bracket (or to satisfy required minimum distributions, if applicable).

Using different account types for their tax treatment can also help with your charitable giving and estate planning goals—different accounts receive different types of gift and estate tax treatment. For example, you might want to give appreciated securities from your taxable accounts to charity for a full fair market value deduction and no capital gains tax. You can also leave these types of shares to your heirs, who will receive a step-up in cost basis. Roth IRAs also make a great bequest, since distributions are free from income tax for your beneficiaries.

However you decide to split up your portfolio between account types, for asset allocation purposes you still have only one portfolio. In other words, if you kept all your stocks in your taxable account and an equal amount of money in bonds in your tax-advantaged account, you wouldn’t have two portfolios consisting of 100% stocks and 100% bonds. You would have one portfolio consisting of 50% stocks and 50% bonds. The different assets just happen to be in different accounts.

Other considerations.

In general, holding tax-efficient investments in taxable brokerage accounts and less tax-efficient investments in tax-advantaged accounts should add value over time. However, there are other factors to consider, including:

  • Periodically rebalancing your portfolio to maintain your strategic asset allocation. Rebalancing involves selling and buying assets that have either grown beyond or fallen below your original allocation, causing an additional tax drag on returns in your taxable accounts. When you rebalance, taking profits from assets that have grown may result in either long- or short-term capital gains. For this reason, you may want to focus your rebalancing efforts on your tax-advantaged accounts and include your taxable accounts only when necessary. Keep in mind that adding new money to underweighted asset classes is also a tax-efficient way to help keep your portfolio allocation in balance.
  • Active trading by individuals or by mutual funds, when successful, tends to be less tax-efficient and better suited for tax-advantaged investments and accounts. A caveat: Realized losses in your tax-advantaged accounts can’t be used to offset realized gains on your tax return.
  • A preference for liquidity might prompt you to hold bonds in taxable accounts, even if it makes more sense from a tax perspective to hold them in tax-advantaged accounts. In other situations, it may be impractical to implement all of your portfolio’s fixed income allocation using taxable bonds in tax-advantaged accounts. If so, compare the after-tax return on taxable bonds to the tax-exempt return on municipal bonds to see which makes the most sense on an after-tax basis.
  • Estate planning issues and philanthropic intent might play a role in your portfolio planning. If you’re thinking about leaving stocks to your heirs, stocks in taxable brokerage accounts are generally preferable. That’s because the cost basis is calculated based on the market value of the stocks at the time of death (rather than at the time they were originally acquired, when they may have been worth substantially less). In contrast, stocks in tax-deferred accounts don’t receive this treatment, since distributions are taxed as ordinary income anyway. Additionally, highly appreciated stocks held in taxable brokerage accounts for more than a year might be well suited for charitable giving because you’ll get a bigger deduction. The charity also gets a bigger donation than if you had liquidated the stock and paid long-term capital gains tax before donating the proceeds.
  • The Roth IRA might be an exception to these general rules. Since qualified distributions are tax-free, it’s best to place assets you believe have the greatest potential for higher return inside a Roth IRA when possible.

The bottom line.

Tax-efficient investing can seem a bit complex, but it’s an important concept to understand as you try to manage the effects of taxes on your investment returns.

We're here to help

Clients of independent investment advisors: You may also contact your advisor or call Schwab Alliance at 800-515-2157.