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:
|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 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.
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:
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.
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Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager. Schwab does not provide legal or tax advice.
Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.