The taxman gets a bite of everyone’s income, and he is definitely coming for the sweet fruit of your investments: those juicy returns. That winning stock pick or high-yielding bond may eventually come with a big tax bill attached.
“The good news is you made money and the bad news is you have to pay tax on it,” says Michael Masiello, president of Masiello Retirement Solutions in Rochester, New York.
Luckily, there are strategies to defer the inevitable tax sting or even avoid taxes altogether in some cases. How? Simply by strategically planning what type of account certain investments are placed in.
“Quite often you can make as much or more money saving taxes on investments as you can investing more aggressively to make money,” says Michael Silver, CFP professional and partner at Baron Silver Stevens Financial Advisors in Boca Raton, Florida.
Investors just need to understand the types of tax-advantaged accounts available to them and how the returns from their investments are taxed.
“To understand how you should be allocating or locating investments, is to understand the account types,” says Phillip Christenson, CFA, financial planner and portfolio manager at Phillip James Financial in Plymouth, Minnesota.
Retirement accounts such as Roth IRAs and Roth 401(k)s give investors tax-free income in retirement. Investments in these vehicles are made with money that you’ve already paid taxes on.
“In a traditional IRA, the opposite would happen. You get a tax deduction for the year in which the contribution is made and then when it comes out, it’s taxed at ordinary income rates,” Christenson says.
In taxable brokerage accounts, income from investments is taxed for the tax year in which you sell them. “You can get hit with capital gains taxes when you hold the asset for more than a year,” says Christenson.
Investments that have appreciated and are sold after less than 1 year would be taxed at ordinary income rates.
The most beneficial strategy for locating assets is dependent on your personal situation and the tax efficiency of the individual investments.
Within taxable accounts — those that are not IRAs — some types of investments are taxed more favorably than others.
“Every vehicle is going to have taxation and it’s either interest income, dividend income or capital gains,” says Silver.
Those 3 types of returns are taxed very differently.
Tax treatment and tax rates
|Interest income||Ordinary income||10% to 39.6%|
|Short-term capital gains||Ordinary income||10% to 39.6%|
|Ordinary dividends||Ordinary income||10% to 39.6%|
|Long-term capital gains||Capital gains||0% to 20%|
|Qualified dividends||Capital gains||0% to 20%|
“Knowing the holding period on each security becomes very important,” Silver says.
“The other piece is that qualified dividends are taxed at a preferential rate — maximum of 20% and for most at 15%,” he says.
Qualified dividends mostly come from American companies and some foreign corporations as well. Dividends are qualified if you hold the stock for more than 60 days around the period in which dividends are distributed.
Knowing the tax benefits of your accounts and the tax treatment of your investment returns can help you find the right place to put those investments.
“Asset classes that create a lot of taxable income should be in retirement accounts,” Silver says.
That’s because, as we’ve seen, taxable income is generally taxed at higher rates than long-term capital gains and qualified dividends. Keep in mind, too, that capital gains rates correspond to income tax rates. For example, investors in the 2 lowest income brackets don’t have to pay any capital gains taxes when they sell stocks that they’ve held for at least 366 days.
“Investments with less taxable income should be outside retirement accounts,” says Silver. “Less taxable income includes index stock mutual funds or ETFs that are stock-related and there isn’t a lot of turnover.”
Fast-growing investments come with a bigger tax bill than investments that grow more slowly.
“Small cap stocks might grow 11% or 12% (a year) over time while large cap is 8% to 10%,” says Christenson.
He suggests putting high-growth stocks into a Roth IRA. “You’re paying no tax on the investment growing the most,” he says.
Investors who trade a lot can benefit from confining their trading to a retirement account as well. “Then you don’t pay taxes on the capital gains while you’re trading,” Christenson says. And you don’t have to keep track of your holding periods.
In addition, investments that pay interest income, such as bonds, leveraged loans and REITs, says Silver, should go into a tax-advantaged retirement account.
Some investments, such as gold, may have some benefits, whether in a taxable account or a retirement account. Still, other complex investments, such as master limited partnerships, should probably stay in a taxable account.
“You want it outside of a retirement account. There can be tax benefits and can be tax detriments,” Silver says.
“The main benefit of an MLP is that when you’re getting income, it is often added to the cost basis and creates less taxation. When you sell, then you can recapture depreciation and cause capital gains tax, but you’re deferring that tax over some period of time,” he says.
With an MLP, the problem in retirement accounts occurs when unrelated business taxable income, or UBTI, is produced. If the investment generates a UBTI that “exceeds $1,000 inside of a retirement account, it is subject to tax at the highest rate of 39.6%,” Silver says.
The IRA will have to pay the tax. And then, if the account is a traditional IRA, the account holder would be taxed again when he or she takes those funds out of the account as a distribution.
Michael Kitces, partner and director of research for Pinnacle Advisory Group in Columbia, Maryland, wrote about asset location in his blog, Nerd’s Eye View.
How much wealth would you end up with if you put bonds in a taxable account and stocks in an IRA?
Assuming that you invest $500,000 in bonds that grow at 5% and that you’re in the 25% tax bracket, your taxable account would be worth $1,508,736 after 30 years. And assuming you invest the same amount in an IRA, and that the annualized return of stocks is 10% over 30 years, the IRA would be worth $6,543,526 after taxes. Total after-tax wealth: $8,052,262.
What would happen if you did the opposite — put stocks in a taxable account and bonds in an IRA? Assuming the same investment amounts, returns and time horizon, the bonds would be worth $1,620,728 after taxes, while the stocks would be worth $7,490,996 after taxes. Total after-tax wealth: $9,111,724.
The difference: a little more than $1.6 million.
“Stocks in a taxable account aren’t always best in the long run, though,” Kitces says. “It’s crucial to consider the compounding impact of capital gains turnover and dividends, too.”
Taxes can be tricky. Learning to minimize them where possible, or working with a professional, can be as profitable to investors as picking smart investments. It may be less glamorous, but important nevertheless.