What is the best way to match asset classes in your taxable and tax-deferred investment accounts? For example, should you put your actively managed stock funds in your taxable brokerage account or in your Roth IRA? Follow these handy rules to avoid adversely altering your portfolio’s overall risk and return profile as well as unnecessarily increasing your tax burden. Of course, you always need to keep in mind when you will need your funds so that your investment strategy serves your overall needs.
Taxable Brokerage Accounts
1. Minimize taxes on bond interest: To minimize taxes in a brokerage account, it is best to use tax-exempt municipal bonds for the bond portion of your taxable account. Tax-exempt bonds will generate income that is free from federal income tax and some state income tax (depending upon the bond or bond fund).
2. Low-turnover stock funds: Invest in mutual funds (or ETFs) that have very low turnover ratio that will not generate capital gains from excessive buying and selling of securities. Index stock funds often have very low turnover as opposed to actively managed stock funds. Without the realization of capital gains, there is no tax liability. You also can buy and hold individual stocks in a broadly diversified portfolio as well. As long as you don’t buy and sell a lot and hold for the long term, there will be little tax liability on realized gains.
3. Seek qualified dividends: Mutual funds or individual stocks in your brokerage account should pay qualified dividends (as opposed to non-qualified dividends), which will be taxed at a low rate. Dividend-paying stocks and mutual funds are attractive because their total return includes both the dividend and any market price appreciation. Adding to the appeal of some dividends is the special tax treatment they receive. For tax purposes, dividends are considered either “qualified” or “nonqualified.” Qualified dividends are:
• Tax-free for those in the 10% and 15% brackets to the extent qualified dividend income remains within those brackets
• Taxed at a 15% rate for those in the 25% up to 35% tax brackets
• Taxed at a 20% rate for higher income taxpayers whose income surpasses the 35% tax bracket
Nonqualified dividends are taxed at the same rates as ordinary income (currently a 39.6% maximum). Qualified dividends are paid by all common and some preferred stock of U.S corporations. Dividends from mutual funds that pass through to investors can be qualified or nonqualified, depending on the underlying securities the fund holds. If a fund receives a qualified dividend, that dividend will maintain its qualified status when passed through to you. Use the fund’s prospectus or online service to determine when distributions were paid in the past and whether they are long- or short-term gains and/or qualified dividends to get a picture of the fund’s tax implications.
401k Tax Deferred Accounts
4. Keep a diversified portfolio in your tax-deferred account. This account is the workhorse for your retirement savings. These accounts can be employer accounts (401(k) 403b, 457 plans) or a traditional IRA. Contributions are often tax deductible (e.g., they reduce your taxable income in the year you make the contribution). Growth in the account (whether through capital appreciation or dividends) are tax free. Withdrawals from the account are taxed as ordinary income in the year of the withdrawal. The one exception is if there were post-tax contributions to a tax-deferred account then that is no tax paid on the withdraw (but see my post on Roth conversions of post-tax dollar IRA contributions).
These accounts should have holdings in nearly all asset classes. So run the gamut of all types of bonds (short-term/medium-term/long-term) and credit quality (safe to junk status) as well as all asset equity classes and real estate. For example, if your portfolio is 70% equities / 30% bonds, you can have broad diversification in all asset classes: large cap, medium and small cap, developed and emerging international markets, real estate, bonds (including all types of taxable bonds such as treasuries, corporate, agency). See my post on how to allocate stock and bond holdings to avoid unnecessary risks.
5. Avoid cash in tax-deferred accounts. I discourage large sums of cash in tax-deferred accounts. Consider using a short-term bond fund that will provide at least some dividends and possibly appreciation. Cash does not earn anything right now so cash in a tax-deferred account is not taking advantage of the main feature of these types of accounts, which is tax deferral.
6. Dont’ hold tax-exempt bonds in tax-deferred accounts. Don’t hold municipal bonds (tax-free) in a tax-deferred account for several reasons. Tax-exempt bonds offer lower yields than taxable bonds so you would be better off with taxable bonds in a tax-deferred account. In addition, because interest on municipal bonds is not taxed, you are missing out on the benefit of using a tax-deferred account.
Roth Type Accounts
7. Use stock funds with the most potential for gain in Roth accounts. Roth accounts are where I like to put the funds that have the most potential for a gain because the gain will never be taxed upon withdrawal. Small cap funds, emerging markets funds, and real estate investment trusts have historically provided the highest returns. High yield bonds (e.g., corporate junk bonds) have often done well, but are very volatile.
8. No tax-exempt bonds in Roth IRAs. Never hold tax exempt bonds in a Roth account since any gain will never be taxed.
9. Never hold cash in a Roth IRA. Rarely hold cash but rather use short-term bonds. unless about to withdraw the money.
With these nine pointers, you can efficiently match your investment and asset classes with your account types.