This post is in continuation of the recent post Tax Efficient Investing.
When it comes to investing, it's a good idea to consider the tax consequences of your decisions. Without a plan in place, you could end up paying more tax than you really need to. While I don't advocate avoiding tax legally increasing your tax efficiency is smart. As you prepare to invest, consider tax efficiency, and make a plan to properly place your investments. You might be surprised to learn that not every asset performs efficiently in a tax-advantaged retirement account.
Tax-Advantaged Account vs. Taxable Account
First of all, it helps to understand that certain types of investments are automatically more tax-efficient than others, and they don't need to be held in tax-advantaged retirement accounts. In fact, you might be better be better off with them in taxable accounts, since the tax you pay now is likely to be lower than the tax rate you'll pay in the future (assuming taxes rise over time), when you are taxed at ordinary income rates upon withdrawal. Tax-exempt municipal bonds, savings bonds, and tax-managed funds rarely need to be held in a tax-advantaged account. Other tax-efficient investments that might do better in a taxable account include large-cap, mid-cap, and small-cap index funds; total-market index funds; low-yielding bonds; and cash. These investments might serve you better in taxable accounts, where you can:
- Let them sit so that you pay long-term capital gains tax (on stocks), which is usually lower than what you'll pay for regular income tax when you withdraw.
- Harvest tax losses so that you can gain some advantage from losing stocks.
- Low-yielding bonds aren't likely to provide high enough returns to make a huge difference right now, and neither is interest earning from cash, so it's not a big impact on your tax bill, and could take up valuable space for less efficient investments in tax-advantaged retirement accounts.
- Ability to donate appreciated stocks to charity while taking a deduction for the full value of the investment — without paying any taxes.
Your tax-advantaged retirement account can provide you with the ability to enjoy advantages as well, but you want to think about where you place them. Some of the investments that are especially appropriate for tax-advantaged retirement accounts include balanced funds, many bonds (especially those with high yields), active stock funds and funds with high turnover, and REITs. It's important to note that many of these investments would normally result in higher tax rates. Actively traded funds, and funds with high turnover, often result in gains that are taxed at marginal rates. Holding them in a tax-advantaged account can help you avoid some of the tax issues that would otherwise result.
Where you keep your investments matters in the long run. You will pay more in taxes if you aren't careful about tax efficiency, and if you don't plan properly. Recognize the tax efficiency of your assets, and then distribute your assets in a manner that reflects that. With the right planning, you can keep more of your money, maximizing your returns and reduce your tax liability.