Financial advisers so often sing the praises of tax-deferred 401(k)s and IRAs that many investors never even consider stashing some cash in a taxable brokerage or mutual-fund account. Hooked on pretax contributions and tax-deferred growth, the average saver shovels far more money into 401(k)s and individual retirement accounts than taxable accounts. Based on his experience, Charlie Farrell, chief executive officer of Northstar Investment Advisors in Denver, thinks that the typical 30-to-50-year-old who earns less than $200,000 a year keeps the bulk of his or her savings tied up in tax-deferred accounts.
So what’s the problem with that? It limits your financial flexibility, now and in the future. You generally can’t tap a tax-deferred retirement account before you reach age 59½ without paying a 10 percent early-withdrawal tax penalty. You also pay tax at ordinary income rates on your withdrawals. Moreover, you must start taking required minimum distributions from such accounts when you reach age 70½, even if you don’t need the money.
But with a taxable account, you decide if and when to take money out. In addition, long-term capital gains and qualified dividends that your taxable account throws off get more favorable tax treatment than withdrawals from tax-deferred plans.
Having taxable and tax-deferred accounts will also allows you to maximize your income during your retirement years. For instance, you might take money from your taxable account during the first few years so you can benefit from lower tax rates on long-term capital gains and allow investments in your tax-deferred accounts to grow until you have to take RMDs.
Moreover, you can minimize taxes by practicing what financial planners call asset location. That means holding various types of investments in taxable or tax-deferred accounts based upon the severity of the tax headaches they cause. Remember, however, that tax-friendliness is only one attribute to consider when choosing investments. “You want to be mindful of taxes, but you don’t want them to be the tail that wags the dog,” said Christopher Wills, a certified financial planner and director of wealth management at R.W. Rogé & Co., a financial planning company in Bohemia, N.Y.
That said, there are some types of securities that simply don’t belong in taxable accounts. They include taxable bonds and bond funds as well as stocks that pay high dividends and stock funds that concentrate on such equities. You should also avoid putting real estate investment trusts in a taxable account because those trusts often pay dividends that are taxable as ordinary income.
The following investments work well in taxable accounts.
- Municipal bonds and funds. You don’t pay federal income tax on municipal bond interest, and you might dodge state income tax, too, if you buy bonds or a bond fund dedicated to your state’s issues. But investors in lower tax brackets may pocket more interest after taxes if they buy taxable bonds, which yield more than comparable municipals. To figure out if municipal bonds make sense for you, use one of the tax-equivalent yield calculators available online. Another warning: The Alternative Minimum Tax applies to payouts of certain municipal bonds. If you pay the AMT, avoid such issues.
- Individual stocks, with the exception of those that pay high dividends. Stocks are a good fit for taxable accounts because you control when you cash in your capital gains. If you hold onto your shares forever, your heirs will enjoy the tax treat of a stepped-up basis. Say, for example, that stock you bought for $50 a share is worth $100 a share at your death. Instead of paying tax on a capital gain of $50 a share if they sell, your heirs can “step up” their cost basis to the price of the stock on your day of death.
- Tax-efficient stock mutual funds and exchange-traded funds. The tax collector is not kind to fund investors. You pay tax if you sell or exchange shares for a capital gain. In addition, you pay tax on any income and capital-gains distributions that the fund makes each year, regardless of whether you reinvest those payments in the fund. So if you want to buy funds for your taxable account, you should stick with those that minimize income and capital gains distributions.
A few investment companies market so-called tax-managed or tax-efficient funds designed to minimize income and capital gains distributions. But many other funds are appropriate for taxable accounts. You can identify them using measurements of a fund’s turnover rate, tax-adjusted return, tax cost ratio, and potential capital-gains exposure. The investment research firm Morningstar publishes all of that information online. To find a fund’s turnover rate, search for its fund report on Morningstar.com and click on the chart tab. To find the other indicators, click on a fund’s tax tab.
The turnover rate measures how frequently a fund manager trades his or her entire portfolio. For example, a 25 percent turnover rate indicates that the manager trades the entire portfolio every four years. Funds with high turnover rates tend to generate a lot of capital gains, including short-term gains taxed at your ordinary income tax rate. Funds with turnover rates below 10 percent tend to be tax-efficient.
Most large-cap index funds have low turnover rates. The Vanguard Group’s Total Stock Market Index, for example, sports a 3 percent turnover rate. Index funds tend to have low turnover rates because they aim to match the returns of a market index, and their managers generally make portfolio changes only when the index adds or drops a stock.
Look, too, at a fund’s tax cost ratio. That number shows how much of a fund’s annualized return a shareholder in the top tax bracket has lost to taxes on the fund’s distributions. For example, if a fund has an annualized pretax return of 10 percent and a tax cost ratio of 2 percent during a three-year period, investors in the fund lost 2 percentage points of their return to taxes, on average, each year. “That’s a lot of money that people are just leaving on the floor,” said Don Peters, portfolio manager of the T. Rowe Price Tax-Efficient Equity Fund.
You can compare a fund’s tax-efficiency with its peers by checking its tax-adjusted returns for various periods. Oakmark International, for example, has a three-year pretax return of 12.83 percent and a tax-adjusted return of 12.13 percent, putting it in the top 1 percent of the foreign large-blend stock funds that Morningstar follows.
To gauge a fund’s future tax-friendliness, check its potential capital-gains exposure. That number is an estimate of the percentage of a fund’s assets that represents capital gains embedded in its portfolio. If a fund’s potential capital-gains exposure rate is 30 percent or higher and it has a high turnover rate, it will probably distribute gains in the next few years, just the sort of surprise to avoid.
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Once you place the proper investments in your taxable account, take these steps to further minimize taxes.
- Avoid short-term capital gains. Hold securities for at least one year before you sell to qualify for the lower capital-gains rate.
- Harvest losses to offset taxable gains. If your capital losses exceed your capital gains in any year, you can use up to $3,000 of your loss to reduce that year’s taxable income and carry the rest forward to offset gains in future years.
- Never buy a mutual fund just before it makes a taxable distribution. Distributions are typically made late in the year. Check with the fund company to find out if a distribution is imminent.
- Use your taxable account for charitable giving. Instead of writing a check to your favorite charity, make a donation of appreciated securities from your taxable account. Say, for example, that you bought shares of a mutual fund more than one year ago for $2,500 that are now worth $5,000. By giving the shares directly to your favorite charity or to a donor-advised fund, you dodge tax on their gain and receive a tax deduction for their full $5,000 value.
Editor's note: The article also appeared in the April issue of Consumer Reports Money Adviser.
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