An AAII member recently asked, “What is the most tax-efficient investment?" Before you answer, stop and give the question some thought. The answer is not as straightforward as it may seem.
A few factors influence the tax efficiency of investing. One, of course, is the type of investment. Municipal bonds receive very favorable tax treatment, particularly if they are held until maturity.
A stock held for the long term can also be very tax-efficient. Since it is held for more than one year, it will qualify for long-term capital gains. An individual stock also gives the investor the ability to sell shares in increments. The latter allows any capital gains to be recognized over time, thereby limiting the size of the tax bill for any calendar year. Losses can also be strategically realized to reduce taxes. Mutual funds, even those managed in a tax-efficient manner, do not give shareholders any control over the timing of distributions.
Another factor is the type of account used. A Roth IRA is funded with aftertax dollars. Once taxes are initially paid (albeit at ordinary income tax rates), no additional taxes will be due. All capital gains accrue tax-free. Similarly, all income received will be tax-free. Even withdrawals are tax-free, subject to certain restrictions regarding age and holding periods.
Health savings accounts (HSAs) offer similar advantages, though with tighter restrictions regarding withdrawals. Capital gains and income accrue tax-free in traditional IRAs. Withdrawals are taxed at ordinary income rates, but those tax rates may be lower in retirement for those earning high incomes during their working years.
Then there is the strategy. An active trading strategy will realize more capital gains, and very possibly short-term capital gains taxed at ordinary income rates. Dividends are taxed at ordinary income rates if the stock is held for the less than the mandatory 61-day period to qualify for the reduced 15% tax rate (20% for high-income earners). Even an exchange-traded fund can be tax-inefficient if it is frequently bought and sold.
The final, and perhaps biggest, influence is the type of account an investment is held in. Referred to as asset allocation, this strategy uses the tax rules to your advantage. Place the least tax-efficient investments and use the least tax-efficient strategies in your tax-preferred accounts. Use your taxable accounts for the most tax-efficient investments and strategies. IRAs (traditional and Roth) are good for avoiding the tax bite of corporate bonds, mutual funds that are not tax-efficient, and investing strategies with higher levels of turnover. Traditional brokerage accounts are better suited for index funds, tax-efficient exchange-traded funds, long-term stock holdings and municipal bonds. A simple rule of thumb is to place investments that are taxed at your ordinary income tax rate in traditional and Roth IRAs.
Realize there is no single golden rule that will apply in every situation. Some judgment calls will need to be made based on your various accounts and investments. For example, losses realized in a taxable account can be used to offset gains; losses realized in IRAs cannot. If you are unsure of what the optimal strategy for your situation is, it can be worth the cost to speak with a tax professional.
The Week Ahead
The U.S. financial markets will be closed on Monday. On behalf of everyone at AAII, I wish you a happy and sunny Memorial Day.
Just three members of the S&P 500 will report earnings next week as first-quarter earnings season wraps up: Medtronic(MDT) on Tuesday, Michael Kors Holdings (KORS) on Wednesday and Broadcom (AVGO) on Thursday.
The week’s first economic reports will be April personal income and outlays, the March S&P Case-Shiller housing index, the May Chicago PMI and the Conference Board’s May consumer confidence survey, all of which will be released on Tuesday. Wednesday will feature the May ADP Employment Report, the May PMI manufacturing index, the May ISM manufacturing index, April construction spending and the Federal Reserve’s periodic Beige Book. May jobs data (including the unemployment rate and the change in nonfarm payrolls), April international trade, April factory orders and the May ISM non-manufacturing index will be released on Friday.
Only two Federal Reserve officials will make public appearances: Federal Reserve Board Governor Jerome Powell on Thursday and Chicago president Charles Evans on Friday.
About The Author - Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky. (EconMatters author archive here)The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.
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