Tax-Efficient Investing: Understanding How Your Investments Are Taxed

June 25, 2018

 

In today’s complex tax environment, understanding how your investments are taxed and how best to be tax-efficient with the way in which you invest can have a significant impact on your bottom line. To help you make better sense of the complicated rules regarding investments, we’ve come up with a series of tax rankings for types of accounts and types of investment income to help you make more efficient decisions with your hard earned dollars in the future.

 

Tax Ranking of the Types of Accounts

 

Best: Tax-Exempt Accounts (Roth IRAs, 529s, ESAs) – Your earnings in tax-exempt accounts are never taxed (unless you pull them out at a penalty), which makes them the most efficient type of account to use.

 

Ok: Tax-Deferred Accounts (Traditional IRAs, 401ks) – Tax-deferred accounts are taxed later on which is what makes them “deferred.” Tax-deferred accounts are a good idea for long-term savings because the earnings grow without being taxed at current rates. This is more important for someone who is in a high tax bracket currently, but will likely shift to a much lower tax bracket in the future. For example, consider someone who is currently earning $250k, but will likely only need $80k to live off of in retirement. Right now that individual is in a high tax bracket, but in retirement, he or she will drop to a lower tax bracket. By choosing a deferred account, they are avoiding current tax rates, allowing their money to grow tax-deferred, and will pay much lower taxes in the future.

 

Worst: Taxable Accounts – Taxable accounts have no tax benefits because all of the earnings in them are taxed. One great tip to saving on taxes is what is known as asset location and involves placing your most tax-efficient investments – usually individual stocks and municipal bonds – in your taxable accounts, and placing your most tax-inefficient investments - usually your bonds – in your tax-deferred accounts. By putting your most inefficient securities in your most tax-efficient accounts, you are able to shield yourself from those higher taxes. To better understand how your investments are taxed in a taxable account, the next ranking will discuss how individual investments are taxed.

 

Types of Taxes on Investment Holdings

 

Best: Municipal Bond Income: Municipal bonds are bonds that are issued by a government entity. Interest income from municipal bonds is not taxed by the federal government. Furthermore, many states will also not tax the interest income from municipal bonds issued by their governments if you are a resident of that state. For example, if you live in California and own a municipal bond issued by a government in California (state or local) you will likely pay no taxes on the interest income from that bond. Municipal bonds are a great idea for anyone in the highest tax bracket who is looking for tax-free income on their investments.

 

Ok: Long-Term Capital Gains: Within a taxable account, the ideal investment, tax-wise, for the average investor is one with long-term capital gains. Long-term capital gains occur when a stock has been held for longer than a year and is sold for a higher price than it was purchased for. The capital gains rates are 0%, 15%, and 20%, depending on your tax bracket, but are always lower than the short-term and ordinary income rates, which is why it’s always better to recognize long-term gains as opposed to short-term gains when you need cash.

 

Ok: Qualified Dividends: Qualified dividends are taxed like long-term capital gains. In order for dividends to be qualified they must be paid by a U.S. corporation or qualified foreign corporation, meet the holding period requirements (60 days during the 121-day period that cover 60 days before and 60 days after the ex-dividend date), and not meet any of the IRS exclusion criteria.

 

Worst: Short-Term Capital Gains: When an investment in a taxable account has been held for less than a year and is sold for more than it was purchased for, it is subject to the short-term capital gains rate which is the same rate as your ordinary taxable income rate. This means that if your tax rate is 28%, you will also pay 28% on any short-term gains you recognize during the year (remember, a gain or loss is recognized when you sell a security).

 

Worst: Non-Qualified Dividends: When a dividend is not qualified, you are taxed as if the dividend is part of your ordinary income. This means that if you are in the 28% tax bracket, your dividend income will be taxed at 28%.

 

While there are many types of investments when it comes to taxes, there are also many strategies that you can employ as an investor to help you save when it comes to paying taxes. One of the easiest strategies that your advisor can employ is what is known as tax-loss harvesting where losses are used to offset gains. To learn more about tax-loss harvesting, asset location, and other tax-saving strategies sign up for our weekly newsletters at the bottom of this page in the footer.

 

 

*a version of this article first appeared on this blog in March of 2015

 

 

 

 

 

 

 

 

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