Place Tax-Efficient Investments in Taxable

Placing tax-efficient investments in taxable accounts is a key strategy for minimizing taxes on your investment returns.

Tax-efficient investments are those that generate lower taxable income or are taxed at lower rates, making them more suitable for taxable accounts. Here’s how to approach this:

What Are Tax-Efficient Investments?

Tax-efficient investments typically include:

Stocks (Especially for Long-Term Holding):

Qualified Dividends: Many stocks pay qualified dividends, which are taxed at the lower long-term capital gains rates (0%, 15%, or 20%) instead of the higher ordinary income tax rates.

Capital Gains: Long-term capital gains (from assets held for more than one year) are taxed at favorable rates compared to ordinary income.

How to Use: Invest in individual stocks or stock index funds in your taxable account. Hold these investments for the long term to benefit from lower tax rates on capital gains.

Index Funds and ETFs:

Low Turnover: Index funds and ETFs often have lower turnover rates, meaning they buy and sell assets less frequently. This results in fewer taxable events (capital gains distributions), making them more tax-efficient.

Tax Efficiency of ETFs: ETFs are particularly tax-efficient because of their unique structure, which minimizes capital gains distributions.

How to Use: Choose broad-market index funds or ETFs that focus on long-term growth and have low turnover. Place these in taxable accounts to minimize taxable distributions.

Municipal Bonds:

Tax-Free Interest: Municipal bonds (munis) generate interest income that is generally tax-free at the federal level. If you invest in munis issued by your state or local government, the interest may also be exempt from state and local taxes.

How to Use: If you’re in a higher tax bracket, consider holding municipal bonds in your taxable account to benefit from tax-free interest income.

Growth-Oriented Investments:

Lower Immediate Income: Investments focused on capital appreciation (growth) rather than income generation (like dividends or interest) are more tax-efficient in taxable accounts because they don’t produce much taxable income until you sell them.

How to Use: Growth stocks, certain types of mutual funds, and ETFs that focus on long-term capital appreciation are ideal for taxable accounts.

Why Place Tax-Efficient Investments in Taxable Accounts?

Maximizing After-Tax Returns:

By placing tax-efficient investments in taxable accounts, you reduce the tax drag on your portfolio, meaning you keep more of your returns.

Leveraging Tax-Advantaged Accounts for Less Efficient Investments:

Tax-inefficient investments (e.g., bonds, REITs) generate income that’s taxed at higher rates. By placing these in tax-deferred accounts (like IRAs or 401(k)s), you defer taxes until withdrawal, ideally when you’re in a lower tax bracket.

Example of a Tax-Efficient Investment Placement Strategy:

Taxable Account:

Index Fund ETF: A broad-market ETF like the Vanguard Total Stock Market ETF (VTI) due to its low turnover and tax efficiency.

Individual Stocks: Especially those you plan to hold for more than one year to take advantage of long-term capital gains rates.

Municipal Bonds: For generating tax-free interest income.

Tax-Deferred Account (e.g., Traditional IRA, 401(k)):

Bonds or Bond Funds: As bond interest is taxed as ordinary income, holding them in a tax-deferred account allows you to avoid annual taxes on the interest.

REITs: Real Estate Investment Trusts (REITs) pay high dividends, often taxed as ordinary income, making them more suitable for tax-deferred accounts.

Tax Efficiency Considerations

Harvesting Losses: In taxable accounts, you can also engage in tax-loss harvesting, where you sell investments that have declined in value to offset gains and reduce your taxable income.

Gifting Appreciated Securities: In taxable accounts, you can gift appreciated securities to charity, which allows you to avoid capital gains taxes and potentially receive a charitable deduction.

Conclusion

Placing tax-efficient investments in taxable accounts is a smart strategy for optimizing your overall tax situation and maximizing after-tax returns. By understanding the tax implications of different types of investments and strategically allocating them across taxable and tax-advantaged accounts, you can enhance the efficiency of your investment portfolio.