David Grant
Contributing Writer
instructor@mywealth.com
According to a 2004 study published in The Journal of Finance, 20% of your after-tax investment earnings can be lost if funds are placed in the wrong type of account. WOW! This problem, once understood, can be easily avoided.
Everyone should be familiar with the concept of asset allocation: the division of your money into different stocks/mutual funds that represent different areas of the stock market (e.g. large cap, small cap, and intermediate-term bonds, international). However the way these funds are treated according to the current tax code causes some headaches.
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For example, if you sell a stock fund in a taxable account and that fund has been held for over one year, the gain on that fund is taxed as a “long-term capital gain” 5% or 15% (and even 0% for the time being, depending on your tax bracket).
What if you are investing in a bond fund in a taxable account? Bond funds will issue income throughout the year that is payable when your file your taxes every year. Then when you sell the fund, you will pay taxes on the gain, just like the stock fund. Now if you are in a high tax bracket, you may be paying a high amount of taxes on this yearly income.
Also, if you hold stock funds in your tax-deferred account (e.g. Traditional IRA) you do not have the advantage of paying 0%, 5% or a 15% capital gains tax rate. You have to pay taxes on all of the money that is withdrawn at your individual tax rate, which could be as high as 35%!
Is there a more tax-efficient way of investing? Yes.
The short answer is to invest in bond funds (or income producing stock funds like REITS) in tax-deferred accounts (401k, Traditional IRA). This way you do not pay taxes on the income that is produced every year.
All of your stocks should be held in taxable accounts so you will be able to take advantage of the long-term capital gains treatment when you sell the funds. Also, should you need to minimize any capital gains in this account, you can sell another fund that will produce a loss to minimize some or all of your overall gain. This will bring down your tax bill when tax-filing season comes around.
Is this method as simple as it sounds? Not really. For example, when you come to rebalance your portfolio it may get a little tricky if you do not have any cash on hand. The reason being is you won’t be able to withdraw money from your tax-deferred account to buy more stock funds in the taxable account. If this happens, you can buy stocks in your tax-deferred account and then sell them when you need to rebalance the other way in the future. There are some other situations that may make this strategy a little tricky to implement, but this article was just an introduction into the subject and these situations will not be explored here.
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