A series of strategies for tax-wise investors. Table of Contents.
Location
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There are good places and bad places to park certain kinds of investments. Swapping locations can save a bundle at tax time.
You have, or should have, three slots for money: a taxable brokerage account, pretax 401(k) or IRA retirement accounts and a tax-free Roth account.
The taxable account is a good place to put most common stocks and the funds that own common stocks. There they get the benefit of a favorable tax rate (15% for most investors) on dividends and long-term capital gains.
For foreign stocks, there’s a second reason to prefer the taxable account: You can effectively get a refund of most (sometimes, all) of the foreign income tax that has been withheld from your dividends. You do that by claiming a foreign tax credit on your U.S. tax return. Tax-favored retirement accounts aren’t eligible for the credit.
At the other end of the asset spectrum are certain items that are bad news in a taxable account. Either find room for them in a retirement account or don’t own them.
Junk bonds, for example, combine high coupons taxed at stiff ordinary-income rates with principal erosion that turns into capital losses. Capital losses can’t offset ordinary income except in small amounts. So you really shouldn’t own these things in a taxable account.
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Another investment that is positively toxic in a taxable account is one of those newer commodity funds branded “K-1 free.” These strange products involve derivatives and offshore holding companies, the side effect of which is that, if you are foolish enough to own one in a taxable account, you get taxed on the gains but can’t deduct the losses. Insulate yourself from this outcome by owning the fund in a retirement account.
A few things can go in either a taxable account or a tax-deferred one. In this category are short-term Treasury bonds and most real estate investment trusts. You can park these two varieties of investment wherever you have room for another asset.
The bonds pay so little interest that the ability to defer tax on them isn’t of great consequence. Outside an IRA the Treasury incurs federal tax but not state tax; inside, it incurs both, but with a deferral.
As for REITs: They pay dividends that, for the most part, aren’t eligible for the favorable rates on dividends, but do benefit (for now, anyway) from a pass-through deduction.
The big issue with asset location is deciding between taxable accounts and tax-favored retirement accounts. Once you have identified the assets that belong in retirement, you have a further choice to make: Which things go in the pretax IRA and and which in the aftertax Roth. Answer: Select the riskier, higher-return items for the Roth account.
The Roth has no mandatory withdrawal during your (or your spouse’s) lifetime. Let it grow and tap it last.