When developing investment strategies and long-term plans for our disciplined savings, we often focus on the investments – how well they perform, how much income they pay, and how much they cost. While these are necessary considerations, understanding the potential tax consequences of your investment decisions is equally important. After all, it’s not what you make – it’s what you keep!
Think of your total investment portfolio like a garage full of automobiles. Each vehicle has its own personality, speed, and purpose. The sports car has the potential to be aggressive at high speeds, but with the downside of increased risk and costs, whereas the slower hybrid car might be more comfortable for long road trips, saving money along the way. Just like automobiles, your investment accounts are aligned with their own characteristics – tax efficiency, risk capacity, and time horizon. Aligning your investment vehicles with their appropriate passengers can significantly improve your experience on the journey to reaching financial independence.
- Pre-Tax Retirement Accounts: Most workers contribute to pre-tax retirement accounts, which may include a traditional IRA, 401(k), 403(b), 457, pension, or qualified annuity. Contribution amounts are deducted from income in the year of deposit, and no taxes are paid until the money is later withdrawn from the account – hopefully in retirement! These distributions are subject to ordinary income tax since none of the contributions or earnings are taxed along the way. We view these accounts as personal assets, but the government sees them as income that has not yet been taxed.
- Roth Retirement Accounts: Roth accounts such as Roth IRAs and Roth 401(k)s offer tax-free growth and tax-free withdrawals in retirement, subject to rules. Roth contributions are made with after-tax dollars, but the taxation can end there. Since all investment growth and earnings are tax-deferred and potentially withdrawn tax-free, Roth accounts are the perfect vehicles for investments with the ability to appreciate over a long period of time. A Health Savings Account (HSA) has similar tax-free growth potential if used as a retirement account.
- Taxable Brokerage Accounts: Unlike retirement accounts, taxable brokerage accounts do not benefit from tax-deferred growth. There are tax consequences along the way as investment income is earned and securities are sold, but there are also potential tax benefits. The investment earnings can receive favorable tax treatment, including long-term capital gains and qualified dividends that are taxed at capital gains tax rates (0%, 15%, 20% + possible 3.8% NIIT – depending on your taxable income). Realized capital losses that exceed capital gains can also be deducted against ordinary income (up to $3,000 per year).
- If you sell an investment in a taxable brokerage account after holding it for at least one year and a day, any realized gain receives capital gain tax treatment. Qualified dividends also receive this tax benefit if meeting the requirements. Liquidating (selling) investments has tax consequences, but withdrawing money is not a taxable event like it is from a pre-tax retirement account. Taxable brokerage accounts are great vehicles for short-term savings (pre-retirement) and long-term savings (flexibility in retirement).
- Growth Stocks: Companies that generate positive earnings can reinvest their profits back into the company, hoping to accelerate growth at a higher rate than the market average. These companies typically do not pay dividends (sharing of profit) to shareholders, but the shareholders expect the price of their shares to appreciate as the companies grow and increase production – ultimately hoping to sell the shares for more than they purchased them. Most start-ups are in this category, as they strive to fuel the fire and grow quickly.
- Since these stocks have a high potential for long-term capital appreciation (growth), they are most appropriate for retirement accounts, especially Roth, since the growth is never taxable. They are also suitable for taxable brokerage accounts if held long-term since the realization of gain receives favorable tax treatment. If held and sold within a year in a taxable brokerage account, short-term gains are taxable as ordinary income – turnover is important!
- Dividend Stocks: Unlike growth companies, dividend-paying companies share their net profits with shareholders. These are usually well-established companies with track records of consistent profits, within energy, financials, materials, utilities, and healthcare sectors.
- Stocks that pay high qualified dividends are most favorable in taxable brokerage accounts, since the capital gains rates apply. If held in a pre-tax retirement account, these dividends effectively become non-qualified and taxable as ordinary income when taking distributions in retirement. These stocks can still have the potential to grow in pre-tax retirement accounts, but be aware of this forgone tax benefit. Also, keep in mind that dividends that are not reinvested can be strategically assigned for short-term income needs within any account type.
- Taxable Bonds: Taxable government and corporate bonds distribute yield (income) to bondholders by paying interest, usually on a semi-annual basis. These interest payments are taxable as ordinary income, meaning they are treated just like your normal wages and do not receive favorable tax treatment. You may have heard that bonds make a portfolio safer, but not all bonds are created equal – taxable government bonds (like U.S. Treasuries) are known to provide stability with a lower yield, whereas corporate bonds vary in their levels of risk and income – chasing high yield requires taking on more risk. Before you purchase bonds, review the bond ratings (creditworthiness) and maturity dates (when the bonds are repaid); these measures can indicate the amount of risk you are taking to receive the expected return.
- Merely from a tax perspective, these bonds are most appropriate in pre-tax retirement accounts to avoid the taxable interest income each year. But here’s the rub – since bonds can provide stability and liquidity, they can be appropriate for Roth and taxable brokerage accounts if positioned to meet short-term income needs. If you own bonds, be sure to understand why and where you are holding them and whether you intend to hold them to maturity.
- Non-Taxable Bonds: Municipal bonds are issued by public entities to fund projects such as schools, hospitals, and roads. Since the borrowed funds are often used for the purpose of improving communities, the interest payments may not be taxable as income. Not all municipal bonds are tax-exempt at the federal and/or state level, so be sure to understand how each bond is structured before purchasing. Like corporate bonds, municipal bonds also have various risk and return characteristics.
- Municipal bonds that receive favorable tax treatment are not appropriate for tax-deferred accounts, as the interest income can only receive a tax benefit if held in an taxable brokerage account. These securities are predominately purchased by investors who have high levels of taxable income, and do not want their bond interest to be taxed up to the highest marginal rates.
- REITs: Real Estate Investment Trusts are companies that invest in income-producing real estate across a range of sectors, not limited to buildings. I like to say this is a way to invest in real estate without being a landlord. REITs distribute taxable income to their shareholders in the form of dividends. Like taxable bonds, these payments are taxed as ordinary income.
- If you plan to hold REITs for their growth and yield potential, a Roth account can be the ideal vehicle, as the dividend income and gains will never be taxable. Note: Under the Tax Cuts and Jobs Acts of 2017 (TCJA), REIT income can potentially receive a tax benefit (QBI deduction – 20% deduction for pass-through businesses) if held in a taxable brokerage account. Read the rules carefully before considering these investments.
- Cash Equivalents: We don’t often think about cash as an ‘investment,’ but any interest earned on this savings is taxable as ordinary income – effectively like holding a ultra-short-term, taxable bond. I encourage you to start thinking about cash as an investment, not a lack thereof – each investment decision has an associated opportunity cost.
- Cash and near-cash investments are not appropriate for retirement accounts unless positioned for short-term income needs. An example of this is when a retiree de-risks an IRA to prepare for lifestyle needs, as the money should not be subject to market volatility. There are other short-term bond options that can provide stability over a short time horizon, with potential for additional yield.
Once you understand the characteristics of each investment type and its appropriate vehicles, align your risk tolerance with your risk capacity, and determine your investment time horizon, you can make an educated decision on how to allocate your portfolio. Be careful not to act on one-size-fits-all investment advice online or otherwise since the recommendations do not account for your personal financial landscape and goals. Consult a professional if you need additional resources or a personalized financial plan. Enjoy the ride!