Where to Stash Your Investments

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By Nellie S. Huang From Kiplinger’s Personal Finance

Which investments you hold matters, but so, too, does where you hold them, whether it’s in a tax-advantaged account or a taxable one.

The strategy of divvying up your assets into certain types of accounts to lower your tax bill is called asset location. The general advice is to hold less-tax-efficient investments in tax-sheltered or tax-free accounts and to put tax-efficient assets in a taxable account.

Tax-Deferred Accounts

In a tax-deferred account, such as a traditional IRA or 401(k), you sock away money pretax and it grows tax free. You’ll pay income tax on the money only when you withdraw it.

So, for example, capital gains distributions from mutual funds won’t trigger a taxable event in a tax-deferred account. That’s why mutual funds make sense for these accounts, especially actively managed strategies with a history of large capital gains distributions or high turnover. Bond income is taxed as ordinary income, so income-oriented taxable bond mutual funds are best held in tax-sheltered accounts as well.

Shares in a real estate investment trust work well in a tax-deferred account; the majority of REIT dividends are taxed as ordinary income. You should park alternative funds here, too, because they tend to generate a lot of capital gains distributions.

Taxable Accounts

You’ve already paid income tax on the money you deposit in taxable accounts, so you only owe taxes on the profits you pocket. But taxable accounts offer some flexibility that tax-advantaged accounts don’t. You can offset realized capital gains with realized losses with a strategy called tax loss harvesting. And inherited assets in a taxable account get a step-up in cost basis to the value on the day of the original owner’s death.

If you’re a buy-and-hold investor, stocks work well in taxable accounts. Any gains on stocks held for more than one year get a preferential tax rate of zero percent, 15 percent or 20 percent, depending on your taxable income and filing status. Profits on assets you’ve held for one year or less are taxed at ordinary-income rates.

The payouts from most dividend stocks, particularly large dividend payers, get taxed at favorable zero percent, 15 percent or 20 percent rates, too, depending on your income, which makes them sensible holdings in a taxable account. Exchange-traded funds, whether they hold bonds or stocks, are also ripe for taxable accounts.

Because interest payments from municipal bonds and muni bond funds are often exempt from federal taxes, and in some cases state and local levies, too, park them in taxable accounts.

Finally, foreign stocks, even in a mutual fund or ETF, are best in taxable accounts. Most pay qualified dividends, which get preferential tax treatment, and there’s a credit for foreign taxes paid.

Tax-Free Accounts

Roth IRAs and Roth 401(k)s hold after-tax money, so you don’t get a tax break on contributions. But your money accumulates tax-free, and all withdrawals are tax-free, too, as long as you take them after age 59 1/2 and the account has been open for at least five years. That makes aggressive investments best for Roth accounts. That includes growth stocks or stocks in high-volatility asset classes, such as emerging-markets and small-company stocks.

(Nellie S. Huang is senior associate editor at Kiplinger’s Personal Finance magazine. For more on this and similar money topics, visit Kiplinger.com.)

©2022 The Kiplinger Washington Editors, Inc. Distributed by Tribune Content Agency, LLC.

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