If you’re invested in the stock market, chances are you don’t have positive returns for the year. If you want to improve your returns, keep in mind that the investment return equation is pretty much the same as the net income equation: you can directly improve your returns by lowering your taxes.
Total Investment Returns = (Investments Gains or Losses) – Fees – Taxes
If you’ve never thought about the “tax efficiency” of your investments, now is the time, especially since the chances of your taxes increasing in the coming years are extremely high. The principles are very simple, so you can keep them in the back of your mind whenever you have investing decisions to make, and save your self a bundle over the course of your life.
What is “tax efficiency”
Investment vehicles (stocks, bonds, munis, mutual funds) and account types (IRAs, 401ks, brokerage accounts) are all taxed differently, and at different times. Some investments have low or no taxes, some are taxed at your highest tax rate. Some account types allow you to defer taxes for years until you take the money out. This means it’s possible to arrange different investments in different accounts in such a way to minimize taxes, legally. This is called “tax efficiency”. Keep in mind that I’m not saying you should make investment decisions entirely based on taxes – that is definitely not the case. But considering the investments you already have, you should arrange them in the most tax efficient manner.
Here’s the rule: keep low-tax investments in current-tax (or after-tax) accounts, and high-tax investments in deferred-tax accounts.
Why? Deferred tax accounts delay taxation for years and years – during this time, the high-taxes won’t drag on your returns. And, when you withdraw money, they are taxed at your highest tax bracket anyway. If you hold a low or no-tax investment in a deferred tax account, you’ll force yourself to pay the highest tax rate on it anyway!
Some definitions:
If you don’t know the difference, after-tax accounts don’t get a deduction when putting in money, and deferred-tax accounts do get a deduction (usually via “pre-tax contributions”).
Deferred-tax accounts
- Traditional IRA
- 401(k)
- 403(b)
Current-tax (or after-tax) accounts
- ROTH IRA
- After-tax Brokerage account
- Checking accounts
- Saving accounts (assuming non-IRA)
- Bank Certificates of Deposit (assuming non-IRA)
Low-tax investments
- stocks held > 1 year
- stock index funds held > 1 year
- Exchange traded funds (ETFs)
- municipal bond funds (can be completely tax free)
High-tax investments
- open-end mutual funds
- closed-end mutual funds
- bonds and bond funds (anything that pays “income”)
- Certificates of Deposit (CDs)
Some examples:
- Stocks you hold for > 1 year should be in after-tax accounts – they have special long-term capital gains treatment, currently only 15% tax rate
- Bond funds should be in deferred-tax accounts – the income from bonds is taxed at your highest marginal tax rate (currently up to 35%)
- Tax-free muni bond funds should be in after-tax accounts (don’t you dare put these in your retirement account! they have lower returns because they are tax free – you will completely wipe out the returns if you put them in your IRA!)
- Stocks you hold for < 1 year should be in a deferred-tax account (this includes your “play” a.k.a. gambling stock day-trading account – which you shouldn’t have anyway, but if you do, hopefully it’s a small % of your total assets)
This weekend, pull out your statements and take a look – how efficient is your portfolio?
When was the last time you thought carefully about your finances? If you are like most 20 - 30 somethings, it's been too long. Now is the time to get your financial ass into shape. After all, it's YOUR future. Read on: I guarantee you will learn something new here that will have a big impact on your life. 
Interesting post. I hadn’t thought about the implications of different investments in different style accounts before. Though, I don’t have many investments yet anyway…hopefully soon!
Question for you – I recently heard the CEO of a particular company say in an open forum (ie. this isn’t a hot tip!) that he was buying preferred stock in his company because the dividend was something like 11%. Could that be right? Can normal people buy preferred stock like Mr. CEO?? If so, which account should that go into because it pays “income” like a bond, but is actually a stock?
Hey DS,
Yes it’s true, some preferred stocks do pay seemingly ridiculous dividends. With the credit markets the way they’ve been, sometimes issuing preferred stock is the only way companies can raise money. Big banks like Citigroup and JPMorganChase used this method earlier in the year. For example, Citigroup’s issue from January is paying 8.5%. Is it a good deal? Is 11% better?
Well let’s remember the cardinal rule of investing: more return = more risk. There is a reason they are paying rates like this. This historically sleepy, safe income investment can quickly turn into a more risky one. Citigroup’s shares came out at $25, paying that 8.5% dividend. Preferred stocks are known for low volatility, but it’s now worth around $17. Woops. Now your income investment is getting it’s principle eaten. And there is default risk too: if a company files for bankruptcy protection, preferreds holders are 2nd in line to not see any of their money again (right behind common stock holders, but before bond holders). Then there’s the control issue – most preferreds have call provisions that start, say, 5 yrs after issue. So if the company can get financing elsewhere for less than that dividend, they can call it away from you. The ball is in their court, not yours. Yes, normal people can buy preferreds, through brokers, and even online brokerages. But know the risks first.
Now let’s consider why a CEO is saying he’s buying his own company’s preferred stock… sound like a bit of a conflict of interest to you? His company needs the money to operate and succeed, and (hopefully) his bonus depends on that success. You better believe he’ll be shouting about his great stock in that open forum!
Lastly, taxation – different preferred issues are taxed differently.. some get preferential capital gains treatment like common stocks, others don’t. Check with the selling broker. If it does get preferential treatment (15% on gains.. for now), then it should be in an after-tax account. Otherwise it’s just like a bond, and should be in a deferred tax account.
(BTW – “many” investments is not necessarily a good thing!)
Thanks!