Taxes can take a significant bite out of your investment returns over time.
Consider two individuals investing in the same portfolio of assets. The first person places all their investments in a taxable account, while the second person invests the same assets in tax-advantaged accounts.
Taxable Account: Let’s assume an investor holds a stock that grows 8% annually, and it is subject to capital gains taxes at 15%. After one year, the stock would grow by $800 on a $10,000 investment. After taxes, the return would be reduced by $120 (15% of $800), leaving the investor with $680 in growth.
Rather than 8%, the effective annual return is reduced to 6.8%.
Tax-free Account: Now, imagine the same $10,000 investment in a Roth IRA. The growth of $800 is tax-free, meaning the investor keeps the full $800.
Comparison of Growth in Tax-Free and Taxable Accounts:
Over the course of 30 years, the initial $10,000 in the Roth accounts grows to $100,627. However, the taxable account only ends up with $59,030, which is about 40% less than the tax-free growth.
Tax Efficiency of Different Funds
Not all investments are created equal when it comes to taxes. Some produce a lot of taxable income (like dividends, interests and short-term capital gains), while others are more tax-efficient. Here’s a look at common assets and their tax characteristics:
Stocks:
Stocks, especially those that pay qualified dividends, are relatively tax-efficient. Qualified dividends are taxed at the lower capital gains tax rate (0%, 15%, or 20%, depending on income). However, if you sell stocks for a capital gain, you’ll owe taxes on that gain at the capital gains rate.
Index Funds:
Index funds are often more tax-efficient than actively managed funds because they tend to have lower turnover (i.e., they buy and sell less frequently). This means fewer taxable events (like capital gains distributions). Vanguard’s research has shown that indexing can improve tax efficiency due to this low turnover.
Municipal Bonds:
Municipal bonds are one of the most tax-efficient investments for taxable accounts because their interest is often exempt from federal income taxes. If you’re in a high tax bracket, municipal bonds can be a very effective way to earn interest without triggering a tax bill.
Example: A 3% municipal bond yield would be equivalent to a higher yield on a taxable bond depending on your tax bracket. For example, in the 35% tax bracket, the equivalent taxable yield would need to be 4.6% to match the tax-free yield of the municipal bond.
REITs (Real Estate Investment Trusts):
REITs are less tax-efficient because they typically distribute income (often in the form of dividends), which is taxed at higher rates than capital gains. While REITs are required to distribute 90% of their taxable income to shareholders, these distributions are usually taxed as ordinary income, which can be at a higher rate than long-term capital gains.
Example: If a REIT distributes $500 of income to you, that $500 will be taxed at your ordinary income tax rate (which could be up to 37% for high earners), reducing the return you earn on those dividends.
High-turnover stock funds:
Actively managed stock funds with high turnover are less tax-efficient, because they sell most of their stocks with gains, generating large taxable gains1. Short-term capital gains are taxed as regular income.
Tax-Smart Allocation: Where to Place Different Funds
Overtime, you usually find yourself dealing with multiple accounts with different tax attributes. (If you’re not sure about this, check out tax-advantaged accounts to learn why and how to prioritize your contribution to different accounts). The next step is to figure out which accounts to pick for different asset and funds. In general, you should try to locate less tax-efficient funds in more tax-advantaged accounts.
Tax-Deferred Accounts (e.g., Traditional IRA, 401(k))
These accounts allow you to defer taxes until retirement, which means they’re well-suited for investments that generate substantial taxable income in the form of interest or short-term capital gains. Here are good candidates for tax-deferred accounts:
- Bonds: Bonds generate interest income, which is taxed at ordinary income rates. Holding them in a tax-deferred account allows you to avoid paying taxes on this interest until you withdraw the funds in retirement.
- REITs: As mentioned earlier, REITs often generate ordinary income. By holding them in a tax-deferred account, you avoid paying immediate taxes on the dividends.
Roth IRAs
Since Roth IRAs allow for tax-free growth and tax-free withdrawals, they’re ideal for assets that are likely to have high growth potential. The tax-free withdrawal feature is especially valuable when you have a long time horizon and expect your investment to grow significantly.
- Stocks & Growth Funds: High-growth assets like stocks and growth-oriented index funds are perfect for Roth IRAs because all capital gains and dividends will be tax-free when withdrawn.
Taxable Accounts
For taxable accounts, you want to minimize the impact of taxes as much as possible. This means placing tax-efficient assets in taxable accounts and avoiding highly taxable investments.
- Index Funds: Due to their low turnover, index funds are ideal for taxable accounts, as they generally produce fewer taxable events than actively managed funds.
- Qualified Dividend Stocks: If you’re invested in stocks that pay qualified dividends, a taxable account can be a good option. Since qualified dividends are taxed at favorable rates, these stocks are relatively tax-efficient in taxable accounts.
- Municipal Bonds: Municipal bonds can also work well since they are already tax-advantaged, and you can avoid paying taxes on their income as well.
- Clemens Sialm; Hanjiang Zhang (December 16, 2013). “Tax Efficient Asset Management: Evidence from Equity Mutual Funds”. Available at SSRN. ↩︎