Investments and Tax Efficiency

by Dual Income No Kids on August 13, 2009 · 0 comments

Hi All,

Once you get started in personal finance you may find yourself in a situation where you have a number of investments and a diversity of accounts in which you are holding them. For example, you might have a taxable brokerage account, an IRA and a 401k.

In these situations its important to consider the possible tax efficiencies having this diversity can offer you. For many people, income taxes are their single biggest expense. Therefore, it’s in your interest to follow every legal means available to cut down on the bill.

As a quick rule of thumb, consider holding tax inefficient assets in sheltered retirement accounts like ROTH IRAs. Likewise, put tax efficient investments in accounts subject to levy.

Sure, so that’s pretty obvious. But, which investments are tax efficient? Great question. Here is a breakdown of some common types and their tax efficiency.

1) Growth Stocks. Growth stocks are shares of corporations that have exhibited faster than higher average earnings gains. Over the long run, these corporations can outperform slower or more stagnant stocks. However, they don’t pay dividends. Since they don’t generate income they aren’t subject to tax. The bottom line is these investments are tax efficient.

2) International Stocks. If you are holding dividend paying foreign stocks, you may be subject to both foreign taxes and U.S. levies. However, many countries have tax treaties with the US that allows you to deduct the amount of foreign tax you pay. But you’ll still have to pay US tax, so there is no free lunch here. You’ll get stuck with capital gains or dividend taxes no matter how you cut it with these investments. Might not be the best option to build wealth, but it also depends on the returns you are getting.

3) Stock & Bond Mutual Funds. Both stock and bond funds usually pay some sort of dividend. In many cases they annually distribute capital gains to their owners as well. So, for these investments be aware that you’ll likely get stuck with some sort of impact on your federal and state obligations.

Exceptions to this are bond funds that hold exclusively non-taxable bonds. Dividend distributions from these often have some sort of tax protection.

4) Commodity Funds. Since commodity funds have a high level of turnover, expect a higher taxation potential from these investments.

5) Bonds. Assuming you hold bonds for the interest payments they give you, expect to pay more on both your federal and state tax bill. The exception to this is of course tax free bonds. Tax free bonds are typically municipal bonds issued by state or local governments and are usually free from income tax. The government takes a bigger slice of regular bonds, but municipal bonds are hard to beat from a tax efficiency standpoint.

6) Real Estate Investment Trusts. When you invest in a REIT you buy shares in a company that owns and manages real estate – land and buildings. By law, in order to qualify for REIT status, the trust must pass 95% of its taxable income on to its shareholders. This is why REITs often have very large dividend yields. However, because of this, you should expect that your dividends will be subject to income tax. This is one of the more tax inefficient investments out there.

Okay, just to recap. Hold taxable investments in your retirement accounts. Hold non-taxable investments in your brokerage accounts.

Taxable (Retirement or other sheltered accounts)
– Commodities
– High dividend paying mutual funds
– International stocks
– Non-growth stocks

Non-Taxable (Brokerage account)
– Individual municipal bonds or muni bond funds
– Growth stocks or growth mutual funds

Hope some of this helps, feel free to leave us a comment if you have anything to add!



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