Avoid These 10 Traps With Your Taxable Account
Taxable accounts can be useful investing receptacles, but understand the ins and outs for best results.
Note: This article is part of Morningstar's February 2016 Tax Relief Week special report.
Company retirement plans and IRAs offer tax breaks. So do 529 college-savings plans and health-savings account.
But a plain old taxable account deserves a slot in investors' portfolios, too. Liquidity--the ability to tap assets at any time and for any reason--is the key attraction; you wouldn't want to have to raid your IRA each time you had a car repair or big vet bill.
Moreover, the tax effects of investing inside of a taxable account are arguably pretty light relative to historical norms. Although long-term capital gains rates have begun to creep up on the high end--the highest-income investors now pay a 20% rate--most investors pay 15% on their long-term capital gains and qualified dividends, and those in the lowest income bands pay no taxes on long-term capital gains and qualified dividends. True, you'll pay your ordinary income tax rate on securities like bonds and cash. But yields are so low right now that the tax bite--in dollar terms--of holding those securities inside a taxable account isn't that great. And in any case, you can circumvent at least part of the tax burden by holding municipal bonds.
Yet, as simple as investing inside of a taxable account might seem, enhancing your take-home return entails sidestepping a few key pitfalls. Here are some key traps to avoid when investing taxable assets.
1) Using Past Tax Efficiency to Predict Future Tax-Friendliness
Morningstar provides a useful suite of data for investors holding mutual funds in taxable accounts, including tax-cost ratios, which summarize how much investors in the highest tax bracket would have paid to own a fund over various time periods. But there are no guarantees that a once tax-friendly fund will remain so. Third Avenue Value (TAVFX) is a good case in point. During his tenure, longtime former manager Marty Whitman managed the fund with an eye toward tax efficiency, but a series of manager changes and dramatic investor outflows have increased portfolio turnover. The net effect, as depicted in its escalating tax-cost ratios, is that this once-tax-efficient fund has been anything but in recent years. This illustrates that investors in search of tax-efficient equity holdings should opt for funds that are structurally tax-efficient, such as broad-market ETFs and exchange-traded funds and tax-managed funds, rather than relying on backward-looking measures of tax efficiency to guide their choices.
2) Assuming ETFs Will Be Much More Tax-Friendly Than Index Funds
One of the key attractions of exchange-traded funds is their tax efficiency, making them a natural choice for taxable accounts. And it's true that ETFs do have some tax advantages that index funds don't have. For one thing, the ETF portfolio manager doesn't have to sell shares to meet investor redemptions, as shareholders trade with one another; thus, broad-market equity ETFs tend to distribute few capital gains. But ETFs aren't necessarily much more tax-efficient than traditional index funds, because the two product types share an important commonality: the very low turnover associated with their index structure. Thus, both equity ETFs and index funds will tend to be quite tax-efficient, provided they track indexes that remain stable over time. (Vanguard's total U.S. stock market index fund/ETF pairs show that the traditional index fund has actually been a hair more tax-efficient than the ETF, in part because the firm's ETFs are share classes of the original index funds.)
Moreover, bond investors should note that an ETF doesn't bestow any tax-efficient magic upon its investors. The main tax-efficiency benefit of holding ETFs is on the capital gains front; bond investors, meanwhile, have to pay ordinary income tax on their income distributions no matter where they hold their bonds. (Holding municipal bonds, whose income is exempt from federal and in some cases state and local taxes, is the only way to lessen the tax burden of bonds inside of a taxable account.)
3) Mishandling Impending Capital Gains Distributions
Fund investors have heard that they should avoid "buying the distribution"--purchasing a mutual fund toward the end of a given year, when funds tend to distribute any capital gains they've realized in the prior year. That's good advice. But well-meaning investors can also compound their tax pain when they unload a fund they already own before it makes a distribution. That's because fund shareholders can owe capital gains taxes on their funds in two ways: first, if the fund makes a capital gains distribution, and second, if the investor sells a fund that has increased in value since purchase. If you wanted to lighten up on a fund position, by all means pre-emptively sell before your fund makes a distribution. But if you want to hang on, selling before a distribution can trigger an even bigger tax headache by prompting you to realize your own capital gains.
4) Not Using Distributions to Increase Your Cost Basis
If you do receive and reinvest a distribution from a fund that you own in a taxable account, make sure that you've properly accounted for it by increasing your cost basis. That way, you won't pay taxes on that distributed amount twice: first, when you received it, and second, when you sold your holding. Fund companies are now required to calculate cost basis for their shareholders; but if you owned a fund prior to the rules going into effect in 2012, you'll need to have a paper trail documenting your distributions.
5) Not Harvesting Losses and Gains
One of the advantages of a taxable account is the ability to harvest tax losses; that's cumbersome if not downright impossible to do in an IRA or company retirement plan. By selling depreciated securities, you can use that tax loss to offset capital gains or up to $3,000 in ordinary income; unused losses can be carried forward into future years. Yet, many investors don't take advantage of tax-loss selling, perhaps because they believe it's tantamount to admitting a mistake (it's not) or because they think the depressed tax-loss candidate has good rebound potential. To address the latter hesitation, investors could swap into a like-minded (but not identical) security instead. For example, they could buy an ETF that heavily emphasizes the same sector in which a depressed stock resides, or they could buy an index fund in lieu of an actively managed fund in the same style box square.
On the flip side, investors who are currently in the 10% or 15% tax brackets can take advantage of the 0% tax rate on long-term capital gains to harvest gains. By selling appreciated securities and then immediately rebuying them, they can reset their cost basis to a new, higher level. That way, if the tax laws change or they're in a higher tax bracket down the line, they'll owe a lower tax bill when it comes time to sell.
6) Not Using Specific Share Identification for Cost Basis
Investors can choose a number of different cost-basis calculations for their accounts. The default method for many mutual fund companies is simply averaging together all purchase prices, but that produces fewer opportunities for loss and gain harvesting. Instead, a cost-basis election called specific share identification enables investors to cherrypick the most advantageous lots of a security to sell--those with the highest cost basis--while leaving lower-cost-basis lots intact. This method will tend to afford the most flexibility and precision for tax-loss or tax-gain harvesting.
7) Not Getting That Money Invested If the Pool Is Big Enough
For many investors, their taxable accounts start out as a parking place for liquid assets: the place where they hold their emergency fund and whatever assets they need for ongoing household maintenance. But thanks to a few bonuses, a random inheritance, or simply a high savings rate, their taxable accounts may grow a lot larger than they intended. The mistake, in that case, is to allow an outsized chunk of money to sit idle in cash. Instead, it's better to hold only as much in cash as you need for near-term expenses and invest the rest in line with intermediate- or long-term goals and in a tax-efficient manner.
8) Not Using Highly Appreciated Shares for Charitable Giving
Congress' decision to make the qualified charitable distribution (QCD) permanent in late 2015 was big news for charitably minded investors who are post 70 1/2 and, therefore, subject to required minimum distributions from their IRAs. But an equally if not more advantageous strategy for the charitably inclined is to make charitable donations of highly appreciated securities held in a taxable account. You not only receive a tax deduction on the donated securities, based on their current value, but you also remove the tax burden of those highly appreciated assets from your account.
9) Not Being Savvy About Dividends
Since 2003, dividends have been taxed favorably--in line with long-term capital gains. But not every dividend earns favorable tax treatment: Nonqualified dividends, such as those from REITs, are dunned at your ordinary income tax rate, as are the dividends from many hybrid securities like preferred stock. If you're attracted to a stock, mutual fund, or other security because of its high yield, read the fine print to ensure that it's tax-friendly before plugging it into your taxable account. Some otherwise-fine funds with nice dividend yields, such as American Century Equity Income (TWEIX), are better held in an IRA because their nonqualified dividends increase the drag of taxes on their returns.
10) Assuming You'll Never Pay Tax on Municipal Bonds
Municipal bonds are generally exempt from federal taxes, and if you buy a muni bond from your home state and/or municipality, you may be able to circumvent state and local taxes, too. But not every municipal bond or fund will skirt taxes altogether. If you own a private-activity bond, or your fund does, the income from those bonds is subject to the Alternative Minimum Tax even as other muni types are not. That's one reason why AMT-subject investors should look for non-private-actvity bonds or, if they're investing in funds, opt for those with "tax-free" in their names. Fidelity Tax-Free Bond (FTABX) is a favorite among Morningstar's analysts.
Mark your calendars for the 2016 Morningstar Individual Investment Conference, taking place on April 2 at 9:00 a.m. CST. At this live-streamed event, we'll cover strategies to help you strengthen your investment plan, regardless of age or investing expertise. Register for free today.
Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.