Are You Paying Too Much in Investment-Related Taxes?

Christine Benz: A lot of these tax-inefficiency problems owe to issues with what we call asset location, where someone has the wrong asset in the wrong account type. Among the most frequently spotted tax issues that I observe are someone holding high income producers in taxable accounts, whether dividend-paying stocks or bonds, securities that are kicking off a lot in income, some of which may be taxed at ordinary income tax rates. People also cost themselves taxes by holding active equity funds in taxable accounts. Active equity funds are often distributing big capital gains to their shareholders, which in turn result in tax bills when the fund is held in a taxable account. So, active equity funds are generally not a great idea in taxable accounts. And finally, all-in-one type funds are also not a great idea for taxable accounts. These funds are often rebalancing back to some specific asset-allocation target, often taking money off the table in stocks which have depreciated and adding funds to bonds. That tends to result in tax bills. And so, even though these can be great holdings overall, I typically like to think of them as belonging inside of investors’ tax-sheltered accounts.

So, how do we improve a portfolio's tax efficiency? At the top of the heap would be to take advantage of all of the tax-sheltered receptacles that you have available to you when you're in accumulation mode. That would be IRAs, that would be 401(k)s and other company retirement plans, health savings accounts, 529 college savings plans. The whole gamut of tax-sheltered receptacles are worth considering as you are accumulating assets for retirement. And the key benefit of them is that they effectively shield you from owing taxes on those accounts. As long as the money stays inside those accounts, you won't owe taxes on them. That's the key benefit, the key reason, to take advantage of all those tax-sheltered receptacles.

And then, within those accounts, it's really helpful to shelter those investments that are inherently tax-inefficient inside of those accounts. I referenced high income producing securities, whether stocks or bonds—hold them inside your tax-sheltered accounts. To the extent that you have active equity holdings in your portfolio, especially those that kick off a lot of turnover and, in turn, capital gains, you'd want to hold them inside of your tax-sheltered accounts. And similarly, funds that rebalance back to a target. We talked about balanced funds and target-date funds, all-in-one type funds that typically are taking equity exposure out of their portfolios as the years go by, those tend to be tax-inefficient choices, so they are great options for your tax-sheltered accounts.

In terms of how to position your taxable accounts, so if you have nonretirement, non-HSA, non-529 assets, just plain-old taxable brokerage accounts, you want to focus on making those accounts as tax-efficient as you possibly can. So, for equity exposure, index funds and exchange-traded funds, especially those that track broad market indexes, tend to be superb tax-efficient choices. Individual stocks are also great options for your taxable account because they give you a lot of control over your capital gains realization in the way that you don't necessarily have with active equity funds.

If you're in a higher tax bracket and you are holding fixed-income investments inside of your taxable account, you'd want to think about municipal bonds. Run the numbers to see if you're actually ahead on an aftertax basis with a municipal-bond fund or municipal bonds, but in many cases, higher-income investors will indeed be better off by holding municipal bonds versus taxable bonds if they are actively holding bonds within their taxable accounts.

It's also important to pay attention to your cost basis when you're repositioning. The nice thing about the current down market is that some investors may have the opportunity to do a little bit of repositioning because their holdings have dropped in value. But if you've had positions in your account for many years, you probably still have gains in them. If you are doing repositioning, just pay attention to your cost basis. You don't want to trigger a big tax bill without thinking through the implications. Just bear that in mind when you're repositioning your taxable account.

And finally, in retirement, I think there's a great opportunity for thinking through how you might alleviate the tax bill as you're withdrawing from your account. I think it's super helpful to develop a year-by-year plan for where you will go for your withdrawals. So, not just thinking it through how much you'll take out of your portfolio each year, but also look across your total plan and determine where you'll go for those cash flows on a year-to-year basis. This is a great spot to get some help from a financial advisor or a tax advisor who can help you figure out how to source your withdrawals with an eye toward reducing the tax bills associated with them.

It can also be a great idea to consider conversions of traditional IRA assets to Roth, and to do that conversion, especially in the early years of retirement shortly after retirement has commenced but before required minimum distributions have come on board, so before you’re age 72. That’s a great period to do some strategizing about how you might reduce your future tax bills, and I mentioned it’s really important to get some help in this area as well, because this can all get very complicated very quickly when you think about taxes on Social Security and taxes on Medicare.