- If you own an investment that’s generating ordinary income in the form of interest, it is going to be taxed at your ordinary income tax rate.
- If you own a high-income-producing security within a retirement plan, you are not subject to tax payments on that account on a year-to-year basis.
- Think twice about holding high-income-producing investments inside of a taxable brokerage account.
- When looking at a municipal money market versus a municipal-bond fund, first use a tax-equivalent bond calculator.
Susan Dziubinski: I’m Susan Dziubinski for Morningstar. Higher interest rates have provided welcome relief to savers, but they could also lead to higher tax bills for investors. Joining me to discuss how asset location can help reduce the tax bite is Christine Benz. She is Morningstar’s director of personal finance and retirement planning.
It’s great to see you, Christine.
Christine Benz: Hi, Susan. Great to see you.
Tax Treatment of Nonretirement Accounts
Dziubinski: Let’s first discuss what the tax treatment is of income that’s earned in a nonretirement account like a taxable brokerage account or a taxable bank savings account.
Benz: Right. So, if you own an investment, whether some sort of a cash investment or a bond investment, anything that’s generating ordinary income in the form of interest is going to be taxed at your ordinary income tax rate. If you own something that is paying out capital gains or dividends, that’s eligible for a lower tax rate, which is 15% or 20% for most taxpayers. For people with fairly low levels of overall income, they’ll pay a 0% tax rate on capital gains and dividends. But that ordinary income that you’re getting from bonds, that you’re getting from now decently yielding cash accounts and CDs and so forth, that will be taxed at your ordinary income tax rate.
IRAs and Company-Sponsored Retirement Plans
Dziubinski: That matters for a taxable account. Does any of this matter if this money that’s generating income is held in an IRA or some sort of company-sponsored retirement plan?
Benz: It doesn’t. It doesn’t matter. So, if you are owning some sort of high-income-producing security within the context of that retirement plan, you are not subject to tax payments on that account on a year-to-year basis. You’re typically only going to be subject to taxes either when you’re putting the money in, in the case of Roth contributions, or when you’re pulling the money out, in the case of traditional tax-deferred contributions. So, don’t worry about this if most of your funds are inside of a retirement account. Another wrinkle here, Susan, though, is if you own the investment inside of a taxable account, even if you’re reinvesting those distributions, the tax rate is still the same. It doesn’t help you, unfortunately, if you’re reinvesting those distributions. That’s an important thing to keep in mind.
Should You Keep Securities in Tax-Sheltered Accounts?
Dziubinski: It seems like an obvious conclusion then from this is that if you own securities that generate a decent amount of income, it’s wise to keep them in some sort of tax-sheltered account. Is that fair?
Benz: That’s absolutely fair, and this is why financial advisors and tax advisors often talk about this concept of asset location, not to be confused with asset allocation, which is how we apportion our investments across different investments. This is how we apportion our investments across different account types. And for most of us, we have three main silos that we could use. One would be Roth, where we’re making the contributions with aftertax dollars; we’re pulling the money out tax-free in retirement. Another would be traditional tax-deferred accounts where we are typically earning a tax break on our contribution, paying full freight on the way out. If you own high-income-producing securities, those are the accounts to favor because you won’t get dinged on a year-to-year basis. If you own money in a taxable brokerage account on the other hand, that’s where you need to be really careful about what you’re putting in there. When we think about broad market index funds, for example, or even better yet, exchange-traded funds—a perfect choice for a taxable brokerage account because it’s going to not generate much of that year-to-year cash flow on which you’ll owe taxes. On the other hand, you’d want to really think twice about holding high-income-producing investments inside of that taxable brokerage account because you are paying that full freight, that ordinary income tax, year in and year out as long as you’ve got the investment inside there.
How to Help With Tax Drag for Cashlike Investments
Dziubinski: What about investors who are trying to keep cashlike instruments or shorter-term instruments for their spending needs and maybe aren’t holding them in these tax-sheltered accounts? Is there anything that they can do to help limit that tax drag?
Benz: Right. This is the tricky part of it because for many of us, especially if we’re in our preretirement years, we probably do have some near-term or intermediate-term goals for our money and so we want to keep them liquid, and a retirement account doesn’t usually make sense. And so, in that case, one idea to consider would be to hold, if you’re owning a cash instrument, some sort of a municipal money market fund, municipal-bond fund, or you can own individual securities that are issued by municipalities. And the beauty of that is that you will not owe federal income tax on those income distributions. And if you happen to buy a security that’s issued by your home state, or even better yet your home municipality, you will skirt those state and local taxes as well. That’s definitely something to consider, especially for people who are in higher income tax brackets. If you can avoid that income tax hit on a year-to-year basis, that can be very, very valuable. I took a quick look at a municipal money market fund that my husband and I own in a taxable account. The current yield is very favorable relative to taxable cash yields, and yet we’re not paying federal income tax on those income distributions. So, it’s definitely something worth checking out.
Municipal Money Market vs. Municipal-Bond Fund
Dziubinski: How can you determine whether you are better off using something like a municipal money market or a municipal-bond fund versus one that’s taxable?
Benz: Right. I would recommend using what’s called a tax-equivalent bond calculator. Bankrate has a good one. Fidelity has a good one. You hop on there, and assuming you’re comparing like investments, so a municipal-bond fund with similar duration and credit-quality characteristics to the taxable-bond fund, you can compare them in terms of what your yield would look like once those tax effects are factored in. So, do the math. I try not to get too cute in terms of rotating in and out of taxable. We typically hold municipal funds in our taxable account. But investors before they set this up should run the numbers. Investors who are at lower ordinary income tax rates may be better off, in fact, sticking with the taxable bond or the taxable cash instrument.
Dziubinski: Well, Christine, thank you so much for your time today for these tax tips. We’re glad to have higher rates around to generate some income, but there are those tax consequences to be aware of. We appreciate it.
Benz: Thank you so much, Susan.
Dziubinski: I’m Susan Dziubinski. Thanks for tuning in.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.