Which investments you hold matters (and in what proportions), but so, too, does where you hold them, whether it's in a tax-advantaged account or a taxable one. A recent lawsuit against Vanguard Group reveals how important such a decision can be.
Earlier this year, three investors sued Vanguard for negligence and breach of fiduciary duty after the investment company's target-date funds made a substantial capital gains distribution in late 2021, generating an unexpected tax bill for the plaintiffs (and other Vanguard investors). (Mutual funds are required to pass on any realized net gains to fund shareholders at least once a year.) But if the investors had held those mutual fund shares in tax-sheltered accounts instead of in taxable ones, the unwelcome tax bill could have been avoided.
Just as taxable and tax-advantaged investment accounts get different tax treatment, so do certain types of investment income. The strategy of divvying up your assets into certain types of accounts to lower your tax bill is called asset location. The general advice is to hold less-tax-efficient investments in tax-sheltered or tax-free accounts, such as an IRA, an employer-sponsored 401(k) or a Roth version of either, and to put tax-efficient assets in a taxable account.
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Of course, much may depend on how much money you have, your time frame and cash needs, and whether you're a buy-and-hold investor or an active trader, among other things. Tax considerations shouldn't drive every decision, says Boston, Massachusetts, certified financial planner Jay Karamourtopoulus, but ultimately, "a well thought out asset location plan can reap many benefits and should be addressed."
Below, we tackle the strategy with a long-term view and break down which investment assets are best, generally speaking, for tax-deferred accounts, tax-free ones and, of course, taxable accounts. Tax rules guide the advice, which we'll get into in each section.
Tax-Deferred Accounts
In a tax-deferred account, such as a traditional IRA or 401(k), you sock away money pretax and it grows tax-free. You'll pay income tax on the money only when you withdraw it (as long as you’re at least 59½ years old; otherwise, penalties usually apply).
Because all taxes are deferred until your retirement years, including any realized gains from the sale of stock shares, bond income or mutual fund capital gains distributions, more of your money works for you, compounding over time. It's a key reason Los Angeles certified financial planner John C. Pak says, "Having all your money in tax-deferred or tax-free retirement accounts is the best asset location."
So, for example, capital gains distributions from mutual funds won't trigger a taxable event in a tax-deferred account. That's why mutual funds make sense for these accounts, especially actively managed strategies with a history of large capital gains distributions or high turnover (a measure of how often the underlying assets in a specific fund are bought and sold).
Bond income is taxed as ordinary income, so income-oriented taxable bond mutual funds, including closed-end funds, are best held in tax-sheltered accounts as well. Interest rates are on the rise, says Shaun Williams, a Denver-based certified financial planner, and that will boost payouts.
Shares in a real estate investment trust (REIT) work well in a tax-deferred account; the majority of REIT dividends are taxed as ordinary income. You should park alternative funds here, too, because they tend to generate a lot of capital gains distributions.
Finally, the tax treatments vary for the types of assets held in commodity funds, which can get complicated. This makes them prime candidates for a tax-deferred account. That includes funds that are free of Schedule K-1 forms. (A K-1 form is an annual form issued by the IRS for an investment in a partnership, which is the structure for some commodity funds.) Even outside the partnership format, "These new K-1-free commodities investments convert capital gains into ordinary income and don't allow an investor to offset gains with losses," says Williams.
Taxable Accounts
You've already paid income tax on the money you deposit in taxable accounts, so you only owe taxes on the profits you pocket. But taxable accounts offer some flexibility that tax-advantaged accounts don't. You can offset realized capital gains with realized losses with a strategy called tax-loss harvesting. And inherited assets in a taxable account get a step-up in cost basis to the value on the day of the original owner's death. So when the inevitable happens and you die, says New York City-based certified financial planner Gary Schatsky, "any gains disappear for your heirs."
If you're a buy-and-hold investor, stocks work well in taxable accounts. Any gains on stocks (or other assets in taxable accounts, for that matter) held for more than one year get a preferential tax rate of 0%, 15% or 20%, depending on your taxable income and filing status. Short-term gains – profits on assets you've held for one year or less – are taxed at ordinary-income rates. (That's why active stock traders should consider limiting their taxable activity to tax-sheltered accounts. More on that below.)
The payouts from most dividend stocks, particularly large dividend payers, get taxed at favorable 0%, 15% or 20% rates, too, depending on your income, which makes them sensible holdings, tax-wise, in a taxable account.
Exchange-traded funds, whether they hold bonds or stocks, are also ripe for taxable accounts. Many are index funds, which tend to generate less in capital gains distributions compared with actively managed mutual funds. But even active ETFs tend to be more tax-efficient than mutual funds because of the way ETFs are structured.
Because interest payments from municipal bonds and muni bond funds are often exempt from federal taxes, and in some cases state and local levies, too, park them in taxable accounts.
Finally, foreign stocks, even in a mutual fund or ETF, are best in taxable accounts. Most pay qualified dividends, which get preferential tax treatment, and there’s a credit for foreign taxes paid, says Elizabeth Buffardi, an Oak Brook, Illinois, certified financial planner, "which acts in most cases as a credit against the tax you owe the federal government."
Tax-Free Accounts
Roth IRAs and Roth 401(k)s hold post-tax money, so you don't get a tax break on contributions. But your money accumulates tax-free, and all withdrawals are tax-free, too, as long as you take them after age 59½ and the account has been open for at least five years.
That makes aggressive investors – active traders with big short-term gains, which are taxed as ordinary income – and aggressive investments best for Roth accounts. That includes growth stocks (or funds that invest in them) or stocks in high-volatility asset classes, such as emerging-markets and small-company stocks.
REITs and dividend-paying stocks, are good for Roth accounts, too. Dividend stocks get preferential tax treatment in a taxable account, but in tax-free accounts, "you avoid the tax altogether," says Kevin Cheeks, a San Francisco–based certified financial planner.