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Tips to Beat the Tax Man

If you're like me, you tend to think of your taxable brokerage account and your retirement accounts as two separate portfolios. If your taxable account is mostly shorter-term savings -- an emergency fund, or money you're setting aside for a down payment on a beach house in a few years -- that makes some sense, especially if you're more than five or six years away from retirement.

But if your taxable account is intended to be a long-term savings vehicle, it makes sense to think of it and your retirement accounts as one big portfolio -- and to consider how to allocate your investments between them for maximum advantage.

That's one for you, 19 for me
Tax-smart asset allocation starts with knowing which investments generate the most tax liability -- or are least "tax-efficient," as the experts say. The least tax-efficient investments should go into your retirement accounts, and the most tax-efficient into your taxable account. Makes sense, right?

To help you figure out which of your investments fall into which categories, here's a list of common investment types sorted from least to most tax-efficient. You may have to do some digging to figure out where some of your holdings fall -- looking at your mutual funds' turnover rates, for example -- but this should help get you started. Without further ado:

  • Junk bond ("high income") funds. These carry a double whammy: They pay high yields, which are taxable at ordinary income rates, rather than the lower rates on stock dividends. They also usually have high turnover, generating a big tax liability that is passed on to shareholders. (For a full explanation of the tax costs of high turnover, click here.)
  • Stocks sold within a year of purchase. Did you make some easy money on a stock, then decide to sell it a few weeks after you bought it? Those quick gains are taxable at the lofty "ordinary income" rate. If you'd held that stock more than a year, your gains would have been taxable at the lower "capital gains" rate, limited to 15%.
  • Corporate bonds, "investment grade" bond funds, and money market funds. Again, interest income is taxable as ordinary income. The turnover rate on higher-grade bond funds is often (but not always) lower than that on junk-bond and aggressive stock funds -- check yours to be sure.
  • Many actively managed stock mutual funds. Here's the turnover problem again, which plagues many active stock funds. Aggressive small-cap funds are often the worst, but the offenders show up in all categories. These are often best held in your IRA or 401(k).
  • Treasury bonds, bills, notes, and TIPS. Like other bonds, the interest on these investments is taxable as ordinary income -- but unlike other bonds, it's exempt from state taxes. Note that the annual inflation adjustment to TIPS (explained here) is taxable, too -- but also exempt from state taxes.
  • Index funds and "tax-efficient" low-turnover stock funds. You'll still have to pay taxes on your gains when you sell, but the annual turnover bill should be much lower than that on most actively managed stock funds.
  • Stocks held for more than a year. You'll pay the lower capital gains rate on your gains when you sell. As a bonus, dividends on these stocks are generally taxed at the same lower rate. Blue-chip dividend payers such as Pfizer (NYSE: PFE  ) and Wells Fargo (NYSE: WFC  ) can compare favorably with bonds when taxes (and gains) are taken into account.
  • Municipal bonds. Free of federal taxes, and possibly free of state taxes if you live in the city that issued them. But beware of the AMT, which may apply to some municipal bond interest.

I've just scratched the surface of what you can do with tax-smart asset allocation for your retirement portfolio. But even these simple tips can save you big money come tax time.

To learn more -- including tax details on other types of assets, and how this allocation strategy works with your selling strategy once you retire -- check out this article by Robert Brokamp from the December 2005 issue of the Fool's Rule Your Retirement newsletter. You can take a free look at that article -- and dozens of others, including those in the current issue -- with a 30-day trial. There's no obligation to subscribe.

Fool contributor John Rosevear has no position in the stocks named in this article. Pfizer is an Inside Value recommendation. The Motley Fool has a disclosure policy.

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10/25/2016 3:01 PM
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