Just in case you aren't facing enough pressure deciding which stocks, bonds, and mutual funds to buy, there's another angle to the whole investing process. If you want to avoid adverse tax consequences, you also need to ensure that you put those investments in the right type of account. This is the art of asset location -- distributing your assets among different savings vehicles so as to minimize your tax burden. Don't worry. It's not as onerous as it sounds. Just keep a few tips in mind when dealing with the two different types of accounts.
With the decline of traditional pension plans, more and more Americans are using 401(k) or IRA accounts as their primary retirement savings tool. Obviously, the main benefit of accounts like these is that your money is not taxed until you withdraw it -- ideally in retirement. Dividend and interest income generated by your investments is also tax deferred. So if you want to put off paying the taxman as long as possible (and who doesn't), you want to stick your high income-producing investments in tax-deferred accounts.
That means bond funds and REITs are key candidates for inclusion here. Both types of investments throw off meaningful income on an ongoing basis, so you'll want to shelter that income from taxes. So think about picking an inexpensive, well-diversified fund like Vanguard Total Bond Market ETF (NYSEMKT:BND) or Vanguard REIT ETF (NYSEMKT:VNQ) to take care of your bond or real estate exposure within your 401(k) or IRA.
The same thinking applies to high-yielding stock funds -- if you've got a fund that makes frequent, sizable dividend payments, owning that fund in a tax-favored account will cut down on your current tax liability. High-turnover stock funds are also a good choice for tax-deferred accounts since lots of churn can end up generating short-term taxable gains that are distributed back to fundholders.
These rules also apply to Roth IRAs and 401(k)s -- since you'll have already paid taxes on your contributions and can withdraw that money tax-free in the future, consider stashing tax-inefficient, high-growth, and high-income investments in accounts like this.
If you have a non-tax-advantaged account, you are responsible for paying taxes on any "taxable events" that occur during the year, such as dividend or interest payouts. So the key with taxable accounts is to load up on low-turnover investments that don't produce much in the way of income and that you intend to hold for long periods of time. One of the best examples of investments that fit the bill in this category are equity index funds. These funds typically have low turnover since index constituents don't change all that often, keeping realized capital gains to a minimum. So funds such as Vanguard Total Stock Market ETF (NYSEMKT:VTI) or SPDR S&P 500 ETF (NYSEMKT:SPY) are great choices for taxable investors, with annual turnover of 5% and 4%, respectively. Other low-turnover, active tax-managed stock funds can also be good candidates for taxable accounts.
And while bonds are generally more appropriate for tax-favored accounts, there is one exception: municipal bonds. Because these bonds are already exempt from federal (and possibly state and local) taxes, you would lose those special tax-exempt features if you owned them in a 401(k) or IRA. So if you've done the math and muni bonds make sense for your tax situation, make sure you house them in a taxable account.
While certain types of assets may be a better fit for either taxable or tax-advantaged accounts, you don't want to let the tax tail wag the investment dog. In other words, your primary focus should be on buying the right investments and building a suitable asset allocation. Worrying about taxes should be a secondary concern.
If you are one of the many investors who hold most of your investment dollars in your employer's 401(k) plan, you should not open a separate taxable account just to house your low-turnover equity index funds. There's nothing wrong with owning stock funds in a tax-deferred account. In fact, you shouldn't consider opening a taxable account at all (with the exception of an emergency cash cushion) unless you are at least maxing out the employer match in your plan. Ideally, you should hold off on taxable investing until you have completely exhausted all your tax-deferred contribution options. But if your 401(k) plan leaves a lot to be desired and is riddled with high-cost, poorly performing funds, then you may have more of an incentive to open a separate IRA and/or taxable account.
Taxable and tax-advantaged accounts can live happily side by side in your investment portfolio; you may just have to play a little investment musical chairs to help minimize Uncle Sam's tax bite.
Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. She has no position in any stocks mentioned, and neither does The Motley Fool. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.