As you know, taxes are one of those consequences that are hard to avoid. However, there are ways that you can reduce your tax burden by reducing your taxable income from interest, dividends, and capital gains. There are two primary ways to organize your investments that will minimize the taxes you pay.
- Own interest-producing investments inside of tax-free and tax-deferred retirement accounts.
- Own capital gain- and qualified dividend-producing investments outside of retirement accounts.
This process of choosing which types of accounts hold particular investments is called "asset location."
Assets That Fit Best in Retirement Accounts
There are several reasons that asset-location strategies work to reduce taxable income. First, interest income and short-term capital gains are taxed at a higher rate than long-term capital gains and qualified dividend income. Therefore, assets that produce interest income or short-term capital gains are best allocated to retirement accounts.
Benefits of Short-Term Gains in Retirement Accounts
When you hold investments that pay interest income or realize short-term capital gains inside of a retirement account, you create savings. Mutual funds are a good example of these types of investments—even if an individual investor holds onto their mutual fund shares, the fund may distribute short-term gains to investors throughout the year.
Payments from mutual funds would be subject to income tax if they were held in a brokerage account, but they are not reported as taxable income when they're held within a tax-deferred retirement account. The only time you report this income—and pay taxes on the money—is when you make a withdrawal. Since these are retirement accounts, withdrawals will usually be done at a lower tax bracket later in life.
Rollovers and transfers from one retirement account to another—like when you change jobs—don't count as withdrawals and don't create a tax situation as long as they're done properly.
Drawbacks to Long-Term Gains in Retirement Accounts
When an investor owns an asset for more than a year, the gains that the asset produces are considered long-term, and they are taxed at a more favorable rate. Depending on your overall annual income, long-term capital gains may not be taxed at all. However, when you own investments that generate qualified dividends and long-term capital gains inside of the tax-deferred retirement account, you negate these lower, more favorable tax rates. All withdrawals from tax-deferred retirement accounts are taxed at your ordinary-income tax rate, so it doesn't matter whether they're short-term or long-term gains.
Investments That Fit Outside of Retirement Accounts
Since the benefits of long-term gains are negated by tax-deferred retirement accounts, those investments may best fit in a taxable brokerage account. Standard brokerage accounts don't offer the same tax breaks as retirement accounts, but you do have more flexibility as to how you're affected by investment taxes.
Not only can you control when you sell an asset to take advantage of long-term capital gains, but you can also take advantage of losses. Any assets that have a loss can be sold to generate a capital loss. Capital losses can be used to offset other capital gains made in that tax year. If you have more losses than gains, you can use losses to offset your income, but this is limited to a deduction of no more than $3,000 per tax year.
You cannot offset gains with capital losses from investments when the losses occur in retirement accounts.
A Simplified Example of How Asset Location Reduces Your Tax Bill
Below is a simplified example that shows how asset location reduces your tax bill. This example has an allocation of 50% of investment capital in stock or a stock mutual fund and 50% in bonds or certificates of deposit (CDs).
In this case, the owner holds all the stocks and stock mutual funds in their individual retirement arrangement (IRA) and holds all of their bonds and CDs in a non-retirement brokerage account.
Location Strategy 1: Non-Tax Efficient Portfolio
- IRA Account: $100,000 in stocks and stock mutual funds
- Non-Retirement Account: $100,000 in bonds/CDs yielding 5% on average
The $100,000 in the non-retirement account produces $5,000 of taxable income that flows through to the tax return each year.
Location Strategy 2: Tax-Efficient Portfolio
- IRA Account: $100,000 in bonds or CDs yielding 5% on average
- Non-Retirement Account: $100,000 in stocks and stock mutual funds
By putting the bonds and CDs into the retirement account, no taxable interest income is reported for the year (unless you choose to take withdrawals from your IRA account).
Capital gains must be reported each year, but now when there are losses, they can be used to offset capital gains. When you have long-term capital gains in the non-retirement account, they're taxed at a lower rate than interest income and in some cases are not taxed at all.
- You can use passive index funds to reduce your annual capital gains distributions. You could also move the mutual funds to the retirement account and leave only stocks in your brokerage account—deferring any taxes on fund distributions and giving you full control over the gains you experience in your brokerage account (and the taxes you pay on them).
Comparing the Tax Liability
Assume you have an annual income of $81,000 in the 2021 tax year, landing you in the 22% tax bracket. In the first portfolio, with $5,000 of taxable interest income, you would pay $1,100 in taxes on the $5,000 of interest income.
In the second portfolio, the gains in a given year would depend on how the market performed in that year. Let's assume the stocks and stock funds returned $5,000 in the non-retirement account, but all of the gains came from long-term assets. Therefore, instead of the 22% tax rate you'd pay on ordinary income, these gains would be subject to the more favorable capital gains rate of 15%. That means the total tax bill on those $5,000 in gains would be $750—a $350 tax savings compared to the first portfolio.
Keep Your Reserves Set Aside
Of course, common sense says you would not invest all your non-retirement account money in stocks and stock mutual funds. You must keep an adequate amount of money in cash reserves in non-retirement accounts as an emergency fund.
Cash reserves in emergency funds are typically invested in things like money markets, CDs, and other safe investments that will generate taxable income. While this might not be ideal from an asset-allocation standpoint, it's much easier to withdraw money from non-retirement accounts, so it's better to keep emergency funds there.
The Balance does not provide tax or investment advice or financial services. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.