Some parts of this blog were updated on March 14, 2018
Selecting the best assets for your investment accounts can be confusing and intimidating. There are many options, which can have radically different tax implications, so it’s often best to know which ones are the most efficient to narrow your choices to a smaller, manageable list.
If you’re thinking that you’ll just take the most tax-efficient assets and be done with it, you’ll find that it’s not quite that simple. There are tradeoffs to consider. For example, you may need to sacrifice some tax efficiency to achieve a well-diversified portfolio.
To begin your journey, here is some high-level information on investment options and their corresponding tax efficiency:
- Individual stocks: When properly managed, holding individual stocks can be the most tax-efficient way to gain exposure to equities because you are entirely in control of when you realize gains or losses. You may, however, owe taxes on dividends, if you purchase dividend-paying stocks.
- Exchange traded funds (ETFs): One of the primary advantages of ETFs is their tax efficiency compared to active mutual funds. This is mostly because they are passively managed, which results in lower turnover. Another advantage of ETFs is that they trade like stock on the secondary market and they are structured for easy purchase and redemption.
- Mutual funds: These funds, when held in taxable accounts, can create excessive annual tax bills because of their high turnover rates. Except for some passively managed funds, mutual funds generally have lots of turnover because active managers are trying to beat fund benchmarks. This frequent buying and selling creates tax issues. In addition, mutual funds make periodic (mostly annual) distributions, which are also subject to taxes. A 2010 study by Lipper indicated that owners of mutual funds in taxable accounts gave up an average of 0.98% to 2.08% in annual return to taxes over a 10-year period1.
- Bonds: Passive bond mutual funds and bond ETFs are generally more tax efficient than actively managed bond funds, but come with some other tax considerations. Income generated from these funds is taxed as ordinary income. There are exceptions, such as municipal bonds, which can be tax advantaged. If you live in the state in which they are issued, you are exempt from state tax in addition to the federal income tax on these bonds. While this sounds good, municipal bonds often pay lower returns. Generally, those in high tax brackets benefit the most from municipal bonds.
- Real Estate Investment Trusts (REITs): Unlike private REITs, which can provide diversification but are usually illiquid, ETF REITs are an efficient portfolio diversifier because they allow you to gain exposure to real estate through an instrument that is liquid. Additionally, investors do not have required maintenance and upkeep responsibilities for the properties held in a REIT. However, a REIT (ETF or private) must pay out at least 90% of its income annually in the form of dividends, which are generally taxed as ordinary income.
As you can see, each asset offers tax advantages and disadvantages. While each of these categories appears to offer straightforward tax options, there are numerous other nuances to consider, which should be considered in the context of the tax implications of the individual asset before you decide on a basket of assets for your investment accounts. Your financial advisor can help you review and choose a tax efficient strategy.
Learn more about taxes and how they fit into your investment strategy by reading our free Personal Capital Tax Guide for the Savvy Investor.
This blog is for informational purposes only and is intended to offer guidance; not specific legal or tax advice. Clients are advised to consult their personal estate attorney and CPA before taking action based on this advice.
1. “Taxes in the Mutual Fund Industry – 2010: Assessing the Impact of Taxes on Shareholders’ Returns”, Lipper Research, 04/28/2010