Tax season is just about over. You've trimmed your tax tab by
taking as many tax write-offs as you could. Warning: Your job is
not over yet.
When it comes to minimizing your tax bill, your annual tax
return is just a short-term tactic. You can save more money over
the long term if you engage in strategies to boost your after-tax
investment returns. "Taxes are the biggest drag on returns," says
Rande Spiegelman, vice-president of financial planning at
You can't eliminate all investment-related taxes, of course, but
studies show that you can extend the life of your retirement nest
egg by improving the "tax efficiency" of your investing.
It's a strategy that many investors overlook, says David
Blanchett, the head of retirement research at Morningstar. "It's
easy for an investor to figure out whether a mutual fund
outperformed an index," he says. "But most people don't think about
how taxes affect their long-term portfolio." And like limiting
investment fees, managing the tax bite is one of the few areas that
you can control. "It's almost a free lunch," he says.
The strategy is based on the fact that different kinds of
investments are taxed differently. Also, earnings from the same
investment are taxed differently depending on whether it is in a
taxable brokerage account, tax-deferred IRA or 401(k), or tax-free
Roth. The goal is to put the right investments in the right
accounts to maximize after-tax returns. The order in which you
withdraw from the various accounts also helps or hurts your overall
The most basic rule of thumb is to place stocks in a taxable
account and bonds in your IRA. (We'll get to the intricacies and
the exceptions later.) During retirement, you withdraw from
accounts in this order: taxable, traditional IRA and Roth.
To demonstrate the advantage of tax-efficient investing,
Blanchett and Morningstar colleague Paul Kaplan created nine
hypothetical portfolios, all with an allocation of 40% stocks and
60% bonds--a reasonable allocation for someone approaching or in
the early years of retirement. The account balances for a 401(k)
and taxable account were equal. At one end of the spectrum, an
investor pursued a rule-of thumb strategy--placing the stocks in
the taxable account and most of the bonds in the 401(k), and then
tapping the taxable account before withdrawing from the 401(k).
With an inefficient portfolio, the 401(k) held stocks, and the
investor withdrew from the retirement account first. In a "split"
portfolio, stocks and bonds were placed equally in both accounts,
which were tapped simultaneously.
The tax-efficient portfolio generated 3.23% more in after-tax
annual income during retirement than the split portfolio, the
researchers found. Blanchett used the split portfolio to compare
with the "efficient portfolio" because he assumed that typical
investors would more likely spread different types of investments
and income across accounts--but not tax efficiently.
A big caveat: You should not worry about tax efficiency if
nearly all of your money is in a tax-favored IRA or 401(k). The
objective of employing strategies to boost tax-efficiency is to
reduce taxes generated in your taxable account. If, say, 90% of
your retirement stash is in tax-deferred accounts, place the
most-efficient 10% of your assets in the taxable account and don't
worry about the rest. And don't skimp on stowing away money into
your retirement account in order to play the tax-efficiency game.
Place as much money as you're allowed in your IRA or 401(k), where
your investments will grow tax deferred for years.
First choose a well-diversified portfolio based on solid
investments and your risk tolerance. Then you can play the
tax-efficiency card to the extent possible based on your specific
situation. "You hear a lot of people saying, 'Never let the tax
tail wag the dog,' " says Tom Roseen, head of research services at
investment research firm Lipper. That's true, he says, but, "on the
flip side, if you're surrendering two percentage points a year to
Uncle Sam, keeping a good eye on after-tax returns and on asset
location is hugely important."
Even a "seemingly small tax drag" can have a big impact on an
investment's long-term growth, Roseen says. To illustrate, he
looked at the before- and after-tax performance of taxable
fixed-income funds for the ten years that ended December 31, 2012.
The before-tax annual performance averaged 5.44% a year.
If $10,000 of fixed-income investments had been placed in an IRA
at an annual return averaging 5.44% a year, the investment would
have grown to $48,933 after 30 years. If the same investments had
been placed in a taxable account, Roseen figures that taxes on
capital gains and other distributions would have consumed 1.76
percentage points--for an average after-tax performance of 3.67% a
year. After 30 years, the taxable account would have held
How much of the IRA's apparent advantage would be lost to taxes
upon withdrawal would depend on the investor's marginal tax rate.
If the investor's tax rate is 25%, the IRA would still be more than
$7,000 ahead after the full $48,933 was withdrawn.
You can get even more flexibility if you open a Roth IRA. You
can convert part of your traditional IRA or, if you're still
working, funnel money into a Roth 401(k). If you choose the
conversion route, take care that the income from the switch does
not bump you into a higher tax bracket. And opening a Roth may only
make sense if you expect to be in the same or a higher tax bracket
down the road.
Location, Location, Location
Once you settle on asset allocation, turn your attention to
asset location. To the extent possible, figure out which holdings
are most tax-efficient and most tax-inefficient. It's the
least-efficient ones that should go into a tax-sheltered
Facing new, higher rates on ordinary income and capital gains,
wealthier taxpayers have the most to gain by pursuing a
tax-efficient investment strategy, says Maria Bruno, a senior
investment analyst at Vanguard. "When tax rates rise on individuals
with higher income, or when you're in a higher bracket, asset
location is all the more important because of how the accounts are
taxed," Bruno says.
With a taxable account, you pay ordinary income tax of up to
39.6% on interest payments and up to 20% on qualified dividends and
long-term capital gains. Higher-income investors also now pay a new
3.8% surtax on certain investment income. With a traditional IRA,
you pay ordinary income tax on all withdrawals (assuming you've
made no nondeductible contributions), while all withdrawals from a
Roth are tax free.
A brokerage account is the best place to hold any tax-exempt
municipal bonds you own--why waste the tax break in a tax-favored
IRA? (And muni-bond interest earned inside an IRA will be fully
taxed when it's withdrawn.) Assuming you have room, perhaps your
taxable account will include a large-company index fund that you
intend to hold for a long time--you pay the tax-favored
capital-gains tax on profits and you'll incur most of that only
when you sell. Holding stocks in an IRA converts those long-term
gains into ordinary income, which is taxed at a higher rate when
you withdraw. Stash living-expense money in a bank account, or
Bruno suggests, use tax-exempt municipal money-market funds for
your short-term needs.
Place investments that generate the most taxable income in a
traditional IRA. This includes real estate investment trusts and
most taxable bonds and bond funds, especially high-yield bonds and
inflation-protected securities. Interest on these assets--and
inflation adjustments in the case of inflation-protected
securities--would be taxed at ordinary income-tax rates each year
if they were held in a taxable account. "They kick out a lot of
annual income," Bruno says. Individual stocks that you intend to
hold less than a year also may be better off in an IRA; in a
taxable account, you would pay short-term capital-gains taxes, at
your ordinary income-tax rate, if you sell within a year. You'll
pay ordinary income rates on the money when it comes out of the
IRA, too, but you'll enjoy tax-deferred compounding until that
The rules of thumb--stocks in taxable accounts and bonds in
tax-favored accounts--don't always apply. For mutual funds, you
need to consider the "turnover rate." Even if you lose money on a
fund, you'll pay long- and short-term capital-gains tax on
distributions each year if the fund is held in a taxable account.
That occurs when a fund manager sells--or turns over--holdings for
more than their purchase price. You also will pay tax on interest
on any bonds held in a fund.
Index funds and exchange-traded funds that follow a broad
benchmark, such as a fund that tracks Standard & Poor's
500-stock index or a broad international-fund index, have low
turnover rates. Trading in these funds is limited so they generate
little in capital gains and the dividends tend to be low. The
relatively low annual tax liability makes such funds better
candidates for a taxable account than a tax shelter. Actively
managed funds tend to have higher turnover "so they probably should
go to the tax shelter," Roseen says.
But not all index funds cry out to be in a taxable account. Some
narrower index funds and ETFs, such as those that follow a sector
or an individual country, may have considerable turnover and could
be better off in an IRA. Small-company stock index funds also tend
to be inefficient because fund managers may need to buy and sell
holdings more often. And bond index funds tend to generate taxable
To check the fund's turnover rate, go to
, plug in the fund's symbol, and click on the "Tax" tab. The
Vanguard 500 Index fund, for instance, has 3% turnover, which means
it tends to hold stocks indefinitely. Many actively managed funds
that invest in large U.S. companies have turnover rates of 50% or
more, meaning that half of the stocks are sold and replaced within
a year. Compare a fund's turnover rate to those of its peers.
Also look at the fund's performance, particularly its
tax-adjusted return. Lipper, which is owned by Thomson Reuters, a
business information company, offers two tools to help you judge a
fund's after-tax return and its tax efficiency. Go to
, place your cursor on the "Money" tab, and click "Fund Screener"
from the menu. At the bottom of the page (at "view overview page
for"), plug in the fund's symbol or name.
By clicking on "Lipper Leader Ratings," you can see the fund's
tax-efficiency rating--5 is the best. By clicking on the
"Performance" tab, take a look at "after-tax preliquidation" and
how it compares with the "SEC performance." The difference is the
amount of the return you will pay per share in taxes on capital
gains, dividends and interest income.
These measures can help you figure out the best home for a
particular fund or choose a fund for a taxable account. If you're
looking at two funds with the same returns, Roseen says, "but one
is more tax efficient than the other, that is the fund I would
choose for a taxable account."
The asset's returns also could be as important as the tax rate
in deciding where to place an asset. Generally, for example, Roth
accounts should hold investments with the potential for the highest
return, such as growth stock funds. In a Roth, you don't need to
take minimum distributions and investments grow tax free.
Michael Kitces, director of research at Pinnacle Advisory Group,
in Columbia, Md., believes location matters more for high-return
investments than for low-return assets. The goal of placing assets
inside a retirement account "is to take advantage of tax-deferred
compounding returns," he says. If returns are low, he says, "there
simply isn't much to compound in the first place." That's the case
for many bonds, particularly low-yielding government bonds.
Kitces says that with bond interest rates so low it may not
matter where you place the bonds if you have other tax-inefficient
assets that have higher returns--and you have a small IRA. The idea
is to set priorities for placing your most inefficient and
He offers this example: Say you have a $90,000 taxable account
and a $10,000 IRA. Your investments are split equally among bonds;
cash; a high-turnover, high-return stock fund; and a high-return
index fund. The first priority would be to put the most inefficient
asset--$10,000 of the stock fund--into the IRA. The bonds would go
into the taxable account, Kitces says, "not because we prioritized
them there, but because we prioritized something else in the IRA
Your priorities would change if you had a $10,000 taxable
account and a $90,000 IRA. Your most-efficient asset--$10,000 of
the index fund--would go into the taxable account, "where it
benefits most," Kitces says. The rest would go into the IRA.
Beyond choosing the best account for each investment, other
moves can hold down Uncle Sam's take of your investment profits. If
you're about to sell a stock in a taxable account, Spiegelman says,
pay attention to the holding period. If you bought it nearly 12
months ago, hold on to it a year and a day, to avoid the short-term
capital-gains tax. But if you'd have to wait six months to move
into long-term gain territory, go ahead and sell, he says. It's
better to pay the taxman than risk a loss in the market.
When you rebalance your portfolio, do as much as possible inside
your IRA, where transactions have no tax consequence. For example,
if your stock portfolio is now above your target allocation
relative to bonds, Spiegelman says, "the first place to go is your
tax-advantaged accounts. You can sell some stocks without incurring
taxable capital gains."