Placement of Assets
Most investors comparing investment results look at portfolio return – and ignore expenses related to the portfolio. The most significant expense, which should never be ignored, is income tax. Federal tax rates on some investments are as high as 35%, while rates on other investments are 15%, while on others there are no taxes! Additionally, if one adds state and local income taxes to the total, the tax burden has a very major effect on net portfolio results. Thus, it is important to consider taxes when deciding what, when, or where to buy or sell. For purposes of this discussion, tax rates quoted will be the maximum federal rates. Keep in mind that this is a "simplified" example so the alternative minimum tax and state income tax are not taken into consideration for the purpose of the following example.
One thing that is important to understand is that different types of accounts are treated differently for tax purposes. Here are some of the most common:
Traditional IRA, 401K, pension and other qualified accounts: When money is removed from these accounts, it is taxed at the ordinary income tax rate, which currently is as high as 35%. Taxes on these accounts are DEFERRED until the investor withdraws the funds; it does not matter if the gains come from capital gains, dividends, or even municipal bond interest – all distributions are taxed at the same rate.
Individual, joint, trust and other non-qualified accounts: Here taxation depends on the source of the income. Interest, short term capital gains, and non-qualified dividends are taxed at the 35% rate, while qualified dividends and long term capital gains on the same investment are taxed at 15%. Municipal bond interest will not be taxed at all.
Roth IRA accounts: This is the best deal – once the funds are in the Roth IRA account, when certain age and time periods are achieved, there will not be any tax on distributions.
In my view, the two most important areas of tax planning are the placement of assets and the timing of a sale. Here's why.
In this example, let's consider that you are buying a stock that you expect to hold for a few years and that at the same time, you are going to purchase a bond that you plan on holding until maturity. Does it matter which account you use to purchase/hold the stock and the bond? YES!
You have the option of placing this stock in your individual account; in this case, upon its sale (as long as you have held it for a minimum of one year), you will pay 15% tax on the gain. Alternatively, you have the option of placing the stock in your IRA, not paying any tax now, but you will have to pay 35% tax when you withdraw the funds
At the same time you also have the option of purchasing the bond in the IRA or your individual account. If you purchase the bond in the IRA account, upon withdrawing the funds, you will have to pay the 35% tax. Otherwise, if you place the bond in your individual account, you will pay the tax at the 35% rate when the interest is earned.
To me this is an example of a no-brainer: the stock goes in the individual account – the bond to the IRA.
How about that municipal bond you are about to purchase? Place it in your individual account and you will not pay tax on the interest. However, if you place the municipal bond in your IRA account, you will eventually pay tax on the interest when those funds are withdrawn. Another no-brainier!
Another consideration is when to sell your investments. If you have a gain on investments that are held in your non-qualified accounts, you should try to hold onto them for more than a year, and thus qualify for the 15% tax rate. In your non-qualified accounts, if you sell an investment that you own for less than a year, you will have to pay 35% on the gain. This is another no-brainier but in this case, only if there is not an overwhelming investment reason to sell before the year is over.
As always, one must be careful as there are many pitfalls with tax and investment planning.