October is National Financial Planning Month, making it a great time to note that not all investments are created equal, especially when it comes to taxation. Some types of investments produce unpredictable capital gains, while others generate consistent dividend distributions. Understanding the differences is integral to a sound financial plan and a tax-savvy investment portfolio.

Below, the Illinois CPA Society highlights which investments you should consider keeping in and out of your taxable accounts as part of your financial plan.

5 common but costly investments to minimize in taxable accounts

1. Taxable bonds: Most of the income earned from taxable bonds is, well, income, which is taxed at your ordinary income tax rate. For many investors, that rate could be higher than the capital gains and dividend tax rates applied to other forms of investments.
2. Multi-asset funds: The simplicity of owning a target-date fund or balanced fund has its appeal, but these funds also commonly hold taxable bonds and are regularly rebalanced, creating tax consequences that could be costly when these funds are held in a taxable account.
3. High-dividend-paying equities and funds: Despite dividends receiving generally favorable tax treatment, high-dividend-paying stocks and funds are often better off in tax-sheltered accounts when tax strategy is top of mind. As dividends are paid on a set schedule, investors can’t delay the tax consequence of receiving them.
4. Real estate investment trusts: REIT income tends to be high, as they must pay out a minimum of 90% of their taxable income as dividends annually. While investors may love the steady income, REIT dividends are typically non-qualified, meaning they’re taxed at an investor’s potentially higher ordinary income tax rate.
5. Actively managed equity funds: As the name implies, these funds have managers that actively buy and sell their funds’ holdings based on their investment strategies. This active trading leads to various taxable events (often near year-end) for the fund and therefore its investors.

5 tax-efficient investments to keep in taxable accounts

1. Tax-managed funds: As the title implies, these funds aim to minimize income and capital gains distributions, thus lowering the tax consequences of their investment strategies.
2. Municipal bonds: Income from municipal bonds and municipal bond funds is exempt from federal income tax, and investors may even be able to avoid state income tax by buying municipal bonds issued within, or municipal bonds funds focused on, their home state.
3. Individual stocks: Holding individual stocks, particularly those that don’t pay dividends, allows for the greatest tax planning flexibility. Taxes aren’t paid on a stock’s capital gains until shares are sold. On the flip side, shares sold for a loss reduce taxable income, a strategy known as tax-loss selling or tax-loss harvesting. What’s more, the tax rate on capital gains also becomes more favorable on investments held for more than one year, ranging from 0% to 20% depending on an investor’s taxable income.
4. Treasury bills, bonds, and notes: Interest earned on U.S. Treasury-issued bills, bonds, and notes aren’t subject to state and local taxes. Moreover, taxation on interest earned on U.S. savings bonds (Series EE and I) is deferred until the owner redeems the bonds (and may not be taxed at all if used for qualifying education expenses).
5. Exchange-Traded funds: ETFs generally hold investments aligned with a specific theme or track a broader index, like the S&P 500, leading to lower trading activity and turnover, thus limiting capital gains distributions and taxable transactions compared to actively managed funds. The wide variety of thematic ETFs makes it easier for investors to diversify their portfolios, and tax exposure, efficiently.

Overall, making tax-savvy investments in your taxable accounts can work wonders for securing your financial future.

Photo credit: 8photo/Freepik

Download this content today!

Register to get free access to this content, as well as newsletters, continuing education, podcasts, and more…

Register Now Already registered? Click here to Log In

Read the FAQs