Are You Losing Money Because of Tax-Inefficiency?

Diversification is a well-known method of mitigating market volatility risk and seeking more consistent returns. And this may lead to a mix of different types of investments as a means of providing diversification. But does it matter where your assets are held.

In other words, are stocks better in an IRA or a taxable account? What about corporate bonds?

Based on research published in the January 2005 Journal of Financial Planning, where you hold various types of investments could have an impact on your overall after-tax return. That's because certain asset types are more likely to benefit from the tax-deferred treatment available in an IRA, while others may provide better after-tax returns in a taxable account.¹

What determines if an asset would work better in an IRA or a taxable account?

According to this research, one factor is the amount of an asset's total return that comes from capital gains. Thanks to recent changes in tax regulations, capital gains (defined as gains achieved on investments held for at least one year) are now taxed at a rate of 15% or 5%, depending on your current tax bracket. Therefore, investments that generate a significant portion of their total return from capital gains, such as corporate common stock, could potentially benefit from these lower tax rates.

However, if these investments were held in an IRA, their returns would be treated not as capital gains but as ordinary income when removed from the account. Therefore, these gains would be taxed at your ordinary income tax rate, which could be higher than the capital gains tax rate. Assets that tend to generate significant capital gains may be more appropriate for a taxable account, where they would benefit from the lower capital gains tax rate. Conversely, for those assets where capital gains comprise very little of total return and more income (e.g., corporate bonds and preferred stock), an IRA might be a better choice.

Asset appreciation potential is also something to consider, and can have an effect upon the income taxes that might be paid by your beneficiaries in the future. For example, assets held inside and IRA do not receive a stepped-up cost basis at the death of the account owner. On the other hand, assets held outside of an IRA will receive a stepped-up cost basis when the owner of the assets passes away. The point is the place where assets are held can also affect the future income taxes of your younger family as well!

Please note however, that investments in securities such as corporate stocks and bonds carry market risk, and your principal investment can lose value regardless of the manner the securities are held. Additionally, the principal and interest payments from corporate bonds are subject to the financial stability of the issuing company. Corporate bonds are also subject to interest rate risk. In other words, your risk tolerance and investment time horizon should also be considered when purchasing investments for your portfolio.

If you are not sure whether your accounts are working as tax-efficiently as they could, we can review your tax bracket (both current and projected) and find research ways to make your money work harder for you.

If you would like to meet either in person or by telephone (or simply would like to receive my FREE "Tax Strategy Guide"), please use the CONTACT US link and let me know.

I look forward to meeting you!

¹Journal of Financial Planning (Jan. 2005). September 21, 2005