Inflation is on everyone’s minds right now, but taxes also erode the value of your assets, including investments.
“Investors have good reason to police all the costs that they pay, including tax costs,” noted researcher Morningstar in a new guide that deals with taxes and investing.
There are two key types of taxes for investors to beware — those on capital gains and ordinary income — while different assets and types of accounts receive varying tax treatment.
“Some investors might be doing it wrong when it comes to asset-location decisions,” said Morningstar, citing, as an example, investors who think they should keep most or all of their stock-market holdings in tax-sheltered retirement accounts.
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Taxes and investing can get complicated quickly, but many recommendations from Morningstar’s guide can boil down to a few key rules and strategies.
Please taxable accounts for stocks
A big part of Morningstar’s analysis deals with figuring out whether certain investments fit better in regular, taxable accounts or in tax-sheltered vehicles such as traditional Individual Retirement Accounts and workplace 401(k) plans. Many people hold multiple accounts, so it makes sense to place each investment in the most suitable spot.
For example, a common assumption is that individual stocks and stock funds are best held in sheltered retirement accounts. However, Morningstar’s analysis generally recommends holding stock investments in taxable accounts.
The reason reflects the lower long-term capital gains rates that you can get in taxable accounts. By contrast, money withdrawn from traditional IRAs and 401(k) plans is taxed as ordinary income, at higher rates.
Bonds and bond funds are less likely to generate gains. Rather, they spin off regular income payments that are best sheltered in retirement accounts.
“Fixed-income securities make the most sense in tax-sheltered accounts, where their regular distributions can be reinvested and compounded without taxation until withdrawal time, while equities are better suited for taxable accounts,” Morningstar said.
But consider key non-tax factors
However, the report also acknowledged that non-tax considerations can change things. For example, while bonds and bond funds usually make more sense if held in sheltered retirement accounts, investors need access to stable, liquid assets such as these in accounts they can tap at any time without penalty. “Generally, these are taxable accounts,” said Morningstar.
Meanwhile, investors who seek long-term growth with stocks and stock funds might need to concentrate their holdings of these in IRAs and 401(k)s. Owing to tax deductions, possible employer matching funds and the ease of investing through payroll deductions, investors have incentives to prioritize contributions into these accounts, even if they’re giving up lower capital-gains rates, Morningstar noted.
Sheltered accounts, especially 401(k) plans, also offer creditor protections that you can’t get with taxable accounts. Plus, it’s often easier to rebalance investments within IRAs and, especially, 401(k) plans, and you won’t trigger taxes each time you do.
But a big advantage of taxable accounts is that they’re flexible and easy to use — most anyone can open an account and seed it with as much money as they want. By contrast, sheltered accounts — traditional and Roth IRAs as well as 401(k)-style plans — face various contribution, income-eligibility or withdrawal limits or penalties.
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Taxable accounts also tend to enjoy an estate planning edge, Morningstar noted, in that heirs can receive a step up on a basis upon the death of an account owner. Essentially, this means any tax bills on unrealized gains in the account are wiped clean.
Go with triple tax-benefit accounts
Actually, neither taxable accounts nor traditional retirement vehicles offer the best tax savings features. Rather, Morningstar said, that honor goes to health savings accounts.
HSAs offer three tax advantages: Contributions may be deducted, earnings grow tax-sheltered and withdrawals come out tax-free if used to meet any of a lengthy list of qualified medical expenses.
“Yet plenty of workers who are eligible to contribute to HSAs do not take full advantage of them,” Morningstar said. Many people don’t contribute as much as they can while others don’t invest their account balances for growth, instead sticking with low-earning money-market investments.
Perhaps the key problem with HSAs is that they’re generally available only to employees with high-deductible health insurance plans through work. Also, you can’t put all that much money into these accounts — individuals may contribute up to $3,650 annually, plus $1,000 for people ages 55 and up. Also, there’s a 20% penalty, plus regular taxes, to beware for investors who make withdrawals for nonqualified expenses before age 65.
But from a tax perspective, HSAs are hard to beat and people who are eligible should use them. “The tax benefits of HSAs outweigh those offered through 401(k)s and traditional IRAs, Roth IRAs, 529 education-savings plans and taxable accounts,” Morningstar said.
Control what you can
Death and taxes are inevitable, but people can exert a lot of control over when their tax bills come due. Investors often can choose when to sell and thus when to incur capital gains or losses, and the assets they select vary in how much control they allow.
Morningstar’s focus here was on highlighting investments that make regular and relatively large distributions of income or even principal such as high-yield bonds, REITs or real estate investment trusts and the various funds that hold these assets.
These examples are “a poor fit for taxable accounts,” according to Morningstar, as they “force investors to cede control” over the timing of when they realize or receive income. Various actively managed stock funds do the same with capital gain distributions that can be large and might come at inopportune times.
By contrast, many index and tax-managed funds pay little in the way of distributions, allowing for control over when income or gains are realized. Investors also can retain control over individual stocks, especially those that don’t pay dividends. People may hang onto stocks in taxable accounts for decades, paying no taxes until they sell.
Investors also can control when they incur losses as part of a tax-loss harvesting strategy — an approach the report endorsements. Losses can be used to offset or shelter realized gains during the year, and up to $3,000 in additional losses can be deducted against regular income. Losses beyond that can be carried forward to future years.
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