Managing investments means more than just which stocks, bonds, and other investments you own. Prudent investors should also consider where the investments live—specifically, whether it’s better to keep investments in taxable or qualified accounts. We call this tax location, and it can be an important part of wealth management.
What is tax location?
You may have heard the phrase “It’s not what you make on an investment, it’s what you get to keep after taxes.” When you understand how different accounts, and the investments held inside of them, are taxed, you can start to be strategic about where your investments live. While we try not to let the tax tail wag the investment dog, paying attention to where different assets live can help keep more after taxes.
With a taxable investment account, you invest funds that have already been taxed, like income from your paycheck. You’re also taxed on any realized gains and interest. The rate you pay on those gains depends on how long you held the initial investment and your taxable income.
Qualified accounts (such as 401(k)s and IRAs) work differently. You generally contribute pre-tax money, and gains and interest do not trigger income taxes. Rather, you pay income tax only when funds are withdrawn from the account (ideally in retirement).
How are investments taxed?
There are three main ways investments generate return: the investment increases in value, the investment pays a dividend, or the investment pays interest. All three of these come with tax implications when the investment is held in a taxable account.
Increases in value don’t automatically trigger taxes. You know the saying, “buy low, sell high?” To trigger a taxable event, you need to sell high. In other words, you must realize the increase in value. This is what’s known as a realized gain. If your investment is worth more now than when you bought it, but you still own the investment, this is an unrealized gain. The investment could still lose money before you sell. (Selling an investment that lost value is realizing a loss.) Unrealized gains aren’t subject to taxation.
When you realize gains, the tax rate for those gains depends on how long you owned the investment. If you owned the investment for less than a year, the capital gains are considered short-term. Short-term capital gains are taxed the same as ordinary income, so your tax rate will depend on your taxable income for the year. If you owned the investments for more than a year, the gains are taxed at a lower rate—the long-term capital gains rate.
Dividends are monies companies pay to shareholders out of profits. Dividends are generally taxed at the same rate as long-term capital gains. (Dividends are generally associated with stock or equity investments.)
Interest is a return paid on money that is lent. Banks pay interest on deposits and bond issuers pay interest on bonds. Interest is taxed as ordinary income—which is generally higher than the capital gains rate.
Remember, in a qualified account, none of these events is taxed—your investments grow tax-free. Instead, you pay income tax on the money when you withdraw it.
There are other investment returns with more complex tax rules, such as options, futures, and real estate. If you invest in these, we recommend reviewing the tax considerations with a professional.
How does tax location work?
The basic idea behind tax location is simple: Investments that aren’t tax efficient should be held in qualified accounts while tax efficient investments should be held in taxable accounts. Put another way, if the investment itself doesn’t have favorable tax treatment, you can put it in an account that does. On the other hand, if the investment is taxed favorably, it doesn’t need to live in a tax-advantaged account.
For example, if you are a high-earning individual, you’re likely going to pay a high tax rate on any interest you earn from fixed income investments. (The exact amount would depend on your tax bracket.) Therefore, we often suggest putting bonds and CDs that generate interest into a qualified account (like an IRA) since interest generated in a qualified account isn’t taxed as income.
On the other hand, if you’re invested in stocks that pay dividends and that you plan to hold for a long time, we might recommend keeping those in a taxable account. This way, the dividends are taxed at the long-term capital gains rate. If you don’t plan to hold the stocks for longer than a year, however—say you’re invested in a high-frequency trading strategy—a qualified account might work better, since you’d risk triggering short-term capital gains on those trades in a taxable account.
Some investments may be specifically designed for tax sensitivity, such as municipal bonds and tax-aware portfolios. For example, muni bonds pay interest that is generally not subject to federal (and sometimes state and local) tax. Because of this, it almost always makes sense to keep muni bonds in a taxable account. Some portfolios are designed to minimize capital gains, others to harvest tax losses with the aim of offsetting gains elsewhere, still others might report income as a “return of capital.” These strategies are built to use within a taxable account.
With any of these investments, it’s important to understand that tax treatment is far from universal and can be complex. A professional can walk you through the potential tax implications of different investments and portfolio management strategies.
The Quorum Approach
This discussion of tax location is, of course, very generalized and assumes that a client has an abundance of taxable and qualified accounts to choose from. As we said at the beginning of this article, we focus on choosing the right investments first—those that align with our clients’ goals, time horizon, and risk tolerance. Only then do we look at tax treatment and location.
It’s important to note: Quorum Private Wealth does not provide tax advice. Instead, we prefer to work closely with our clients’ tax advisors to figure out a tax strategy that works with a client’s goals and resources. If you don’t have a tax advisor you’re working with already, we can introduce you to the tax advisors in our network who we have worked with in the past and are experienced with tax law and planning. We always recommend you interview several firms and work with one who understands your personal circumstances and who you’re most comfortable with.
If you pull up the Quorum Private Wealth website (www.quorumpw.com), you will see the words “Simplify, Organize, Optimize.” It’s our goal with every client to simplify, organize, and optimize their financial affairs, from investments to insurance to estate planning to philanthropy. Tax location is one way we help clients do that.
Disclaimer: The subject matter in this communication is educational only and provided with the understanding that neither Sanctuary Wealth or Quorum Private Wealth are rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel, financial professionals, or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.
