Because of the different ways the Internal Revenue Service (IRS) taxes certain types of investment income, some investments are better held in tax sheltered plans while other investments work better in non-sheltered plans. As a general rule, investments that provide predictable income streams, like interest and dividends, need to be in tax sheltered plans to avoid taxes on the income. Investments held for long-term capital gains can be held in non-sheltered accounts since the gains receive favorable tax treatment.
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Tax Treatment of Investment Assets
Capital assets — which are virtually any investment asset you own — can be sold at either a profit or a loss. The IRS has different rules for how capital transactions and other investment income are taxed.
- Short-term capital gains are generally gains on the sale of assets held for one year or less. These must be reported as ordinary income and taxed at your regular income tax rates.
- Long-term capital gains are gains on the sale of assets held for more than one year. They have favorable tax treatment, which depends on your personal income tax rate. If your overall marginal tax rate is either 10% or 15%, the tax rate on long-term capital gains is 0. If you’re in the 25, 28, 33 or 35% tax brackets, your long-term capital gains are taxed at a maximum rate of 15%.
- Capital losses are losses on the sale of assets regardless of the length of time held, and there are restrictions on how much of the loss you can deduct. You can deduct any losses to the extent that you have capital gains. If your losses exceed your gains, you can deduct up to $3,000 against ordinary income in any one tax year. Any loss in excess of $3,000 can be carried forward and used to reduce your income in subsequent years. For example, if you had a net capital loss of $10,000 in 2011, you can deduct $3,000 for that year, and carry the remaining loss of $7,000 forward to 2012. If you have $10,000 in gains in 2012, you can apply the entire $7,000 loss from 2011, reducing the 2012 taxable gain to just $3,000.
- Interest and dividend income are generally taxed as regular income. There are exceptions, such as municipal bond interest and qualified dividends.
Tax Sheltered Accounts
Tax sheltered accounts include retirement accounts, such as IRA’s and 401(k)’s, and certain other accounts, like 529 College Savings Plans. These accounts allow earnings on invested funds to accumulate on a tax-deferred basis. This feature makes them the preferred accounts to hold the following investments in:
- Interest bearing investments. As stated above, interest income is taxed at your regular marginal tax rates. Except for interest on municipal bonds, there are no tax advantages for holding them outside of a tax sheltered plan. There will be income, and it will be taxed every year. If you hold these investments in a tax sheltered plan, they will be able to grow tax free until the time of withdrawal.
- Stocks held mainly for dividends. Dividends are also taxed as regular income. For all the same reasons you would for interest bearing investments, you should also keep stocks held mainly for dividends in a tax sheltered plan. This could include utility stocks or other stocks that pay above average dividends that you have no plans to sell.
- Funds held mainly for income. Certain mutual funds and ETF’s invest mainly to provide regular income streams from either interest or dividends. This can include bond funds or high yield funds whose primary goal is providing a steady income.
- If you’re an active stock trader. If you’re more of a stock trader than a stock investor you’ll probably be better off holding your portfolio in a tax sheltered plan. Short-term capital gains will be taxed as ordinary income, so the tax deferred feature of sheltered plans will be an advantage.
- Mutual funds and ETF’s with high turnover ratios. Some funds have high investment turnover ratios, meaning they do a lot of trading during a typical year. This often results in a high percentage of short-term capital gains. These funds are better suited to tax sheltered accounts since, once again, short-term capital gains have no tax advantage.
Non-Tax Sheltered Accounts
Any investments that rely primarily on long-term capital gains, or are otherwise tax exempt, can be held in a non-tax sheltered account.
- Buy-and-hold stocks. If you’re holding your stocks for long-term capital growth, the gains on them will receive favorable tax treatment and will be better held in non-sheltered plans. It makes no sense for example, to hold stocks for long-term capital growth in a tax sheltered plan if you’re in the 15% marginal tax bracket and long-term capital gains will have zero tax liability.
- Growth type ETF’s and mutual funds. These can be held outside tax sheltered accounts for all the same reasons you’d keep long-term stocks outside. The gains will receive favorable tax treatment and probably won’t need tax deferral.
- Precious metals. Some IRA plans advertise that you can hold gold bullion coins in them but it’s not necessary from a tax standpoint. Since precious metals pay no dividends, they are by default assets that are held for capital gains.
- Tax exempt municipal bonds. The income on these bonds is tax exempt anyway, so there’s no reason to hold them in a tax sheltered plan.
- Stocks held for qualified dividend income. If you have stocks that you hold primarily for dividend income, but those dividends are mostly or entirely “qualified” dividends (meeting certain holding period requirements), the income will be taxed under favorable capital gains rates.
Maximizing retirement savings is certainly desirable, but as you can see, there are certain investments that benefit more from being in non-sheltered accounts. Plan on having both.