June 21st, 2010
Victor from Voorhees, NJ writes:
I have a brokerage account as well as an IRA. How do I know which investments to put in which account? Does it make a difference?
You raise an excellent point! The short answer is that for most investors it absolutely makes a difference. Since your IRA is tax deferred, the exact answer to your question is predicated on your marginal tax rate, the types of investments in your overall portfolio, and the frequency with which you transact. Before we continue, please keep in mind that we are not tax experts and certainly don’t profess to give any tax advice. However, we certainly recommend considering the tax implications when determining an appropriate investment portfolio and the specific location of each investment instrument. Ultimately you should discuss your needs with a qualified tax adviser.
Having said that…generally, in a taxable account, an investor will pay income taxes on short term gains, long term (capital) gains, interest, and dividends. The specific debt (bond) issuance will typically dictate tax liability both federally and at the state level. For equities, some dividends are considered “qualified” and are subject to a lower tax rate than “non-qualified” dividends. The length of time an investment has been held will determine if it is taxed at the short term rate or long term capital gains rate. Naturally, the investor’s marginal income tax rate will also be a material factor. Each of the variables mentioned above contribute to the tax savings of holding an investment in a tax deferred account relative to a taxable account. Given that most investors cannot hold all of their investments in their IRA, it is beneficial to select those instruments with the largest relative advantage from an income tax perspective, to be held in the IRA (tax deferred account).
If there are not a lot of transactions anticipated, the main focus would be on dividends and interest. Below are some common investment instruments and the types of considerations used in determining the relative tax benefit of holding in a tax deferred account.
Treasury/Agency Bills, Notes, & Bonds – Generally not taxed at the state or municipality level. All else equal, the higher the interest rate (due to coupon or discount), the greater the relative benefit of placing in a tax deferred account.
Municipal Bonds – Generally tax free at the Federal level. They may also be tax free at the state level, depending on issuer location and residence of investor. Munis are generally placed in a taxable brokerage account and often held by investors who pay higher marginal income tax rates.
Corporate Bonds – Generally taxed at the investor’s marginal tax rate. Higher yielding corporate bonds produce a greater relative tax advantage when placed in a tax-deferred account.
Domestic Equities – Dividends generally considered “qualified” and thus taxed at a reduced rate. These are most often held in a taxable account, unless frequent transactions are anticipated, causing short term capital gains taxed at the marginal income tax rate.
Foreign Equities – Some foreign equities have reciprocity with the US, allowing favorable “qualified” (lower tax rate) tax rates for their dividends, while others issue non-qualified dividends. Although reciprocity is generally granted by country, each issuer should be reviewed.
Mutual Funds and ETFs – Dividends are all taxed based on the underlying characteristics of the securities held by the fund. So, a Fixed Income ETF will likely pay dividends which are non-qualified and thus taxed at the investor’s marginal tax rate. Many funds contain a mixture of securities which produce a PORTION of the dividends to be considered qualified and the remainder as non-qualified. On the investor’s 1099, the broker/custodian will display the percentage of qualified/non-qualified dividends that were received during the previous fiscal period for each security held.
Commodities – These can be tricky and are sometimes held in different ownership structures (e.g. partnerships) which can trigger certain unanticipated tax liabilities (such as phantom income without a distribution). Holding such an investment in a tax deferred account does mitigate the complexity. As always, we recommend you understand every investment in your portfolio including the tax implications.
If frequent transactions are anticipated in certain investments, the increased tax rate associated with short term gains may make those more suitable for a tax deferred account. Careful consideration to all of the components which create relative tax advantage of owning an instrument in a tax deferred account should be given when determining investment location.
As a general rule of thumb, if you are not transacting frequently, the highest yielding fixed income securities (excluding municipal bonds) usually provide the greatest relative value when placed in a tax deferred account.
Please also note that tax rates and tax laws do change. It is always prudent to consult a knowledgeable tax advisor to get current information when making investment decisions based on your individual tax situation.
We hope that helps and provides fodder for discussion. Please let us know if we can be of further service!
The Friedenthal Financial Team
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