Don’t Give Your Investments a Home Where the Taxman Roams

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Congratulations on the galloping gains in your mutual funds, espec­ially if you’ve held them for a long time, because the market usually rewards riders who hang on to quality holdings. But what about the tax impact of selling them? Should you have kept certain investments in different corrals?

Everything in a Tax-Sheltered Account?

Trying to drive the maximum amount of assets into tax-sheltered accounts seems ideal. You can trade with no regard for capital gains and the money grows tax-free.

Not so fast, pardner! If you’re sure every investment you choose will have massive gains, keeping those gains tax free in a retirement account seems like a great idea. For all accounts except a Roth, however, you’ll be paying tax at your income rate, not the capital gains rate. Depending on your tax rate at withdrawal, you may be paying more taxes on those gains than you’d have paid in a taxable account at the capital gains rate.

If you have to pay taxes on a gain, you’re better off in a taxable account than a tax-sheltered retirement account. In a taxable account you’re paying taxes on the capital gain in one year. If you’re withdrawing no more than your required minimum distribution, taxes on those gains can be spread out, but you’ll still be paying them.

Not every investment performs as anticipated. When you have losses in a retirement account, that money has ridden off. There’s no ability to write off the loss against gains or ordinary income, as would be possible in a taxable account. It seems reasonable to conclude that the more stable investments should be in retirement accounts and the bucking broncos in taxable (brokerage) ones, where the lower capital gains tax rate and loss offset can be applied.

If you’re willing to forgo taking tax-deductible losses, or pretty sure you won’t have any (lucky you), hold the volatile ones in tax-sheltered accounts, mainly Roths and health savings accounts. And hold investments there that will be tax-free upon withdrawal.

In Tax-Free or Tax-Deferred Accounts

REITs
Real estate investment trust mutual funds should always be held in retirement accounts because of their high payouts. REITs must return 90% of their income to shareholders. These dividends are taxed as ordinary income (not capital gains rates), unless they’re qualified dividends.

In addition, some REITs pay out return of capital, which reduces the cost basis. Skip the complex tax issues and make your tax preparer happy by keeping these investments in nontaxed accounts.

Commodities
Commodities funds are another complex taxation problem. Depending on the type of fund, you may be issued a Schedule K-1 as partnership income; funds that issue gains may classify 60% as capital gains and 40% as ordinary income. Keep these in a nontaxed account and you’ll avoid tax-preparation nightmares.

On the other hand, this asset class is volatile and you can see sig­nificant losses. Tread carefully. Funds composed of physical gold or precious metals are considered collectibles and are taxed at the much higher rate of 35% (short-term gains) and 28% (long term). To avoid the blow, hold them only in retirement accounts; even at withdrawal, the ordinary income tax is likely lower.

Big Maybes

International
Many of us try to own some inter­national investments. Unlike the U.S., foreign governments withhold taxes before companies pay out dividends. You’ll also be taxed on dividends by the U.S. government but can receive a credit for foreign taxes paid. If, however, the international vehicles are held in a nontaxed account, you lose the credit for the foreign taxes withheld.

On the other hand, inter­national investments sometimes have larger dividends than U.S. investments, so you still may prefer sheltering those dividends and letting them grow tax-free in retirement accounts. It really comes down to how much you have invested in the international sphere and what size the payout is from the specific mutual fund. But if you have to sort investments into taxable and nontaxed accounts, international funds are a good candidate for being located on the taxable side.

Dividend-Paying Stock Funds

Are you emphasizing dividend-focused mutual funds? Scrutinize the  Form 1099-Div issued at tax time. Anything considered dividends will be taxed at your ordinary income rate, unless classified as qualified dividends taxed at long-term capital gains rates. The fund company classifies the dividends.

If you’re issued significant nonqualified dividends, whether you reinvest them or take them as cash distributions, it may not make much difference where you hold the investment. You’ll pay your income tax rate on the dividends, whether in the year earned (in a taxable account) or in the year withdrawn, perhaps over many RMD years.

In a taxable account, reinvested dividends increase your cost basis, so long-term capital gains taxes may ultimately apply to some gains when the investment is sold. Depending on the fund, “either” may be the right answer here.

Bond Funds

The most frequent recommend­ation is to herd these funds into retirement accounts. I don’t believe this is always the right answer for every investor. Bonds are likely to be slow-growers, and if the only gain is from dividends (or interest), an account made up only of bond funds won’t produce much return to shelter. Municipal bond funds are sheltered from federal taxation and should therefore be held in taxable accounts. If you live in a high-tax state such as California or New York, look for a fund that will be tax-exempt in those states, too.

But don’t go broke saving taxes: Use an online calculator to determine whether you’ll actually be ahead by investing in municipals. Your tax bracket needs to be high enough to save in taxes what you’re losing in the usually lower-paying municipals’ returns.

But let’s say you’re retired and withdrawing from retirement accounts. Where you stable your bonds doesn’t matter as much. You’ll pay ordinary income tax on dividends, except for qualified ones, whether they’re in a taxable account or withdrawn from a retirement account with the exception of Roths and HSA investment accounts.
In retirement you may want dividend-payers in your taxable accounts for income and let capital gains pile up in tax-sheltered accounts, where the compound return will grow tax-free until withdrawal.

Inherited Money

An inheritance may be a retirement account or taxable brokerage or property sale proceeds. First, establish your cost basis. The cost basis for mutual funds (or stocks) is the share price averaged between the high and low price for the day the person died. If the estate is large enough to be subject to estate taxes, different rules apply; please consult an accountant. (For real estate, it’s important to get an appraisal very close to the date of death.)

In taxable accounts, even if the deceased bought the investment for a pittance ages ago, your basis is stepped up to the date of death value. If you decide to hold the investment a long time, subsequent gains or losses are yours.

Evaluate a portfolio for whether it’s suitably allocated and manageable for you. Don’t develop sentimental attachments; your loved one wanted the inheritance to benefit your life, not to pay tribute to a corporation. From a financial point of view, it may be best to reallocate close to the date of valuation, making judgments based on appropriateness, rather than on future taxes on huge gains or losses.

You’re limited in how much you can rehome inherited money. If you aren’t currently contributing to a Roth, are eligible based on income (basically, under $122,000 single and $193,000 joint) and have sufficient earned income to match the contribution (a maximum of $7,000 if over 50), you should fund a Roth.

Consider increasing your contribution to your workplace retirement fund up to the maximum allowable. Use withdrawals from the inheritance to replace the decrease in your regular paycheck.

By doing this you’re effectively transferring money from taxable to tax-sheltered accounts; if it’s a Roth 401(k), tax-free — and you can also contribute to your individual Roth.

If you’re already contributing the maximum to all retirement accounts, perhaps investigate a low-cost variable annuity (a wrapper around mutual funds) to shelter some gains for retirement. Evaluate carefully whether the return (plus tax shelter minus fees) is actually significantly better than retaining money in a more flexible taxable account.

Right now, inherited retirement accounts have an immediate RMD for nonspouses but can be stretched over your lifespan (though legislative change may be coming). Inherited regular individual retirement accounts and 401(k) withdrawals are taxable and will have RMDs (or be taxed on the full amount if you cash them in), while Roth 401(k)s and Roth IRAs aren’t taxed. There’s no requirement that you spend the distribution — you can pay any owed taxes and reinvest the rest in your taxable accounts.

Herd your investments into the right corral and you’ll realize the best return while giving up the lowest taxes to the sheriff.

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This article was originally published in the August 2019 issue of BetterInvesting Magazine. 

Danielle L. Schultz, CFP, CDFA, is a fee only financial adviser with Haven Financial Solutions, Inc., based in Evanston, Illinois. Reach her and read her blog posts at www.HavenFinancialSolutions.com.

No investment recommendations are intended. The author and some of her clients may have positions in some of the funds mentioned in this article.

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