By Stephen Hassell, CFP®
You may be tempted to think that a stock is a stock and a bond is a bond, no matter what account you hold it in. The reality is that account type matters and can ultimately play a big role in wealth accumulation over time.
In this article, we will address the different elements of a return that is usually generated through traditional stock and bond investments and how the chosen account type can make an impact on the taxation of those investments and, thus, overall wealth accumulation over time.
Taxation of Various Account Types
I am periodically asked about what investments can be made in certain accounts. The reality is that you can make the same investment (i.e., by buying the same stock, ETF, or mutual fund) in virtually any account, whether that’s a taxable account, IRA or Roth IRA account, etc. The tax treatment of each account is what sets each account type apart.
For non-retirement accounts (i.e., taxable accounts), investment gains and investment income will be subject to ongoing taxation in the year they occur.
For retirement accounts (like a traditional IRA), any investment gains and income are sheltered until you withdraw money. Upon withdrawal, any distributions are taxed as ordinary income regardless of the type of investment sold.
For Roth IRA accounts, any investment gains are sheltered until you withdraw money. Upon withdrawal, any distribution is tax-free, assuming you have had the account in place long enough and have waited until age 59.5 before withdrawing. This tax-free withdrawal privilege is what makes Roth IRAs attractive to many investors.
The different methods of tax treatment on these accounts will come into play toward the end of the article, where we will pull things together and talk about strategies for boosting overall wealth through a process known as asset location.
Understanding How Investment Income Is Taxed
Before we dive deeper into asset location, it is important to clarify how investments are taxed, whether that is through the income generated by the investment or the gain you may realize after selling an investment that has increased in value.
Short-Term Versus Long-Term Gains
For any investment, whether we are talking about stocks or bonds, if you hold an investment longer than 12 months and then sell that investment at a higher price, any gain will be realized at long-term capital gain tax rates. Long-term capital gain rates are lower than ordinary income rates, which is the same rate you pay on your income from a job assuming you are still working.
Any investment sold for a gain within 12 months or less is considered a short-term capital gain and would have that gain taxed at ordinary income tax rates assuming that investment is held within a taxable investment account.
Below is a table that highlights the 2020 federal long-term capital gains rates depending on your taxable income and filing status.
| Long-Term Capital Gains Tax Rate | Single Taxpayer | Married, Filing Jointly |
Head of Household | Married, Filing Separately |
|---|---|---|---|---|
| 0% | $0 to $40,000 | $0 to $80,000 | $0 to $53,600 | $0 to $40,000 |
| 15% | $40,001 to $441,450 |
$80,001 to $496,600 |
$53,601 to $469,050 |
$40,001 to $248,300 |
| 20% | $441,451 or more | $496,601 or more | $469,051 or more | $248,301 or more |
| *Short-term capital gains are taxed as ordinary income according to federal income tax brackets. | ||||
Returns of a Stock Investment
Whether you are buying an individual stock, an exchange-traded fund (ETF), or a mutual fund, there are two components to a return. There is the income you receive for holding the stock, referred to as a dividend. And there is the capital gain that investors expect to occur over time as an investment grows in value. When taken together, these two components make up your total return.
Not all individual stocks pay dividends, but if you are holding a diversified portfolio of stocks, you are likely receiving some dividend income from those investments.
Most dividends from stock investments are taxed as qualified dividends. This means that income from some stock investments may be eligible for special tax treatment and taxed as if they were a long-term capital gain (see the table in the previous section).
Furthermore, if you hold a stock investment beyond 12 months (which you should be if you’re a long-term investor), then any gains on those investments would also be taxed at those more favorable long-term rates upon sale.
From a tax perspective, it would be reasonable to say that stocks as a broad asset class are a tax-efficient asset class assuming you are keeping turnover to a minimum and not generating significant ongoing gains through frequent trading.
Returns of a Bond
Just like stocks, bonds generate income, referred to as interest income. For most bonds, that income is taxed as ordinary income and, therefore, may have a higher tax rate than dividends from many stocks. Bonds also have the ability to increase in value just like stocks; therefore, any gain on a bond that you have held for longer than 12 months will be taxed at favorable long-term capital gains rates.
Unlike stocks, the majority of bond returns take the form of interest income. This means you will likely find your bond investments generating more in taxable income and less in capital gains through appreciation in value when compared against stocks. The one exception is municipal bonds, which have interest income that is exempt from federal taxation.
With the exception of municipal bonds, it would be reasonable to view bonds as a tax-inefficient asset class, at least when compared when stocks.
Investment Location Matters
So, with all of this said, how can you think about structuring an investment portfolio to achieve the highest degree of growth over time, after taxes? Here is where asset location comes in.
Simply put, asset location is the process of locating tax-efficient asset classes (like stocks) in non-retirement accounts and locating tax-inefficient asset classes, like most bonds, inside retirement accounts.
Depending on your needs for investment income, your overall tax picture, and several other factors, it may make sense for you to deviate from the guidelines listed below. But, in general, these are appropriate considerations to tilt the odds in your favor of improving your after-tax return experience over time.
Non-retirement accounts (i.e., taxable): Locate mostly into stocks (assuming you have no near-term liquidity needs) and possibly municipal bonds, depending on your tax rate and needs for diversification.
Pre-tax retirement accounts (i.e., traditional IRA and most 401(k) accounts): Locate mostly into bonds assuming you have other taxable investments to help provide the necessary exposure to stocks. There’s nothing wrong with holding stocks inside an IRA, and chances are you most likely will in order to achieve your target investment asset allocation.
Roth IRA retirement accounts: Locate mostly into stocks. The rationale here is that because any withdrawals from this account type in retirement are tax-free, you want this account to grow as much as possible. Historically, stocks have offered greater upside potential when compared with bonds.
Your Situation May Be Different
The above information is designed to be educational and give you thoughts that may assist you in optimizing your investment portfolio. It is necessary for you to not only understand the power of asset location but also adapt its use to the uniqueness of your financial situation. Consider speaking with your financial planner about what tax-optimization strategies may make sense in your investment portfolio.
If you do not already work with a financial planner who is helping to connect your life and money through robust financial planning, please reach out to schedule a complimentary 30-minute discovery call with one of our CERTIFIED FINANCIAL PLANNER™ professionals. Our Houma, LA wealth management firm incorporates strategies such as asset location to help our clients meet their goals.