When it comes to taxes, all investments aren’t created equal — everything depends on their character and timing. So before you sell appreciated stock, buy interest-bearing bonds or even rebalance your portfolio, learn the tax consequences.
Deferring vs. paying now
The first distinction is between taxable and tax-deferred accounts. Retirement accounts such as traditional 401(k)s and IRAs are tax-deferred, which means you make pretax or tax-deductible contributions and don’t owe tax on them, or your investment gains, until you take the money out in retirement. Tax-deferred portfolios support — or at least tolerate — investment strategies such as frequent trading activity.
A taxable account that you fund with posttax dollars is less amenable to such investment strategies because you’re responsible for the tax on appreciated investments in the year you sell them. This may be less of an issue if you hold an investment for at least one year and it qualifies for the 15% or 20% long-term capital gains rate. But if you sell earlier, you may owe as much as 39.6% in tax on capital gains, depending on current income.
Taxable accounts make more sense for investments you intend to hold for a long time. Certain types, such as index funds and international funds, which tend to make minimal taxable distributions, are also generally suited to taxable accounts.
The bond question
Bonds often present tax complications for investors. Usually, some interest-paying fixed-income investments need to be in taxable accounts to provide liquidity for trading. But whether it’s better to invest in taxable or tax-free bonds depends on several factors, including your expected return after taxes.
All else being equal, a taxable bond paying 4% and subject to a 40% tax (for a net after-tax return of 2.4%) is less desirable than a tax-exempt bond paying 3%. Your need for current income also affects whether you should hold fixed-income investments in a taxable or tax-deferred account.
You may also be subject to the 3.8% net investment income tax (NIIT), which is in addition to regular income or alternative minimum tax liability. The rules for NIIT are complex, but it generally applies to unearned income and capital gains if your modified adjusted gross income reaches a certain threshold. Contact us with any questions about how the NIIT and other taxes may affect you.