The Tax-Efficiency of your Retirement Portfolio Can Save you Thousands

It official the 2016 Tax Season has started! I’m sure you’re busy gathering your tax documents to complete your return this year. However, in order to get the most tax saving “bang for your buck” you should be smart with your investments and retirement assets throughout the year to get the most benefit. Below is are some tax saving tips that all retirement savers should be doing in 2016 and every year for that matter.

There are a lot of laws in the US related to investing and taxes. Because of this complexity many investors pay a lot more tax than they need to be. On the flip side this is a huge opportunity for smart investors to take advantage of the current system for their benefit just by managing your portfolio to minimize your tax burden.

What we are really talking about is tax efficiency. This is basically looking at your after-tax return. This is one of the best return numbers to consider because it is what you are actually getting once taxes are paid. For example, would you rather have an investment that pays you 20% but 50% is taxable or an investment that pays you 15% but is only 15% taxable. This could very well be the case when you consider state and federal ordinary income taxes versus long term capital gains rates. In general, the more investment income that you receive from an investment (like interest and dividends) the investment is LESS tax efficient. This is when compared to capital appreciation ie. the price going up. This is because of different tax rates on this type of income, taxed at ordinary income tax rates versus long-term capital gains rates. Ok so now that you know that let’s explore how we can save you some money on taxes!

Different Account Types – Taxable, Tax Deferred, and Tax Exempt Accounts

Before you, the investor, can do anything to improve the tax efficiency of your investing you need to know and understand how your accounts are structured and how they operate under the law. In general, accounts can be either taxable, tax-deferred, or tax-exempt. Taxable accounts include individual and joint brokerage accounts, bank accounts, money market among other accounts. These accounts require the investor to pay taxes on their investment income in the year it’s received. This means if you sell a stock for a gain you have to report the gain in that year. Likewise, if you receive interest or dividends, you need to report that income on your tax return that year. Get it? Ok, the next account types are tax-deferred. These accounts are Traditional IRAs and 401ks (there are others but these are the most common). These accounts you have to pay tax on every dollar that comes out of the account at ordinary income tax rates. Money goes in these accounts pre-tax so you either get a deduction on your tax return (as in the case of a traditional IRA) or it’s never included in income (as in the case of 401ks). Finally, we have tax-free accounts. The most common of this type of account is the Roth IRA. (Note you can also have a Roth 401k). The contributions to these accounts were made with after tax money which means when it comes time to take the money out you are not taxed again. All of these accounts have pros and cons and it’s good to have money in all of these different accounts (which you’ll see why a little later) but in general tax-efficient investments should be made in the taxable accounts, and more tax inefficient investments should be made in the tax-deferred or tax-exempt accounts.

Make Sure You Know and Understand your Tax Bracket

Now that we have a good understanding of all the different account types you should learn how to best use them based on your tax bracket. You need to determine your marginal income tax bracket. You should be able to do this by looking at your tax return or by asking your Maple Grove Tax Preparer. The higher your marginal tax rate the better tax efficient investing will be for you. This means that someone who is in the 39.6% tax bracket will gain more benefit from tax efficient investing than someone who is in the 15% bracket.

2016 US Income Tax Schedule

Ok, so you have your bracket, now you need to be aware of the difference between taxes on your income and taxes on your capital gains. Your income is taxed as ordinary income tax rates which is where you bracket comes in. If you make $450k in income per year, every dollar you earn over that will be taxes at 39.6% federally. That’s a lot of money going to the government. Alternatively, capital gains taxes, as long as they are long-term (over a year). Capital gains tax rates are 0%, 15%, or 20% depending on your marginal tax rate.

2016 Capital Gains Tax Rates

In general, short-term capital gains (less than a year) are taxed the taxpayers ordinary income tax rates while long-term capital gains are taxed at the marginal rates mentioned above. So, one of the goals is to make sure to generate gains at the long-term preferred tax rates.

Now we have to look at different asset classes like stocks and bonds and examine how they are taxed and the roles they play within an investor’s portfolio. Historically speaking bonds produce income and are in general lower risk than stocks (although there are some bonds that can be just as risky as stocks). The interest income generated from these bonds are tax in-efficient because as we said the income generated is taxed at the higher ordinary income tax rates. However, there are special bonds such as municipal bonds which are not taxed at the Federal level or at the state level (as long as you live in the same state where your bonds are purchased from). Also, in today’s low interest rate environment you actually are not receiving a lot of income on your bonds, and therefore the argument could be made to hold them in a taxable account. In a more “normal” interest rate environment you should consider holding your bonds in a tax-deferred account. Note that they could also be held in a tax-free account and avoid tax on the income but since they are not very highly appreciating assets you should save the room in your tax-free accounts for other assets.

If you are looking for a rule-of-thumb, your tax-inefficient investments should go in tax-deferred accounts and tax-efficient investments should go in taxable accounts. Tax efficiency is always a relative concept. Just like how we said above, bonds are more tax-efficient when interest rates are low and less tax-efficient when interest rates are high. And more so, you need to compare one investment to another when determining which account to hold it in. The next part of this article will discuss the different types of investments on a tax-efficiency scale going from less efficient to more tax efficient. For more information about bonds keep reading below or check out this post – The Role of Bonds in your Portfolio

Tax Inefficient and Tax Efficient Investments

High Yield (Junk Bonds)

You may have already guessed based on the previous text of this article that junk bonds are some of the least tax efficient investments out there. They generally pay a much higher interest rate than other bonds (because of their high credit risk) which means they are paying you out more income which then means more taxes at ordinary income tax rates.

Preferred Stocks

Next up are preferred stocks. They also tend to be relatively tax inefficient. Preferred stocks are a combination of a stock and a bond. They are similar to a stock in that they do not have a maturity date and you can share in the good fortunes of the company through price appreciation. They are like bonds in that they pay a fixed rate based on a stated interest rate. This may seem like a best of both worlds type of situation however, you are limited in the upside potential of price appreciation. So, because of a large part of the income from these investments are paid out as income they tend to be more tax-inefficient.

Convertible Bonds

In the same family as preferred stocks there are convertible bonds. They tend to be a little more tax efficient. This is because they generally have lower yields, and therefore incur less tax from ordinary income rates. Not only that, these bonds can be converted to the issuer’s common stock and achieve improved taxability of capital gains.

Common Stocks

Some of the most tax-efficient investments are common stocks. But it depends on the holding period because, as discussed, they need to be held for at least a year to achieve the favorable long term capital gains tax rates. Also since they generally appreciate much more over time when compared to bond type investments they are a perfect fit for tax-free accounts. If you a buy and hold type of investor you could build up a lot of capital gains over the years all of which are tax free when coming out of a Roth IRA.

Municipal Bonds

Municipal bonds are bonds issued from a specific state or municipality. They are privileged investments as they are not taxed on the federal level and if you live in the state of the issuer they are also not taxed at your state tax rate (making them even more beneficial if you live in a high state-income tax state).


Tax efficiency is something all investors and do-it-yourself retirees should be paying attention to. Using some of these simple concepts you could save yourself thousands of dollars that would otherwise go the IRS. Use your tax bracket wisely to take money out for retirement. And make sure you are putting the right investments in the right accounts. These two simple things are worth their weight in gold (or at least tax-savings).

Resources used in this Article


Go Banking Rates