Taxes matter.

This is true not just for your take-home pay but also for to savings and retirement. As the Obama administration discusses tax increases on income and capital gains, it is even more important to understand how taxes can work for and against you. One way of making better decisions is by adopting a tax-efficient attitude towards investing, as efficiency will lessen the hit your investments will take from taxes.

You can hold stocks, mutual funds, bonds and other securities in three different types of accounts: fully taxable accounts, tax-free accounts (Roth) and tax-deferred accounts (traditional IRA, 529). Here is an overview of how you can make tax-efficient decisions and adopt a tax-efficient mindset.

Tax-efficient investing:

• Minimizes the taxes paid on both income and capital gains.

• Maximizes value by holding tax-efficient investments in taxable and tax-free (Roth) accounts and less      tax-efficient investments in tax-deferred accounts.

Stocks
When it comes to stocks, many experts advise the buy and hold strategy because the longer you hold on to a stock, the less taxation your profits will be subjected to. If you hold a stock for a short term (less than a year), you will be taxed at your “ordinary tax rate,” which can be as high as 35%. If you hold on to it more than one year, you will be taxed at the lesser rate of the capital gains tax, which is 15% for most tax brackets.

How to hold:

• Put stocks that you plan on holding for more than a year and stocks that pay dividends in taxable accounts
• Put stocks you plan on holding for less than a year in a tax-free account like a Roth IRA or a tax-deferred retirement accounts like a 401(k). For example, if you buy a stock this year and hold it in a Roth IRA (where you pay taxes on contributions), you can withdraw the earnings tax-free at retirement.

Mutual Funds

Tax-efficient mutual funds (Tax-Managed or Index funds) and their fund managers focus on low-turnover (limiting buying and selling transactions), limiting investments in dividend-paying stocks and selling securities strategically to offset taxation. Since active buying and selling is what generates taxes and capital gains and losses, tax-efficient funds design their holdings to produce the minimum taxable income as possible to their shareholders.

How to Hold

• Hold tax efficient mutual funds, index funds, low-turnover funds and non-qualified dividend-paying funds in a taxable account/tax-free account (Roth).

• Hold actively managed funds that produce short-term capital gains in tax-deferred accounts.

Bonds
Bonds certainly run the gamut from municipal tax-free bonds to high-yield junk bonds. Bonds from a municipality, state or local government agency are generally free of taxes (although they may be subject to the alternative minimum tax (AMT) and are considered the most tax-efficient of bonds. High-yield/junk bonds, inflation-protected bonds and taxable bonds are considered the least tax-efficient. 

How to Hold

• Put the most tax-efficient (municipal bonds) in taxable accounts like a brokerage account or Roth IRA

• Put the least tax efficient (high yield bonds) in tax-deferred accounts.

Roth Tax-Free Account
When it comes to retirement planning, you have many investment vehicles to choose from including various types of IRA and 401(k) accounts; however, the decision on making tax-efficient investments depends on your income level.

With a Roth IRA and 401k accounts, your investments grow tax-free since your contributions are taxed. This is an appropriate vehicle for people who feel like they’re going to be in a higher tax bracket at retirement. “For older investors, a Roth IRA may be better suited for investments generating income, such as bonds, bond funds, and REITs,” says Michael Rubin. “Since such income in a taxable account would create income taxed at ordinary (higher) rates, a Roth IRA ability to shelter this income is particularly valuable.”

What to Hold:

• Consider holding the riskiest stocks, like small cap stocks, that have the most potential to appreciate or depreciate in your Roth IRA. The Roth can insulate you from a huge capital gains tax hit as you withdraw your earnings tax free at retirement. Similarly, income-producing securities can be held and never taxed.

Tax-Deferred Accounts – Traditional IRA, 401(k), 403(b), 529
Unlike a Roth account, contributions are not taxed but your withdrawals are taxed. This investment is especially good for those who predict that they will be in the same or lower tax bracket at retirement, thereby lowering their tax liability.

What to Hold

• Tax-inefficient investments like high-yield funds

• Individual stocks you plan to hold one year or less in these accounts.

• Funds that generate many short-term capital gains

Tax Efficiency Chart: A list of the least efficient to the most tax efficient investments

Least efficient

Hi-yield bonds
Taxable Bonds
TIPS
REIT stocks
Stock trading accounts
Balanced Funds
Small-Value stocks
Small-Cap Stocks
Large Value Stocks
International Stocks
Large Growth Stocks
Most Stock Index Funds
Tax-managed Funds
EE and I-Bonds
Tax-Exempt Bonds

Most Efficient