Roth, 401k, Taxable Account? Tips To Optimize Your Income Portfolio For Taxes

They say it’s not what you make. It’s what you keep.

Understanding the tax implications of different types of investment accounts can help income investors keep more.

Compared with other investment topics, tax issues can seem dry. But we get a lot of questions about which holdings are appropriate for the many different types of brokerage accounts. In other words, you understand that optimizing the placement of your securities is another way to get more bang for your investment buck.

Tax season is one of the best times of the year to review your investment accounts. For one thing, it brings tax implications to the front of mind, giving us the chance to reposition our portfolio for the current year (and saving a headache on next year’s tax season). Also, if you had a capital gain or loss in a taxable account during the year, you may want to find an offsetting trade to make before the end of the year.

Also, if you have any questions about individual securities and taxation, it’s always a good idea to chat with a tax professional. A thorough review can also help optimize the placement of your holdings to limit your tax liabilities for this year and beyond.

Taxable Brokerage Accounts

The three main types of investment accounts are regular taxable brokerage accounts, tax-deferred accounts (IRA, 401(k), etc.), and Roth accounts (Roth IRA and Roth 401(k)). The tax rules for each account are different. As a result, some income investments are more appropriate for one kind of account versus another.

In taxable brokerage accounts, most income distributions are taxed in the year in which they are received — even if you reinvest those dividends to buy more shares. Taxes on capital gains are also owed for any securities you sell in a given year, although these can be offset by any capital losses you incur in the same year.

Many securities held in taxable brokerage accounts, however, are eligible for special lower tax rates. Most dividends issued by corporate equities are eligible for the qualified dividend rate, which is 15% for the majority of tax filers. The income issued by many municipal bonds (and muni bond funds) qualifies for a 0% federal income tax rate. (Our colleague Nathan Slaughter gives an overview of muni bonds here.)

The long-term capital gains tax — for securities held more than one year — is just 15% for most filers.

Bottom Line: Securities that qualify for special tax rates are best held in a taxable brokerage account.

Appropriate Taxable Brokerage Account Holdings:

  • Municipal bonds and municipal bond funds
  • Above-average yielding equities or equity funds with qualified dividends
  • High return-of-capital payers. Return-of-capital distributions are not taxed in the year they occur. Instead, they are deducted from your cost basis and will qualify for the long-term capital gains tax rate, as long as you hold your shares for more than one year, and
  • Master limited partnerships (MLPs) should always be held in a taxable account. MLPs can pay a percentage of their distributions in the form of “unrelated business taxable income” (UBTI). There can be unfavorable tax consequences for investors if they earn more than $1,000 in UBTI in a tax-deferred account. Instead of a 1099 tax form, MLPs issue a separate K-1 form, which adds a level of complexity to your tax preparation.

Tax-Deferred Accounts

In tax-deferred accounts such as 401(K)s and IRAs, income distributions and capital gains are not taxed in the year in which they occur. All withdrawals from tax-deferred accounts, however, are taxed at your ordinary income tax rate. Special investment tax rates do not apply.

Bottom Line: Securities that pay income that is taxed at the ordinary income tax rate are best held in tax-deferred accounts.

Appropriate Tax-Deferred Account Holdings:

  • Fixed income and floating rate bonds and bond funds
  • Business Development Companies (BDCs) and real estate investment trusts (REITs)

Roth IRA Accounts

In Roth IRAs and Roth 401(k)s, income distributions, and capital gains are not taxed in the year in which they occur. Better yet, all withdrawals from Roth accounts are tax-free.

Bottom Line: Roth accounts are a favorite among dividend reinvestors. After all, what’s not to like about tax-free, compound growth? Securities that have a high probability of appreciation or securities you think you may hold for less than one year are especially good for Roth IRA accounts.

(Related: My Favorite Way To Reduce Taxes — And How You Can Take Advantage)

Appropriate Roth Account Holdings:

  • Short-term capital gains payers would be a good candidate for a Roth account.
  • Short-term holdings or “rebound” trades
  • Likewise, securities with lower yields but higher appreciation potential are also attractive Roth IRA holdings.

Closing Thoughts

Of course, you certainly don’t need all three account types to benefit from income investing or dividend reinvesting. And these are just general considerations.

Your current personal tax bracket may affect which type of account you chose to place a security. For that matter, the tax bracket you expect to be in when you withdraw money from a tax-deferred account may come into play.

Sometimes the decision about a security’s account placement isn’t cut and dry. Some funds pay out dividends that are comprised of both qualified dividends and ordinary income. Sometimes a security’s appreciation changes over time.

Also, keep in mind that everyone’s situation is different and that we are not tax professionals. If you have any questions, we recommend consulting your own tax professional.

P.S. If you’re an income investor, at some point you’ve probably wished you could get paid monthly instead of every quarter. As it turns out, you can…

You just have to know where to look. And that’s why our colleague Nathan Slaughter has put together an exclusive presentation that reveals 12 of the most generous monthly income payers on the market today.

Get the full story now.