• Subscribe
  • Tax efficient placement

    Tax efficient placement

    This week’s issue is a short one because I’m getting married tomorrow!

    I wanted to discuss efficient tax fund placement. The goal is to minimize taxes within your investments and select the right account for those investments.

    Investors have different account types, including:

    • Taxable brokerage accounts
    • Tax-deferred accounts (401k, 403b, Traditional IRA)
    • Tax-free accounts (Roth IRA, Roth 401k)

    A general rule of thumb is that if your investments are all in the tax-deferred or tax-free accounts, the fund placement will not make a huge difference.

    Tax-efficient fund placement becomes important when you have both a taxable brokerage account and tax-advantaged accounts. Many funds pay dividends and distribute capital gains if placed in your taxable brokerage account. At the end of the year, you receive a 1099 with that information and must pay taxes on the dividends and distributions.

    The goal is to minimize these dividends and capital gains distributions by doing one or all of the following:

    • Choosing investments that don’t distribute many dividends or capital gains
    • Choosing passively managed investments (low portfolio turnover)
    • Placing them in tax-advantaged accounts

    Let me give you a simple example:

    Let’s say you are in a 22% federal tax bracket and a 5% state tax bracket, and you have some money invested in a dividend fund like SCHD, Schwab US Dividend Equity ETF. SCHD dividends are qualified, which means that the dividends get preferential treatment at a 15% federal tax rate.

    The dividend yield is 3.43%. Considering the tax rates, the tax drag is (15% + 5%) * 3.43% = 0.686%.

    To put this in perspective, a $10,000 investment will yield $343 in annual dividends. The tax impact on that investment will be $60.86.

    Now, what if that money was in a Roth IRA instead? You would pay $0 in taxes on dividend distributions. Alternatively, you could invest in something like VTI, which has a lower dividend yield and therefore a lower tax drag. If VTI has a dividend yield of 1.36%, the tax drag would be 20% * 1.36% = 0.272%, or almost 3x less.

    Now, I want to add a few important points:

    • REIT stocks/ETFs are the least tax-efficient asset class because their distributions aren’t qualified, so you pay more tax.
    • Stocks that don’t pay dividends are the most tax-efficient to hold within your taxable account (Adobe, Amazon, Netflix, etc)
    • Not everything should go into retirement (i.e. tax-advantaged) accounts. The big benefit of a taxable account is that the money is always easily accessible (liquidity) and you can control your withdrawal timing. Therefore, analyzing the investments that go into this account is crucial.

    I hope this newsletter sparked some ideas for your own portfolio. See you next Saturday.

    MC, CPA

    Sign up for The Crunch:

      Whenever you're ready, here is how I can help you:

      1. $0 Debt Blueprint: A free 28 page e-book for everything you need to know to pay off debt. I detail the practical steps you can take to immediately improve the quality of your financial decisions through researched methods. I provide you with examples and templates that you can use right away. 

      Subscribe to the Newsletter

      Join 5,000+ readers of The Crunch
      for exclusive tips, strategies, and resources around personal finance.

        Share this article on: