Investment management for private clients presents unique challenges.  Near the top is that profits generated cannot be enjoyed until they’ve passed through the tax filter.  Understanding the tax implications of investing allows some control over the amount of taxes paid even if the path of the financial markets is beyond control.

In a Nutshell

The tax tail should never wag the investment dog.  Make sure you have an appropriate overall asset allocation for your nest egg, carefully balancing considerations such as risk and growth before optimizing for tax efficiency.

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Equity profits are generally taxed at lower rates than fixed income interest.  However, that is true only in taxable accounts, not in tax sheltered accounts like IRAs and company retirement accounts.  Therefore, subject to maintaining an appropriate overall asset allocation, focus your stocks in taxable accounts and your bonds in tax sheltered accounts.

Asset Allocation Is by Far the Most Important Determinant of Your Investment Success

Research indicates that 90% of your investment return is dictated by asset allocation.  Stocks trump bonds over the long term.  Stock investors pay the price for the potentially higher returns with historically greater volatility.  For that reason, most investors should maintain some allocation to fixed income.  Fixed income evens out the ride and provides stability during sharp stock market declines.

Bottom line:  Before focusing on which assets belong in what sort of account, your first analysis should always be what type of portfolio makes sense regardless of your mix of taxable and tax-sheltered accounts.  Don’t choose your asset classes solely based on the tax flavor of your investment accounts.

To Plan for Taxes, Understand Several Key Concepts 

The highest federal tax rate for ordinary income is 37%.  This applies to wage income, bond interest, and other so called “ordinary income.”  This does not include the 3.8% Medicare surcharge applicable to high earners.  State and local taxes may also apply.

Distributions from IRAs and pensions are taxed as ordinary income, although in some states significant amounts are excludible from state taxes.

One exception to the rule that bond interest is taxed as ordinary income is municipal bonds.  The interest on those is generally exempt from Federal tax; it can be exempt from state and local tax, too, if issued in the investor’s home state.  Some municipal bonds are not exempt and are taxed as ordinary income.

Using tax exempt bonds does not moot the general rule to house stocks in taxable accounts.  Because tax exempt bonds normally yield less than taxable bonds, investors are still better off focusing stocks in taxable accounts and holding taxable bonds in tax sheltered accounts.

Stocks Are Taxed at Lower Rates Than Bonds

Stocks afford significant tax advantages when held in taxable accounts.  If held long term, meaning more than a year, the tax rate on profits ranges from zero to 20%.  The Medicare surcharge still applies to high-income taxpayers.  

Qualified dividends, meaning most dividends paid out on stocks, are also taxed at the lower capital gains rate.  Some dividends are not qualified.  These include real estate investment trusts (REITs) and master limited partnerships (MLPs).  The rationale for not affording preferential tax treatment to their dividends is that profits are not taxed at the entity level, but simply passed through to investors.  Some distributions, particularly from MLPs, are not taxed at all and deemed a return of capital; however, an investor’s cost basis in the asset is lowered by the amount of the distribution.  Preferred stock dividends are generally taxed like qualified dividends.  That’s not true for all preferreds, so the nature of any payout must be investigated.

By contrast, distributions from IRAs and most other retirement accounts are taxed at ordinary income rates, even if the source of the distribution was from stock profits.  Some planners call it turning gold into dross if you hold stocks in tax sheltered accounts like IRAs.

Controlling the Timing of the Taxable Event Allows For Superior Tax Results

Common stocks offer significant tax advantages to investors to the extent profits are in the form of capital appreciation. Investors can defer taxation on those gains until sale.  Deferring taxes reduces the present value of that burden.  This planning opportunity is not available for stocks held in retirement account.

Assets held primarily for current income are not as attractive in taxable accounts.  That’s because the profits are taxed currently as the income is paid out, and can’t be deferred, even if their need can be deferred.

Stock Losses Can Be Used to Offset Realized Gains, But Only if Held in Taxable Accounts

If a stock drops, it can be sold, and the loss realized.  That realized loss first offsets any current gain on other asset sales.  If realized losses exceed realized gains, up to $3,000 of that excess can be used against other income.  Any loss that cannot be used in the current year can be carried forward indefinitely for use in future years, at least against Federal taxes.  However, investment losses in tax sheltered accounts cannot offset current income or stock gains.  This is one more reason stock should be focused in taxable accounts, fixed income in tax sheltered ones.

Contributions to Tax Sheltered Accounts Are Strictly Limited So Less Risky Investments are More Appropriate There

Contributions to IRAs, company retirement accounts, and other tax-sheltered accounts are capped.  Losses in those accounts do not trigger an opportunity to replenish.  That’s not the case in taxable accounts.  This is yet more reason that more volatile holdings like stocks are more appropriate in taxable accounts, while less volatile holdings like bonds more suitable in tax sheltered accounts.

Basis Step Up an Important Tax Benefit

One of the most important tax benefits from stocks is the so-called basis step up.  Upon an investor’s death, the cost basis of the asset is “stepped up” to the current market value, eliminating from taxation any unrealized gain.  That benefit is not present in traditional IRAs or company retirement plans; an heir must pay taxes on all profits and untaxed contributions made to those accounts, even if some of the profits would have been eliminated via the step up rule had the underlying investment been held in a taxable account.  

Because taxable accounts can take advantage of the step-up benefit, assets with more growth potential belong there, to sidestep the maximum gain at death.

Some Tax-Sheltered Accounts Are Actually Tax-Free Accounts, and Afford Good Planning Opportunities

Most tax-sheltered accounts are tax deferred: the eventual withdrawals are taxed at ordinary income tax rates.  However, some tax-sheltered accounts, like 529s and Roth IRAs, offer tax-free withdrawals if certain conditions are met.  Investors should, as between tax-deferred accounts versus tax-free accounts, focus their potentially faster growing assets, like stocks, in the latter to maximize tax-free growth.  Note that IRAs inherited from anyone but a spouse typically require withdrawals at faster rates than traditional tax-sheltered accounts; focus your potentially slower growing asset classes, like fixed income, in the former.

Different Asset Allocations in Different Accounts Will Produce Different Investment Results

Because the asset allocation of taxable accounts focused in equities, on the one hand, and IRAs focused in fixed income, on the other, will not be the same, they should not be expected to perform similarly.   In bull markets, the IRAs will lag, while in downturns they should be more resilient.  Focus on the overall, combined account performance. 


Consider carefully how to allocate over taxable and tax-sheltered accounts your overall asset allocation.  Stocks enjoy significantly lower tax rates than does fixed income when held in taxable accounts and should be held there, subject to overall appropriate diversification.

David Dietze is Managing Principal, Senior Portfolio Strategist at Peapack Private Wealth Management. Contact David at (908) 598-1717 or with any questions.

With Trust and Integrity, Peapack Private provides comprehensive financial, tax, fiduciary and investment advice to individuals, families, privately-held businesses, family offices, and not-for-profit organizations. We help our clients set and achieve their goals by developing solutions specifically designed and implemented for them. Contact us at 908-598-1717 or for more information and or to arrange a complimentary consultation.

Peapack Private Wealth Management is located at 382 Springfield Avenue, Suite 208, in Summit.