Taxable Accounts Are Wrong for These Holdings: Christine Benz
Focusing on high dividend payers, however, helps ensure investors will have to pay taxes on their investments year in and year out, even if they reinvest the distributions, she noted.
“Focusing on total return without reaching for dividends gives you more control over your tax bill; that provides the opportunity to realize gains in years when the investor has less income or realized losses,” Benz said.
Benz listed several other securities that may best be avoided in taxable accounts:
Taxable Bonds and Bond Funds
“Generally speaking, bonds will tend to be less tax-efficient than stocks,” she wrote. Because most of the returns are income, they’re taxed at the ordinary income tax rate, which is higher than the capital gains and dividend tax rates that apply to gains from most stock holdings, she explained.
High-yield bond funds and funds holding Treasury inflation-protected securities are especially poor fits for taxable accounts, Benz noted. High-tax-bracket investors who want to keep bonds in taxable accounts for short-term needs might consider municipal bond funds and municipal money market funds, she suggested.
Multi-Asset Funds
Multi-asset funds, such as target-date and balanced funds, generally are better held in tax-sheltered accounts like IRAs and 401(k)s, Benz wrote. They usually hold taxable bonds and the fund allocations either remain static or become more conservative, which can require managers to sell appreciated stocks, socking investors with capital gains taxes, she said.
Actively Managed Equity Funds
“I used to equivocate about whether to hold actively managed funds in taxable accounts. But I’ve seen enough, and the answer is: Don’t do it,” Benz wrote. While some actively managed equity funds have kept their tax bills low, it’s unclear whether they’ll be able to continue to do so, she said, adding, “And some active funds have been absolutely awful from a tax standpoint, dishing out large capital gains year after year.”
Tax inefficiency also makes real estate investment trusts, REIT funds, commodities futures funds, convertible bonds and funds holding convertibles, as well as some alternatives funds, less appealing for taxable accounts, Benz wrote.
Benz acknowledged that broad-market equity index ETFs “do a wonderful job of limiting taxable capital gains distributions,” which partly accounts for the “stampede out of actively managed funds and into ETFs.” She added, though, that there are limits to what ETFs can do to reduce taxes.
If an ETF focuses on current income and the bulk of its return comes from that income — for example, a bond fund or a real estate fund — “it won’t be a lot more tax-efficient than a mutual fund with a similar strategy,” she told ThinkAdvisor.
Benz urged caution about services offering to lower taxes through tax-loss harvesting.
“Services purporting to reduce taxes through strategies like tax-loss harvesting have proliferated over the past few years,” she told ThinkAdvisor. “But advisors should weigh carefully whether any tax savings will offset the additional costs and complexity that such services entail. Moreover, while tax-loss selling helps defer taxable income, it does reset cost basis so the account owner will owe taxes upon sale.”
Pictured: Christine Benz
