Tax Impact of Investment Strategies
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Higher 2013 income and capital gains rates and the new 3.8% net investment income tax (3.8% NIIT) may cause high-income investors to reexamine their investment strategy.
The type of account, taxable or tax deferred (e.g., qualified retirement plan), could affect the investment strategy in a number of ways. Qualified retirement plans, because of their tax-deferred nature, tend to favor the following strategies:
- More frequent turnover (securities transactions within the portfolio) can be tolerated. Recognition of gains is not an issue in a qualified plan account; therefore, a strategy that allows frequent buying and selling (turnover) of the underlying investments would not have a detrimental effect because of associated tax liabilities.
- More active management might be appropriate for a qualified plan, whereas passive investments such as index funds, might be held in taxable accounts.
- Large-cap investments, which are more likely to be dividend-paying companies, may be better suited for qualified plan accounts because the income is not currently taxed.
- Portfolio rebalancing (e.g., shifting funds from small cap to large cap stocks) is better accomplished using assets in a qualified plan to minimize the recognition of taxable income.
Taxable accounts tend to favor the following strategies:
- Buy-and-hold strategies are appropriate to limit gain recognition and to limit gains to assets that qualify for preferential long-term gain treatment.
- Passive investments, particularly index funds that have minimal taxable distributions, are more appropriate for taxable accounts.
- International funds, which frequently have associated foreign tax payments, are more appropriate for taxable accounts so the foreign tax credit can be claimed.
- Small-cap growth stocks are more appropriate because of the minimal dividend income generally associated with these types of investments.
A topic of continuing discussion among investment professionals is where to hold fixed-income investments and where to hold equity investments. Generally, sufficient fixed-income investments need to be in taxable accounts to provide liquidity. Those investments could be, for example, either tax-free or taxable bonds, depending on the after-tax yield as determined by your marginal tax rate. The need for current income will also affect whether additional fixed-income investments are held outside of qualified plans. Beyond the liquidity amount and provision for current income, the remainder of the fixed-income portfolio can be held in a qualified plan.
Similarly, for stocks, that part of the portfolio that is intended to be long-term, low-turnover, passively managed investments can be held in the taxable accounts. More aggressive parts of the portfolio that call for active management and potentially high turnover can be held in qualified plans.
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