I write a lot about investing in retirement accounts, mostly because of their flexibility and awesome tax benefits. But after making the maximum annual contributions to tax-advantaged accounts, inevitably the question of taxable investing arises. I’m an enrolled agent, a tax professional licensed by the Department of the Treasury to represent taxpayers before the IRS. When I tell people that I work in tax, most assume that I prepare tax returns, however, in my position as a tax compliance specialist at an investment firm, I actually spend a lot of time thinking about the taxation of investments. So, I wanted to share some insights and evaluate the strengths and weaknesses of some of the most tax-efficient investments I can think of.
5 investments to minimize tax burden in taxable accounts:
1. Low-turnover mutual funds and exchange traded funds (ETFs)
I love mutual funds and ETFs because of their ability to broadly diversify investment portfolios, at minimum cost, without needing to track dozens, or even hundreds of stock positions. My retirement plan is built on index mutual funds and ETFs, giving me ownership of literally thousands of companies with just three funds (VTSAX, VBR and VWO). So naturally, I turned to these pooled stock funds for my taxable investments. It turns out that they are actually pretty darn tax-efficient. Index funds are passive, meaning there’s not a lot of buying and selling going on, which in turn reduces tax for the investor.
However, not all Mutual Funds and ETFs are tax-efficient. Actively managed funds tend to have a lot more turnover and subsequently, more taxable events. It is also commonly believed that ETFs are always more tax-efficient than mutual funds, but some ETFs are not tax-efficient at all. And some index funds, like VTSAX are just as tax-efficient as their ETF counterparts (VTI).
Mutual Funds and ETFs that are not tax-efficient
- Actively traded mutual funds
Actively traded mutual funds are not tax-efficient because there is a lot more turnover.
- Gold and Silver ETFs
Gold and silver are considered collectibles. Unfortunately, even as part of an ETF they are taxed as such and the long term capital gains tax from collectibles is 28%.
2. Real Estate
Real estate investments are not inherently tax-efficient, someone in the business of house flipping, for instance, is typically saddled with FICA tax in addition to federal, state and local taxes. However, you can avoid a lot of the tax burden by taking a few precautions, such as to:
Buy and hold real estate for longer than a year
Quick flips are great for people in the business of real estate flipping. But to avoid high taxes, you don’t want to be in that business, you want to be in buy-and-hold mode, at least for a year or two. That’s because holding a capital asset for over a year will qualify you for the long term capital gains tax rate which is generally much more favorable for investors. Furthermore, capital gains can be offset by capital losses.
Do a “1031 exchange”
A 1031 exchange allows you to defer normal taxes on the sale of a property, when you elect to use the proceeds to fund the purchase of a new income-producing property. A Section 1031 exchange is an especially lucrative strategy if you use the profits to buy increasingly more valuable properties, all the while having tenants cover the cost of the mortgage and property taxes. After doing a few 1031 exchanges in this manner you will have avoided a huge amount on taxes and can retire with a much more valuable property to live in or sell. You can also plan the disposition of the property at a time when your other taxable income is at its lowest to further reduce your tax burden.
Live in the property for 2 of 5 years
You can achieve the best possible tax position by living in a property for 2 years (2 of the last 5 years, but not necessarily consecutively) to potentially avoid capital gains taxation altogether. Although physically residing in a property is almost always counterintuitive to treating a property as an investment, if you are able to purchase valuable properties in areas experiencing rapid growth, you’ll be in a much better position when it comes time to sell your home, as you must be able to cover the costs of living in the property as well. The capital gains exclusion on the sale of a primary residence is $250,000 for single filers and up to $500,000 for married couples, meaning you won’t be taxed on gains up to those amounts.
Hold the property in a self-directed account
Well, this one has nothing to do with investing in taxable accounts, but it is about tax-efficient investing. Given how few investors are aware of the option to hold real estate in their retirement accounts, I had to include it. With real estate held in a self-directed retirement account, such as an IRA, 401K, HSA and more, savvy investors can supercharge their returns by buying and selling physical real estate, or by collecting rents, completely within a tax-advantaged environment. Investors can even get loans to finance properties and do 1031 exchanges with a self-directed account.
The caveat, of course, is that properties cannot be funded with personal (non-retirement) funds. Money for property taxes, repairs or anything else property-related, must come from retirement account contributions, a retirement account inheritance or returns from other retirement account investments.
Real Estate Investments that are not tax-efficient:
REITs are real estate funds similar to mutual funds in that they are comprised of a pool of investors, but with strict rules governing the distributions of investment income. REITs are required to pay a minimum 90% of investment income to unitholders in the form of dividends. These payments may be categorized as normal income, which is the case most often, return of capital or capital gains. Increasing your taxable income invariably raises your tax, thus eating into your profits.
3. Individual Stock
To clarify, individual stock can be a good option for taxable accounts, but they can also seriously complicate your taxes if you’re not careful. If you invest in a non-dividend paying stock like Berkshire Hathaway (BRKB) and hold it for a year most investors can limit their tax to 15%. If you are a freewheeling, day-trading cowboy you can expect to be much more impacted by taxes.
To simplify taxes when investing with stocks, avoid:
- Buying stock and selling it before qualifying to be taxed at the long term capital gains tax rate
Though I don’t typically recommend individual stocks since it’s a lot of work and doesn’t usually provide better returns, if you do invest in individual equities it’s best (from a tax perspective) to hold them for over a year.
- Dividend investment strategies
As I wrote about in, 5 Reasons Why Dividend Strategies are Overrated, dividend strategies can seriously complicate your taxes
4. Passive Foreign Investment Companies (PFIC)
A passive foreign investment company (PFIC) is a non-American company making most of their income (at least 75%) through investments or other “non-business” activity. American investors can purchase precious metals directly from these entities while avoiding high taxes. Not that I necessarily suggest investing in precious metals but if they are part of your investment portfolio, it’s probably best to avoid high taxation.
Most will want to Avoid:
The long-term tax on collectibles is 28%, however, the short-term rate is the investor’s normal income tax rate. For wealthier investors this means that selling collectibles may actually generate income at a lower-than-normal tax level. For most, however this 28% tax is too much to justify holding collectibles as an investment strategy.
- Holding Physical Precious Metals
The IRS considers precious metals as “collectibles”
5. Municipal Bonds, Treasury Bonds and Series I Bonds
Given the low interest rate environment we have been experiencing, bond returns have taken a major hit. So, if holding bonds outside of a bond fund is part of your taxable investment plan, you’ll want to stick with these Municipal, Treasury or Series I (savings) bonds. Municipal bonds are particularly tax-efficient because the interest is federally tax-exempt and is often also state and local tax-exempt. Similarly, Treasury bonds and savings bonds are tax-exempt at the local and state levels, reducing the typical tax burden of corporate bonds.
Investments that are not tax-efficient:
- Corporate bonds
Interest from corporate bonds are taxable at federal and sometimes state and local levels as well.
- Taxable bond funds, zero-coupon bonds, inflation-protected bonds or high-yield bond funds
My personal preference is to hold broadly diversified mutual funds and ETFs in my taxable account. I am specifically looking at VTI and waiting for a modest drop in prices to start entering the market. The rules of dollar-cost-averaging may mandate that I enter the market at an arbitrary point, and perhaps that would be wiser than trying to time my entry. But my hope is that my pattern of buying low and holding…forever will give me a better long term return. We’re all human. Ideally I would also buy-in during a market crash, which would give me ample opportunity to pick up funds for much cheaper on average.
All things being equal, I have a slight preference of ETFs to mutual funds for the ability to purchase shares throughout the day, but that is probably a pretty meaningless distinction for longer term investment horizons.