In non-qualified accounts (also known as “taxable brokerage account”, “non-retirement account”), capital gains realized, dividends paid, and interest earned are all taxed in the year they are paid. There’s no tax shelter associated with this account. Because of this, tax efficient investing strategies need to be considered when allocating assets inside of taxable accounts.
Two types of investments stand out for me when thinking about non-qualified assets:
- Exchange traded funds (ETFs)
- Municipal bonds
Exchange traded funds (ETFs): ETFs are baskets of stocks, bonds, or other like kind investments that are pooled together. ETFs are similar to mutual funds as they are both “pools” of like kind investments. But one of the major differences between mutual funds and ETFs is taxation.
Mutual funds don’t trade on the exchange. When someone is looking to sell shares or a specified dollar amount of a mutual fund, it’s sold back to the fund/redeemed by the fund family after market close. Because they don’t trade on the exchange, the fund manager may have to liquidate assets inside of the fund to create cash to pay the investor selling. Doing so can often lead to capital gains being realized inside the fund. When a capital gain occurs, it’s then passed onto investors who hold that mutual fund. This can often lead to mutual funds throwing out large, unexpected capital gains. In retirement accounts, this has no impact on taxes because the accounts are tax-sheltered. On the other hand, in brokerage accounts, holding mutual funds can be extremely tax inefficient. For example, let’s say someone holds $100K of XYZ mutual fund in their brokerage account. At the end of the year, this fund throws out a $15,000 short term capital gain. This investor then has an additional $15K of income added to their tax return due to the capital gain distribution of XYZ mutual fund.
This is where ETFs can be so beneficial in taxable accounts. ETFs generally distribute capital gains much less frequently than mutual funds which leads to them generally being much more tax efficient. In 2023, only 1.3% of ETFs were required to make capital gain distributions. ETFs trade on the stock exchange each day and can be bought and sold at any time. Due to the tax efficiency of ETFs compared to mutual funds, I believe that ETFs should be more of a focus in taxable accounts.
The other investment vehicle that can work well in taxable accounts are municipal bonds.
Municipal Bonds: Holding municipal bonds for a large portion of your bond allocation in taxable accounts can decrease tax liability especially if you’re in a high tax bracket. Given current tax law, municipal bond interest is free from federal tax. On top of this, if you purchase municipal bonds issued by your home state, interest is generally tax free at the state level as well. For those in high federal and state tax brackets, this can lead to a lot more money kept in your pocket. For example, let’s say your federal marginal tax rate is 32% (top bracket), and your state marginal tax rate is 9.85%. That’s a total of 41.85%. See my article “How Federal Income Taxes work” for more information on how federal taxes work. If you hold a bond fund in a taxable account that’s paying $10,000 in interest every year, you’ll be paying a total of $4,185 in taxes on that interest. Now, if you instead hold a municipal bond fund issued by your home state, you’ll avoid that tax on the $10,000 of interest being paid. It’ll be tax free!
There’s a lot more that goes into choosing the correct investment strategies for you. But inside taxable accounts, utilizing and municipal bonds is often a good place to start.
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