Managing a portfolio inevitably means dealing with taxes. Every position we hold comes with a tax consequence of some kind: interest earned, dividends paid (qualified or non-qualified), capital gains and losses (short or long term), annuity payments, return of capital from MLPs, and on and on.
Similarly, the type of account where we hold our positions (retirement accounts: 401k, 403b, IRA, Roth 401k, Roth IRA; and non-retirement taxable accounts) can have a significant effect on the taxes levied and when they are owed.
Retirement Accounts (Non-Roth)
Retirement accounts provide the benefit of tax deferral - allowing assets to grow without being taxed until withdrawal. But when withdrawals are made, they come out of the account as ordinary income - without regard to whether they are from payroll contributions, interest earned, dividends paid, capital gains, or even capital losses. They all come out as ordinary income. Ordinary income, for most investors, will be appreciably higher than capital gain rates currently in effect.
Roth Retirement Accounts
Roth accounts provide tax free growth of assets while in the account, plus tax free withdrawals. From a tax perspective, Roth accounts are the best of all worlds as investments are allowed to pay interest, pay dividends, appreciate in price, and ultimately be withdrawn (providing certain age and/or other requirements are met) all tax free.
An exception to the tax free element for both regular and Roth retirement accounts is the complicated business of UBTI (Unrelated Business Taxable Income) that may be paid by MLPs held in a retirement account. See section on MLPs (No. 5) below.
Taxable accounts provide no tax deferral (except for assets that are simply held and not sold), but do provide the benefit of lower tax rates on qualified dividends and capital gains, as well as an offset of capital losses against capital gains.
As a result, it can make a significant difference whether certain types of assets are placed in a regular retirement account, a Roth retirement account, or in a taxable account.
Guidelines for Tax Efficiency
1. Interest Payers in Retirement Accounts
Assets paying interest, such as bonds and preferred stock, are more tax efficiently held in a retirement account than in a taxable account. Interest paid in a taxable account is taxed in the year earned and at ordinary income (the highest) rates. In a retirement account the interest is paid into the account but the tax is deferred (potentially many years) until withdrawal. On withdrawal, it still comes out as ordinary income but you get the benefit of deferral.
Of course, in a Roth account you get both deferral and a tax free withdrawal.
2. Growth Stocks With No or Low Dividends in Taxable Accounts or Roth Account
High growth stocks with significant growth profiles (often smaller or medium cap companies, but also many large companies - like Starbucks (SBUX), Google (GOOG), or Amazon (AMZN) for example) are more tax efficient in taxable accounts. Capital gains are taxed at more favorable rates, and losses can be offset against gains - none of which can be accomplished in retirement accounts.
In a regular retirement account, a capital gain on a stock sold does get the benefit of tax deferral (and one can buy new positions and make additional capital gains without paying taxes until withdrawal years later) but upon withdrawal all of those gains will be taxed at ordinary income rates - rather than at lower capital gain rates.
Once again, in a Roth Account you get the benefit of tax deferral that a regular retirement account provides, and the money comes out at withdrawal tax free (rather than at the ordinary income rates from a regular retirement account). And tax free, of course, also beats any favorable capital gain rate from a taxable account. The downside to a Roth here is there is no ability to offset a loss in a position against a gain.
3. REITs in Retirement Accounts (but Taxable Accounts are Ok Too)
Most REIT dividends are non-qualified and are taxed as ordinary income. As a result REITs are considered more tax efficient in a retirement account since the dividend can be deferred in a retirement account, rather than being taxed as ordinary income in the year paid if held in a taxable account.
On the other hand, REITs can have substantial price appreciation and a capital gain (or loss) - which can be taken advantage of better in a taxable account. For example, National Health Investors (NHI), was up 25% year to date through May 22, 2013. But in the four weeks since that date, it is down that same 25%.
NHI data by YCharts
In a taxable account (depending on when NHI was bought and sold) an investor would be able to book those gains at favorable capital gain rates, or book the losses to offset other gains elsewhere. As a result, either kind of account can work for a REIT.
4. Utilities and High Dividend, Low Beta Stocks in Retirement Accounts (Taxable Accounts Ok Too)
Conventional wisdom is that stocks which are low beta (not as subject to market volatility) and pay significant dividends, like utilities, are more tax efficient in a retirement account. The argument is that the dividend accumulates tax free over a long period and as the stock is low beta, it is primarily an income producer rather than a growth stock producing a large capital gain.
Undercutting this argument is the fact that utility dividends are typically qualified and although they are taxed in the year earned in a taxable account, it is at a lower rate than the ordinary income rate when they come out of a retirement account. You lose the benefit of deferral obtained in a retirement account but get a lower rate of tax when held in a taxable account.
Also undercutting the conventional wisdom is the fact that some utilities can produce large capital gains at times - which are taxed at more favorable rates. For example: PNM Resources (PNM) was up 15% in the first five months of 2013.
In this instance, a Roth account works well as it provides both deferral of any tax on the dividend, and on any capital gain, and the funds come out tax free. However, again, the downside to a Roth here is the lack of ability to offset a capital loss against a gain.
5. MLPs in Taxable Accounts
Tax issues involving MLPs (Master Limited Partnerships) are very complicated. Owners of units in an MLP are limited partners and receive a K-1 from the MLP identifying the owner's share of partnership income, gains, losses, deductions and credits.
MLPs are high yielding entities where cash distributions are paid and typically designated "return of capital". This "return of capital" is not immediately taxed but goes to reduce the owner's basis. Upon sale of the units this "return of capital" will be taxed as gain, and certain allocations will be made for depreciation and/or depletion as well.
MLPs may also throw off what is known as UBTI (Unrelated Business Taxable Income) - which can be problematic when held inside a regular or Roth retirement account. A $1,000 annual exemption is provided for UBTI but if more than that amount of UBTI is earned, the retirement account custodian is called upon to file a tax return and pay the tax from the retirement account.
Numerous articles have been written about MLP taxation issues and addressing whether they are appropriately held in taxable or retirement accounts. My view (which is not universally held) is that MLPs are better in taxable accounts.
This is a very complicated area and the nuances are beyond the scope of this article. Those considering holding an MLP in a retirement account should research the topic to determine their best course. The following (articles by Reel Ken) are good places to start:
Of course, not everyone necessarily has access to every type of account -some, for example, have all of their investments in a 401k at work. But if you do have access to the different types of accounts available, being tax efficient about where you hold your positions can improve your bottom line.
Additional disclosure: Investing is uncertain, The opinions, statements and securities referred to in this article: 1) should not be considered recommendations to any person or entity; 2) should not be considered suitable to or for any person or entity and/or their individual circumstances; 3) should not be considered investment or tax advice or appropriate to any person or entity and their individual circumstances. Although this article discusses tax matters it is not meant to be tax advice and the author is not an expert in taxes. Consult with a professional tax adviser for details on the tax implications involved and appropriate to you.