Tax Considerations for Investment Allocations
Allocating High Dividend Producing Investments to Tax Advantaged Accounts
Tax considerations are an important aspect of investment planning. What type of account you are using (IRA, Roth IRA, 401k, brokerage, etc.) all have implications on the taxes you pay now versus the taxes you pay when the investment proceeds are withdrawn. This article does not focus on these tax implications but instead focuses on which types of investments should be allocated in tax advantaged accounts versus taxable accounts.
There are two main reasons to shield a specific investment fund in a tax advantaged account versus a taxable account.
1. The investment returns high levels of dividends.
2. The investment fund is actively managed with frequent short-term (<1 year) investments.
Real estate investment trusts (REITS) are an example of an asset class that generally produces significant dividend income and comprises most of the expected return of the asset. An investment that relies on dividends to generate returns for investors will generally perform better in a tax advantaged account because the dividends are not taxed and can then be reinvested. The reasoning lies in the difference in how dividends and long-term capital gains are taxed.
Capital gains from long-term (>1 year) stock price appreciation are generally taxed at a lower rate than dividends. Long-term capital gain taxes are capped at 20%. Federal income taxes for dividends can be as high as 37% depending on your income level. The potential increased tax burden of holding a high dividend producing investment in a brokerage account can seriously diminish your returns over time.
Short-term capital gains are also taxed as ordinary income, so you may consider placing actively managed funds in tax advantaged accounts due to higher turnover of investments (investments held< 1 year), which can lead to short-term capital gains (up to 37% tax rate vs 20% for long-term capital gains).
If REIT funds are part of your investment strategy, our Rebalancing Calculator is designed to allow rebalancing of REITs for purchase solely in tax advantaged accounts.