Tax Considerations for Investment Allocations
By: Loot Lasso / Last Edited: 3/12/2025
Allocating High Dividend Producing Investments to Tax Advantaged Accounts
Tax considerations are an important aspect of investment planning. The type of account you use-IRA, Roth IRA, 401k, brokerage, etc.-affects the timing and amount of taxes you pay on your investment returns. 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.
- The investment returns high levels of dividends.
- The investment is actively managed, resulting in frequent short-term capital gains (from holding periods of less than one year).
Bonds are a prime example of an asset class that tends to produce significant income, typically through interest payments (not technically dividends). These interest payments are usually taxed at ordinary income rates, which can be as high as 37%. Since this income makes up a large portion of bonds’ total return, placing them in a tax-advantaged account (like a traditional or Roth IRA) can reduce your tax burden and allow for more efficient compounding.
Similarly, equity funds that generate substantial dividend income may be better suited for tax-advantaged accounts. While qualified dividends in a taxable account may be taxed at the lower long-term capital gains rate (0% to 20%), non-qualified dividends are taxed as ordinary income—again, potentially as high as 37%.
When it comes to actively managed funds, frequent buying and selling of holdings often results in short-term capital gains, which are also taxed at ordinary income rates. This makes actively managed funds another strong candidate for placement in tax-advantaged accounts, where tax drag from high turnover is eliminated.
Roth IRAs
Roth IRAs are unique among investment accounts because qualified distributions are entirely tax-free. Since contributions are made with after-tax dollars, no taxes are owed when funds are withdrawn in retirement. This tax-free growth makes Roth IRAs an ideal place to hold higher-returning assets like U.S. and international stocks. By concentrating growth-oriented investments in a Roth IRA, you can potentially build a larger tax-free pool of money compared to other retirement accounts. To maintain your overall portfolio allocation, you can hold more conservative, income-generating assets—such as bonds—in your 401(k) or traditional IRA instead.
Bogleheads.org has a great resource for tax-efficient fund placement.
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