From Here to Financial Happiness

Day Sixty Two Everything in Its Place

Two days ago, I offered four rules for managing your investment tax bill. Yesterday, we discussed the benefits of deferring taxes. What's the implication of all this? You should think carefully about which investments you hold in your tax‐favored retirement accounts and which in your regular taxable account. The reason: With some investments and investment strategies, you can lose a quarter or more of each year's investment gains to the taxman. With others, you lose little or nothing.

For instance, a corporate bond will kick off interest every year that's taxable – and the tax is assessed at the income tax rate, rather than at the lower capital gains rate. Under current tax law, so‐called ordinary income can be taxed at federal rates as high as 37%. That's almost double the rate levied on long‐term capital gains and qualified dividends, which are taxed at 20% or less.

Similarly, if you trade stocks quickly, so your holding period is a year or less, any gains won't qualify for the long‐term capital gains rate. Instead, you'll have to pay tax at the much higher rate levied on ordinary income.

By contrast, other investments and strategies generate little or nothing in annual taxes. Let's say you buy and hold individual stocks or stock index mutual funds. Because you aren't doing any trading, you won't trigger capital gains taxes – and because most index funds don't actively trade their portfolios, they should pay out little or nothing in ...