Taxable or Tax-Deferred Account: How to Pick – Kiplinger’s Personal Finance

Which investments you hold matters (and in what proportions), but so, too, does where you hold them, whether it’s in a tax-advantaged account or a taxable one. A recent lawsuit against Vanguard Group reveals how important such a decision can be. 

Earlier this year, three investors sued Vanguard for negligence and breach of fiduciary duty after the investment company’s target-date funds made a substantial capital gains distribution in late 2021, generating an unexpected tax bill for the plaintiffs (and other Vanguard investors). (Mutual funds are required to pass on any realized net gains to fund shareholders at least once a year.) But if the investors had held those mutual fund shares in tax-sheltered accounts instead of in taxable ones, the unwelcome tax bill could have been avoided. 

Just as taxable and tax-advantaged investment accounts get different tax treatment, so do certain types of investment income. The strategy of divvying up your assets into certain types of accounts to lower your tax bill is called asset location. The general advice is to hold less-tax-efficient investments in tax-sheltered or tax-free accounts, such as an IRA, an employer-sponsored 401(k) or a Roth version of either, and to put tax-efficient assets in a taxable account. 

Of course, much may depend on how much money you have, your time frame and cash needs, and whether you’re a buy-and-hold investor or an active trader, among other things. Tax considerations shouldn’t drive every decision, says Boston, Massachusetts, certified financial planner Jay Karamourtopoulus, but ultimately, “a well thought out asset location plan can reap many benefits and should be addressed.” 

Below, we tackle the strategy with a long-term view and break down which investment assets are best, generally speaking, for tax-deferred accounts, tax-free ones and, of course, taxable accounts. Tax rules guide the advice, which we’ll get into in each section.

Tax-Deferred Accounts

In a tax-deferred account, such as a traditional IRA or 401(k), you sock away money pretax and it grows tax-free. You’ll pay income tax on the money only when you withdraw it (as long as you’re at least 59½ years old; otherwise, penalties usually apply).  

Because all taxes are deferred until your retirement years, including any realized gains from the sale of stock shares, bond income or mutual fund capital gains distributions, more of your money works for you, compounding over time. It’s a key reason Los Angeles certified financial planner John C. Pak says, “Having all your money in tax-deferred or tax-free retirement accounts is the best asset location.”

So, for example, capital gains distributions from mutual funds won’t trigger a taxable event in a tax-deferred account. That’s why mutual funds make sense for these accounts, especially actively managed strategies with a …….


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