How to Be a Tax-Aware Investor
Don't get a surprise tax bill.
Stock trading exploded at the start of the pandemic, propelled by the post-March stock market boom that made virtually everything go up. About a quarter of stock market trades were done by retail traders in 2020. Traders, many of whom used commission-free trading apps like Robinhood, soon realized the tax consequences. Some even realized massive gains, only to lose them in subsequent trading while getting stuck with a massive tax bill anyway.
Amidst all the excitement of making money off cryptocurrencies or meme stocks, people forget that there are tax consequences to buying and selling.
When investing, taxes almost always come due. You’ll likely deal with two types of taxes: income taxes and capital gains taxes. And investment growth usually comes from two sources: capital gains and dividends.
A capital gain is the difference between what you sell an asset for and what you paid for it. So if you buy a share of stock for $100 and sell it for $200, your gain is $100. How long you hold an asset affects what you pay in taxes. A capital gain is considered long-term if the asset is held for a year or more and considered short-term if the asset is held for less than a year. Long-term capital gains are taxed at generally lower rates: 0%, 15% or 20%. Short-term capital gains are subject to ordinary income tax rates: 10%, 12%, 22%, 24%, 32%, 35% and 37%.
A mutual fund or ETF itself will incur capital gains, which are then passed on to shareholders like a dividend. This is more likely to occur in high-turnover actively managed funds.
A dividend is a share of a company’s profits (or the dividends companies pay to a mutual fund or ETF) that is usually paid to shareholders quarterly. So if a share of stock pays 25 cents per quarter per share and you own four shares of that stock, your total dividends for a given year would total $4.
It’s also important to understand two types of dividends: qualified and nonqualified. Dividends are qualified when they have met certain IRS requirements. Qualified dividends are taxed at long-term capital gains rates, and nonqualified dividends are taxed at short-term capital gains rates. A fund that pays more qualified dividends will be more tax-efficient than a fund that pays more nonqualified dividends.
This concerns federal taxes. Different states have their way of treating investment gains and dividends. States that have no income tax generally don’t tax investment income and capital gains either. Some states tax all investment gains as ordinary income.
So the tax code favors those who hold assets for at least a year and who receive mostly qualified dividends. That’s why many day traders see much bigger tax bills than long-term buy-and-hold investors. Since frequent trading results in higher taxes, those who buy and hold only have to worry about long-term capital gains when they sell and monthly or quarterly dividend payments.
Short-term trading isn’t just more costly, it’s also more complicated. A lot of new traders learned this the hard way when they got pages and pages of tax forms detailing their transaction history in taxable brokerage accounts.
Because of the difference in how dividends are taxed and capital gains distributions in high-turnover funds, it matters what you put inside a brokerage account. For quick reference, here’s a hierarchy of the most tax-efficient investments to the least:
Total U.S. Market/S&P 500 Funds
Total International
Small- and Mid-Cap Funds
Actively Managed Funds
Target-Date Funds
Bonds and Bond Funds
REITs
Total U.S. market and S&P 500 funds tend to be the most tax-efficient, as they have little turnover (how much the fund is buying and selling and moving out of stocks) and virtually all of their dividends are qualified.
While international funds also have low turnover, they have a higher percentage of nonqualified dividends. But they have one advantage in the foreign tax credit. Companies based outside the U.S. pay taxes to foreign governments. The foreign tax credit helps U.S. investors recover some of those taxes in the form of a tax credit.
Small- and mid-cap funds pay out a higher percentage of nonqualified dividends and have higher turnover rates.
Actively managed funds are more likely to have high turnover and are thus inefficient, although the rise of actively managed ETFs helps minimize tax inefficiency.
Target-date funds contain a mix of everything, so if tax efficiency is your goal, they are somewhat middle-of-the-road.
The interest that bonds and bond funds pay is completely taxable as income. The exception to this is municipal bonds, which are exempt from federal taxes as well as state taxes in the case of a fund specific to your state. The same goes for REITs, which pay out 100% nonqualified dividends.
All of these details mostly concern investors using taxable accounts. If you use a tax-advantaged account, there’s good news: It doesn’t matter. You only have to worry about paying taxes once as long as you follow the rules: when you withdraw money in the case of a tax-deferred account or the year you contribute in the case of an after-tax account.
In a tax-advantaged account, every investment and gain is treated equally, regardless of whether it’s a short-term or long-term gain or if it’s a qualified or non-qualified dividend. In a Roth IRA your gains are tax-free, whereas in a traditional IRA your gains are tax-deferred, meaning you pay income taxes on every withdrawal, regardless of how you earned your gains.
While the tax burden of asset classes in a tax-advantaged account doesn’t matter, the proper placement of your investments can be important. You usually want your highest growth assets in after-tax accounts, because as long as you meet the withdrawal requirements, you’ll never pay taxes on investment growth. That might mean keeping all your bonds in pre-tax accounts and maintaining your Roth accounts at 100% stocks, although this level of careful optimization isn’t necessary.
It’s in a taxable account that you need to watch out. Total market funds and large-cap funds are great to put in a taxable account. Actively managed funds, small- and mid-cap funds and target-date funds can potentially cause tax issues. And bond funds and REITs should be kept out entirely if your goal is to minimize taxes.
How Much Do Taxes Matter?
Three factors matter most when investing: how much you invest, whether you stick with your investments and diversification. Invest enough money and stick to a diversified portfolio through good times and bad and you’ll reach your goals.
But investors should also understand how their investments are taxed before selecting them. Careful attention to tax efficiency, including how long you hold positions and how dividends are taxed, should be a factor in your decision-making.
Taxes may not be the most important consideration when investing, but they’re certainly something you should pay attention to. Just like high fees, a tax-inefficient portfolio will end up costing you over the long term. You can keep more money in your pocket by placing funds in accounts where the tax burden will be minimal.