What asset classes should I consider owning?
Before you decide on the percentage of stocks, bonds and cash instruments that make the most sense for you, it’s helpful to understand how the IRS treats the income from those asset classes. Ordinary income, including from interest payments on bonds and cash, is currently taxed at individual rates as high as 37%, plus a potential additional 3.8% if the net investment income tax applies. Profits from the sale of stocks you’ve held for more than a year qualify as long-term capital gains, and the long-term capital gains tax rate currently maxes out at 20%, plus the potential 3.8% net investment income tax. (It’s worth noting that future tax law changes are always a possibility.) Also, be aware that if you hold a stock a year or less and sell it at a profit, the gain will be taxed at your ordinary income rate, which could be considerably more than the capital gains rate.
Should I invest them in a tax-deferred or taxable account?
“Your advisor can help you think through the tax implications of where you hold different types of investments,” says Navani. For instance, currently investment income from assets held within a 401(k) or IRA generally isn’t subject to taxes until you withdraw it. For that reason, you may want to place holdings that generate ordinary income — bonds or non-qualified dividend-producing stocks — in tax-deferred retirement plan accounts. (Withdrawals you take during retirement may be taxed at your ordinary income rate, which may be lower at that time — or potentially not taxed at all, in the case of a Roth account.)
By contrast, it’s often smart to hold non-income-producing assets, such as growth stocks, in taxable accounts. Even if they increase substantially in value, you generally won’t experience any tax consequences until you sell them.
Another exception: municipal bonds, which are generally exempt from federal (and, in some cases, state and local) taxes, notes Navani. Be aware, he adds, that tax-exempt bond income is usually tax-exempt when it’s held directly, but when it’s distributed from a retirement account — unless it is a qualified distribution from a Roth account, generally — it’s treated as ordinary income and is taxable. Ask your advisor whether muni bonds, which often have a lower yield than other bond options, may be an appropriate choice for your non-retirement account portfolio.