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Investments to Avoid in Your Taxable Accounts

Investors should exclude high-income bonds, TIPS, and equity funds with high turnover or high-dividend strategies from their taxable accounts, says Morningstar's Christine Benz.

Jason Stipp: I'm Jason Stipp for Morningstar. It's Model Portfolio Week on Morningstar.com, and today we're talking about investments to avoid in your taxable accounts with Morningstar's Christine Benz, our director of personal finance.

Christine, thanks for being here.

Christine Benz: Jason, great to be here.

Stipp: Christine, a lot of times when we think about investing, we're thinking about 401(k)s and IRAs. But you say that taxable accounts can also play an important role in your investment plan. Why are they useful?

Benz: One of the key reasons is if you have near- or even intermediate-term spending needs, it will be a better bet to save within a taxable account where you can pull your money out without penalties than it will be to save and invest in some sort of a tax-deferred retirement account where you will face penalties if you need to make premature withdrawals under most situations.

Certainly, if you are someone who has already maxed out your tax-sheltered account, your only other option will be to turn to some sort of taxable brokerage account to invest additional assets. And finally, taxable accounts can be really valuable in retirement because they do let you exert a little more control over your tax situation than is the case with your tax-deferred accounts. With those tax-deferred accounts, you will pay your full ordinary income tax rate on those distributions. With your taxable accounts, you may enjoy more favorable capital gains treatment on those withdrawals. So, that's another big advantage especially if retirement is drawing close.

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Stipp: And you do have a sleeve of your model portfolios that are tax-efficient for folks who are investing in those taxable accounts, and a lot of times you are recommending muni-bond funds because of their tax efficiency and also index funds on the equity side as well as tax-managed funds. But what about investments that should just be on the chopping block because they are really not tax-efficient? Let's start with fixed income. What do you probably want to avoid for your taxable accounts when you're investing in bonds?

Benz: Generally speaking, you'd want to keep any sort of bond investment that has high income out of your taxable account. The key reason is that those income distributions are taxed at your ordinary income tax rates. Junk bonds, for example, are the classic example of the thing to keep out of your taxable account because if you are earning, say, a 6% income payment on that junk-bond fund, you will owe ordinary income taxes, which will take a big haircut out of that nice yield. So, junk bonds would be one category. Another category would be Treasury Inflation-Protected Securities because you're taxed not just on the interest income but also on the inflation adjustment that you receive to your principal. So, those would be two categories that would be not such great ideas for a taxable account.

Stipp: What about on the equity side? What kinds of stock funds might you want to avoid for a taxable account?

Benz: Certainly, any fund that is using a very high-turnover strategy I would not hold inside of a taxable account. If the fund is trading very frequently and holding positions for less than a year, you'll pay short-term capital gains tax on those distributions, and those distributions are taxed at your ordinary income tax rate. So, that's one fund category to be wary of. If I held it at all, I would do so within a tax-deferred setting. High-dividend-focused funds would be another category that I would keep outside of a taxable account. The reason is that you will pay taxes on those dividends, whereas if a fund is using a more total-return-oriented strategy and not cranking out such high dividends, your tax bill, on a year-to-year basis, will probably be lower with it.

In general, Jason, I have to say that, over the past several years, I have been pretty disturbed by what we've seen from the whole category of actively managed equity funds--aside from those that are explicitly managed with an eye toward keeping distributions down. We've seen some really high capital gains distributions coming from some of these funds. Some of the distributions have come because there have been manager changes. Some have come because we've seen investors leaving actively managed funds, so the managers have had to sell stuff to meet redemptions. It has not been a particularly tax-friendly environment for investors in actively managed equity funds. I think index funds, in most cases, make more sense.

Stipp: What about niche categories? There are several of them, different kinds of diversifiers. Not all of them are tax-efficient?

Benz: Right. When I put together some of the tax-efficient portfolios, I left some of these investment types out altogether. Real estate investments would be one category--REITs--because they are kicking off nonqualified dividends that are taxed at your ordinary income tax rate, generally not a good idea for a taxable account. Commodity futures investments are another category that I would generally not include in a taxable account because the gains that you earn will be taxed partially at the long-term capital gains rate--which is lower--but also, in part, on your ordinary income tax rate--which is higher. So, that would be another category I would keep out. We've seen an explosion of interest in gold bullion exchange-traded funds--not so much recently, but maybe five years ago. This is a category where your gains are taxed at the collectables rate, which is higher than the long-term capital gains rate. It's 28%. So, that's another category. If I owned it, I'd want to own it outside of a taxable account.

Stipp: Tax efficiency: one of those things that's in the column of things investors can control. Thanks for helping us keep the tax bill lower with these ideas today, Christine.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.