Who wants an easy way to squeeze more return out of your investing profits? You can juice your investment returns with smart asset placement.
Cutting taxes puts real money in your pockets. Although it’s great to make money by investing and pocketing capital gains and dividends, it’s even better to keep more of those gains through smart asset placement. First, I’ll give a quick tutorial on tax treatment of various investment assets.
What is smart asset placement? Simply put, place assets taxed at higher ordinary income rates in retirement or tax-advantaged accounts, and place those with lower tax liability in standard or discount brokerage investment accounts.
The tax system backstory. The complicated U.S. federal tax system rewards investors with lower long-term capital gains tax rates than those levied on ordinary income. Capital gains are the profits you get when you sell an asset. They are the difference between the sale price and the lower buy price.
Dividends are categorized into qualified and unqualified dividends. Qualified dividends are taxed at capital gains tax rates, which are normally lower, whereas, unqualified dividends incur higher ordinary income tax rates. Stay with us, as we find out where to locate financial assets, and pay the smallest amount of taxes possible. First, you need to understand the difference between qualified and unqualified dividends.
Which investments pay unqualified dividends? The following list includes many of the investments which pay unqualified dividends. These are the dividends taxed at the higher ordinary income tax rates.
— Real estate investment trusts (REITs)
— Master limited partnerships (MLPs)
— Dividends paid on employee stock options
— Dividends paid by tax-exempt companies
— Dividends paid on savings or money market accounts
— Interest paid from corporate bonds or corporate bond mutual funds and exchange-traded funds
Which investments pay qualified dividends? In general, dividends paid during the tax year (usually quarterly) from domestic corporations and qualified foreign corporations are considered “qualified.” Qualified dividends are taxed at lower capital gains rates, as long as an investor meets certain holding period requirements. Depending on your income level, capital gains may be taxed at zero, 15 or 20 percent.
Here’s an example of how the qualified dividends are paid.
Manuel owns 10,000 shares of GoGo Company stock. GoGo pays 20 cents per year in dividends. Manual receives $2,000 per year in dividends (10,000 shares x 20 cents, or 0.20). Since these are dividends from a qualified corporation, Manuel pays capital gains tax on the $2,000. His capital gains tax rate is only 15 percent, which is lower than his ordinary income tax rate of 35 percent.
How to cut taxes with smart asset placement. Follow these asset placement guidelines to keep taxes lower:
— Hold municipal bonds and bond funds in standard brokerage accounts. Municipal bond interest is normally tax-free. You usually avoid both federal and state tax obligations, as long as the municipal bond or bond fund is from your own state. In your standard brokerage account, you’ll avoid paying taxes, except on capital gains of municipal bonds and municipal bond funds.
— Hold stocks in standard brokerage accounts. Because stock dividends are generally qualified, they’re taxed at the lower capital gains rate. Going with the standard rule to hold lower tax items in taxable accounts, keep stocks and stock funds, as well as exchange-traded funds, out of retirement accounts, if possible.
— Hold low turnover stock funds and ETFs in standard brokerage accounts. For the same reason as the second rule.
— Hold corporate bonds and bond funds in tax- advantaged retirement accounts. Since bond coupon payments are normally taxed at the higher ordinary income tax rate, it’s a good idea to delay, or avoid altogether, paying tax on these investments. The best way to do this is by holding bond investments in individual retirement accounts, 401(k)s, or other types of tax-favored investment accounts.
— Hold REITS in tax-protected retirement accounts, for the same reason as the rule on corporate bonds and bond funds.
— U.S. savings bonds, tax-free to the state, are usually held in an electronic account, directly with the issuer, treasurydirect.gov. Some paper issues are still floating around, and you may want to register those for safekeeping with the treasurydirect.gov site as well.
The takeaway. Hold investments which tend to generate higher taxed unqualified dividends in tax-advantaged retirement accounts, if at all possible. Keep investments which generate gains taxed at the lower capital gains tax rates in standard, or discount, investment brokerage accounts.
As a caveat, sometimes, due to the offerings in your workplace retirement account, you may not have the discretion to stick to these guidelines perfectly. Consider these asset location suggestions as factors to consider in your overall investment planning.
Barbara Friedberg, MBA, MS , is a portfolio manager, consultant, website CEO and author of “How to Get Rich; Without Winning the Lottery.” Learn more about money and pick up her newest free investing book at Barbara Friedberg Personal Finance.com.
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Investors Can Cut Taxes Through Smart Asset Placement originally appeared on usnews.com
