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Christine Benz

Financial Planning > Tax Planning

Taxable Accounts Are Wrong for These Holdings: Christine Benz

By Dinah Wisenberg Brin

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What You Need to Know

  • Fixing tax-inefficient portfolios may not be as simple as moving holdings around.
  • Doing so might bring unexpected tax bills.
  • Rising yields add urgency to asset location, says Morningstar’s Christine Benz.

Financial experts often advise investors to carefully consider what they’re holding in taxable versus tax-deferred accounts to avoid unnecessary taxes on their investment gains.

The advice is well worth advisors’ and clients’ time and attention, but fixing tax-inefficient portfolios may not be as simple as moving holdings around, which could trigger costly consequences as well.

Christine Benz, Morningstar’s director of personal finance and retirement planning, recently wrote about investments to avoid holding in taxable accounts, and elaborated in comments to ThinkAdvisor.

Fixing a Tax-Inefficient Portfolio

“If an investor has an ‘asset location’ problem — and that’s typically tax-inefficient assets in the taxable account — fixing it can be difficult. I think advisors encounter this a lot; the client may have started amassing taxable assets without a lot of concern for tax efficiency, or the previous advisor hadn’t put a lot of thought into asset location,” Benz told ThinkAdvisor via email.

“Getting the taxable portfolio to be more tax-efficient going forward may be tricky because the [securities] may have appreciated since purchase, so selling and moving into a tax-deferred account may trigger a tax bill. It’s valuable to pay attention to cost basis when deciding the best course of action,” she said.

If an investor has been reinvesting distributions back into a tax-unfriendly fund, they’ve been able to increase their cost basis by the amount of the distributions, Benz noted.

“That, in turn, reduces the tax due upon the sale,” she said.

High-Yield Bond Effects

More broadly, while the advice to keep tax-unfriendly holdings out of taxable accounts is largely evergreen, the fact that yields have increased so meaningfully over the past year “adds more urgency around matters of asset location,” Benz told ThinkAdvisor.

“When yields were so much lower, it was hard to get excited about paying taxes on a very low amount of income,” she said. “But now that cash yields are 4-5% or more, investors who are careful about where they hold income-producing securities will reap a benefit.”

In a recent article on Morningstar.com, Benz outlined investments to avoid placing in taxable accounts. She noted that big capital gains distributions in Vanguard target-date funds led to significant, unexpected tax bills for investors who held the funds in taxable accounts.

The Problem With Dividends

Among the investments to keep away from taxable accounts, Benz cited high-dividend-paying stocks and dividend-focused funds, which she said may do better in tax-sheltered accounts.

“Many investors naturally gravitate to securities that kick off current income, and advisors often accede to that preference without offering a counterpoint about how that might not be a particularly tax-efficient strategy,” she said via email.

“Yes, dividend yields are taxed at a lower rate than ordinary income is, so investors often read that as a license to load up on dividend payers in their taxable accounts. It’s also true that dividends are a big part of the market’s long-run return, and even total market index funds and ETFs have yields of ~1.6% today,” she added.

Focusing on high dividend payers, however, helps ensure investors will have to pay taxes on their investments year in and year out, even if they reinvest the distributions, she noted.

“Focusing on total return without reaching for dividends gives you more control over your tax bill; that provides the opportunity to realize gains in years when the investor has less income or realized losses,” Benz said.

Benz listed several other securities that may best be avoided in taxable accounts:

Taxable Bonds and Bond Funds

“Generally speaking, bonds will tend to be less tax-efficient than stocks,” she wrote. Because most of the returns are income, they’re taxed at the ordinary income tax rate, which is higher than the capital gains and dividend tax rates that apply to gains from most stock holdings, she explained.

High-yield bond funds and funds holding Treasury inflation-protected securities are especially poor fits for taxable accounts, Benz noted. High-tax-bracket investors who want to keep bonds in taxable accounts for short-term needs might consider municipal bond funds and municipal money market funds, she suggested.

Multi-Asset Funds

Multi-asset funds, such as target-date and balanced funds, generally are better held in tax-sheltered accounts like IRAs and 401(k)s, Benz wrote. They usually hold taxable bonds and the fund allocations either remain static or become more conservative, which can require managers to sell appreciated stocks, socking investors with capital gains taxes, she said.

Actively Managed Equity Funds

“I used to equivocate about whether to hold actively managed funds in taxable accounts. But I’ve seen enough, and the answer is: Don’t do it,” Benz wrote. While some actively managed equity funds have kept their tax bills low, it’s unclear whether they’ll be able to continue to do so, she said, adding, “And some active funds have been absolutely awful from a tax standpoint, dishing out large capital gains year after year.”

Tax inefficiency also makes real estate investment trusts, REIT funds, commodities futures funds, convertible bonds and funds holding convertibles, as well as some alternatives funds, less appealing for taxable accounts, Benz wrote.

Benz acknowledged that broad-market equity index ETFs “do a wonderful job of limiting taxable capital gains distributions,” which partly accounts for the “stampede out of actively managed funds and into ETFs.” She added, though, that there are limits to what ETFs can do to reduce taxes.

If an ETF focuses on current income and the bulk of its return comes from that income — for example, a bond fund or a real estate fund — “it won’t be a lot more tax-efficient than a mutual fund with a similar strategy,” she told ThinkAdvisor.

Benz urged caution about services offering to lower taxes through tax-loss harvesting.

“Services purporting to reduce taxes through strategies like tax-loss harvesting have proliferated over the past few years,” she told ThinkAdvisor. “But advisors should weigh carefully whether any tax savings will offset the additional costs and complexity that such services entail. Moreover, while tax-loss selling helps defer taxable income, it does reset cost basis so the account owner will owe taxes upon sale.”

 Pictured: Christine Benz

Dinah Wisenberg Brin

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