What are Tax Efficient and Tax Inefficient Funds, Taxable and Tax Advantaged accounts?
TYPES OF FUNDS OR INVESTMENTS:
Tax efficient funds-e.g. Total stock index funds-produce low dividends, qualified dividends. These are best located in a taxable accounts.
Tax Inefficient Funds/ investments- e.g. small value funds, actively managed funds with high turnover, high yield Bond funds [Junk Bonds] as interest is taxed at full marginal [highest] tax rate, REIT [generate significant dividends]. These are best located in a tax-advantaged accounts like a Roth IRA or 401(k)]
These kind of funds can be placed in one of the following types of investment accounts.
TYPES OF INVESTMENT ACCOUNTS:
1. Taxable accounts [Non-qualified accounts] [pay taxes now]:
You put in after tax money. You pay taxes later on the growth and dividends. If you withdraw money before 1 year, you pay taxes on these growth and dividends at marginal tax rate just like your regular income. If you keep the funds in the account for more than one year and then withdraw, growth/dividends are taxed at long term capital gains tax rate which is less than your regular tax rate [less than 20%].
You should put Low Cost Index Funds” and funds with low dividends, qualified dividends that is tax efficient funds in this type of account as you have to pay taxes year after year
International stock funds are good in a Taxable account since you benefit from the Foreign Tax Credit
Municipal Bonds should be in Taxable accounts as you won’t owe tax at the federal level on bond income
2. Tax Advantaged accounts are two types
You should put least tax efficient funds in this type of account as you won’t pay taxes year after year.
1. Tax Deferred [=Taxed later]-401k, 403b, Traditional IRA, SEPs, Keoghs: You put in pre tax money and you will be taxed when you withdraw money in retirement. You may get tax deduction the year you put the money.
2. Tax Free – Roth IRA: You put in After Tax money and you won’t pay taxes when you withdraw in retirement or any time.
The above types of investment accounts can be opened in one of several companies like Vanguard, Fidelity, Schwab, Ameritrade, LincolnFinancial etc.
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