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Owning Stocks and Bonds in the correct account reduces taxes

This is an advanced financial planning topic appropriate for those with significant Qualified and Non-Qualified assets

Asset Location says that you should own your bonds and bond mutual funds in pre-tax Qualified accounts because interest income and earned income is taxed the same. You should own your stocks and stock mutual funds in Non-Qualified accounts where the growth is taxed at lower capital gains rates.

To begin, let’s review Non-Qualified accounts—those with no special tax bells and whistles. These are individual accounts or those you own jointly with someone else like checking and savings accounts, stocks, bonds, mutual funds, etc. You fund these accounts with after-tax dollars. Each year as growth is realized in the account: Interest and Dividends paid, Capital gains received—you pay taxes on it. When you take money out, there will be a gain or loss on that withdrawal. If there is a gain you will pay taxes. If there is a loss it will reduce your taxable income for that year.

But all income is not taxed the same in a Non-Qualified account:

  • Dividends, Interest and Short-Term Capital Gains (profit on an asset owned for less than a year) are taxed at Ordinary Income rates.
  • Qualified dividends (after a short holding period, most U.S. companies qualify) and Long-Term Capital Gains are taxed at much lower rates. 0 taxes if you are in the 15% marginal tax bracket, taxed at 15% if you are at the 25%, 28%, 33% and 35% marginal tax brackets and taxed at 20% at the 39.6% marginal tax bracket.

NOTE:  Portfolio income is subject to a 3.8% Medicare surcharge when your AGI exceeds certain thresholds.

There are many different types of Qualified accounts that are reviewed elsewhere on this website. As a refresher there are three primary subsets:

  • Traditional: Contributions are pre-tax, growth is tax-deferred and withdrawals are taxed at Ordinary Income rates.

  • ROTH: Contributions are after-tax and growth is never taxed as long as the proceeds are withdrawn for a qualified reason.

  • Non-Deductible: Contributions are after-tax, growth is tax-deferred, a percent of each withdrawal is a return of dollars contributed—since they were already taxed they are not taxed again—growth is taxed at Ordinary Income rates. Which percent is which is determined by an IRS formula.


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