Stocking up on income-paying assets? Here’s how to maximize their tax efficiency

Published Sat, Mar 4 20238:30 AM EST

Investors seeking stability amid volatile stock markets have turned toward income-yielding assets, but they should ensure they are minimizing the tax hit from those investments. Treasurys, once a plain-vanilla investment, are attracting investors attention as the yield on the 10-year note breached 4% earlier this week . Even idle cash can be put to work , as 6-month T-bills offer a yield topping 5%. US6M US2Y,US10Y YTD line Treasury yields have been running higher. Securing the income from those assets is only part of the battle, though. "Now we see corporate bonds paying over 5%, municipal bonds paying over 3%, all at investment grade level," said Jerrod Pearce, a certified financial planner, CPA and partner at Creative Planning. "It's more important to figure out where do you put these assets so that you can take home as much income as you can and not have a lot of it go walking out the door in taxes," he said. Generally, the income that's spinning out of your bonds and dividend payers could come with a tax bite. However, there are steps investors can take to mitigate the hit and aim for tax efficiency. Here's where to begin. The calculus of tax optimization Tax optimization begins with the three types of investment accounts available to investors: taxable brokerage accounts, tax-deferred accounts such as 401(k) plans and individual retirement accounts, and tax-free accounts like Roth IRAs. You can buy and sell assets in a taxable account and thus end up subject to taxes on capital gains. Tax-deferred accounts, meanwhile, allow money to accumulate free of taxes – but you're on the hook for income taxes when you take withdrawals. Roth accounts allow you to put after-tax money away and withdraw tax-free it in retirement, subject to certain conditions . Where you choose to put your income-paying assets will depend on your time horizon and goals. "If you're going to be an income-oriented investor, the first question is what is your purpose?" said Tim Steffen, CPA, CFP and director of advanced planning at Baird. "Is it that you want cash flow off your portfolio? Or is there no opportunity on the growth side and you want a return on investment through yield and income?" he asked. "These are two scenarios and can dictate the investments you would hold and where you might hold them." Your individual tax situation will also be a key factor in determining which income assets are best for you and where you should hold them. For instance, municipal bonds are tax-exempt on the federal level and tax-free on a state level if you live in the locale where the bond was issued. However, investors in a low tax bracket might be better off going for taxable bonds – which tend to pay higher yields than municipal bonds. "Many people become enamored with the idea of tax-free income and immediately want to jump into munis," said Steffen. "Instead of focusing on how much tax you don't pay, focus on how much income you keep." A rule of thumb is that investors whose marginal tax rates are in the 24% bracket and above – that is, you're single and have taxable income over $95,375 or $190,750 if married and filing jointly in 2023 – may be better contenders for municipal bonds. Asset location Taxable brokerage accounts are generally a good place to hold T-bills if you're going to tap the money soon. "If it's going to be earmarked for a cash outlay, it's fine to own it in brokerage and you know it's going to be state income tax free," said Pearce. He said municipal bonds can also go in brokerage accounts. Corporate bonds are better off in a traditional IRA, Pearce said. The income they spin out is taxable on a federal, state and local basis. Taxable bond funds that are also making hefty income payments are also better contenders for your IRA. That's because taxes are deferred on investments in these accounts until you begin withdrawing from them in retirement. If you're holding Treasurys for the long term as part of your fixed-income strategy — rather than for immediate needs — you're also better off keeping them in your IRA. Stocks and exchange-traded funds that pay qualified dividends — that is, they are subject to a lower tax rate compared to the ordinary income tax hit on nonqualified dividends — could be well suited for brokerage accounts, said Pearce. Finally, even the safest and most boring of assets come with tax ramifications. Interest on certificates of deposit – some of which are yielding about 5% for a one-year term, according to Bankrate.com – is subject to tax and must be reported on your tax return. Still, you'll likely want to keep this investment in your brokerage account and away from your IRA if your income needs are in the near term. "If you need the yield, do it outside of your [tax-deferred] account, rather than having it in your retirement account where you'd potentially pay more taxes to get it out," said Steffen.