Because you don't have to pay taxes from year to year on income or capital gains you earn in tax-sheltered accounts like IRAs and 401(k)s, these are good receptacles for higher-returning investments that also have heavy tax consequences. The best example would be junk bonds, junk-bond funds, and multi-sector-bond funds, all of which kick off a high percentage of taxable income. And while it's a stretch to call high-quality bonds and bond funds "high-returning", they're also a better fit for tax-sheltered accounts than for taxable because their payouts are taxed at an investor's ordinary income tax rate.
So generally speaking, to the extent that you hold bonds, you're better off doing so within the confines of a tax-sheltered account. If you need to hold bonds in your taxable accounts, determine whether a municipal bond or bond fund might offer you a better aftertax yield than a taxable bond investment. (Income from munis is free of federal and, in some cases, state income taxes.)
By contrast, stocks and stock funds are generally a better bet for taxable accounts, for reasons outlined in the next section. That said, not all stocks belong in the taxable bin. Although they enjoy relatively low tax treatment currently, dividend-paying stocks are arguably a better fit for tax-sheltered rather than taxable accounts. The key reason is control. Dividend income, like bond income, isn't discretionary. Whereas stock investors can delay the receipt of capital gains simply by hanging on to the stock, investors in dividend-paying stocks don't have that kind of control; they get a payout whether they like it or not. That makes dividend payers, regardless of tax treatment, less attractive than nondividend payers from a tax standpoint.
Your tax-sheltered accounts are also the right spot for REITs, whose payouts are generally considered nonqualified and taxed at ordinary income tax rates. Preferred stock, too, is on the bubble, depending on the type of preferred you're dealing with, and therefore is apt to be a better fit within the confines of a tax-sheltered account. Traditional preferreds generally qualify for dividend-tax treatment, whereas income from trust preferreds is taxed at an investor's ordinary income tax rate. Dividends from some foreign stocks and funds may also be classed as nonqualified, meaning they will be taxed as income.
Finally, to the extent that you hold mutual funds that churn through their portfolios frequently, you're better off doing so within your company-retirement plan or IRA. Such funds tend to generate a lot of short-term capital gains, which are also taxed as ordinary income.
Taxable Accounts = Higher Returners With Low Tax Costs >>