While the tax treatment of different investments can affect your returns, investor behaviour also plays a role in the overall tax efficiency of a portfolio and long-term investment plan.
Certain types of investments are better suited to being held in one account type than another, but not always in the same way for different investors.
Bond or fixed income allocations may increase over time, since investors tend to want to protect their nest eggs’ exposure to the higher volatility of the stock market as they get closer to retirement. Bonds generate interest income that is fully taxable — so, it makes sense to hold as much of this as possible inside a tax-sheltered account. When bond yields are extremely low, however, investors might consider holding bonds in a taxable account, since the interest payments will be relatively minor.
Capital gains generally come from equity investments and are the most favourably taxed, so investors might consider holding some of these in non-registered plans. But, if they have some leftover room inside of a tax-sheltered plan, they might be wise to hold some of these stocks within that account so that those capital gains can completely escape taxation.
Dividends that qualify for a tax credit are a good option to hold in a taxable account, given that the tax credit isn’t available on dividends that wouldn’t be subject to any tax in the first place.
Trading activity will also bring about tax consequences, as heightened trades crystallize what would otherwise be paper losses or gains.
Once investors lock in a trade, they trigger any related tax consequences associated with that transaction, whether it’s for individual securities, mutual funds or ETFs.
Mutual fund and ETF investors should also be mindful of making purchases late in the year. Year-end distributions, which are taxable for any pooled investments held in taxable accounts, can mean they’re left with a tax hit even though they didn’t get to participate in the growth that might’ve triggered that distribution.
Keeping trades to a minimum means investors are effectively deferring payment of any tax on investment gains — as long as they’re still up when they actually sell the investment. This is not to say that investors should never sell something until they need the funds, because sometimes an investment doesn’t pan out and divesting makes sense.
Maximizing the tax efficiency of a portfolio is really about finding a balance between reducing the amount of tax investors have to pay on their investment earnings, without making tax-motivated decisions that are at odds with their overall portfolio goals.