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Jason Stipp: I'm Jason Stipp for Morningstar. We all know the importance of 401(k)s, IRAs, and other types of retirement accounts, but your taxable accounts can also play a big role in retirement planning. Here to talk about some mistakes that folks should avoid with their taxable accounts is Christine Benz, our director of personal finance.

Christine, thanks for joining me.

Christine Benz: Jason, great to be here.

Stipp: Taxable accounts can play a role--a very important one. You have six things that you should avoid doing with taxable accounts. The first one is not have them at all, just writing them off.

Benz: Right. People automatically go to their company retirement plans or their IRAs to invest in, but it is important to put some money inside of taxable accounts. For one thing, if you need money prior to retirement, those are liquid assets that you can tap without penalties or taxes, so that's an advantage. The other thing is, for very high-income folks--say, someone earning over $250,000 a year--that combined $23,500 that people can put in IRAs and 401(k)s if they are under age 50, that's not even 10% of their income. So, they will need to put additional monies aside to make sure that they have enough money in retirement.

Finally, the last reason that people should consider investing inside of a taxable account is that tax diversification in retirement is a really valuable thing. So, ideally, you'll come into retirement and you'll have some tax-deferred assets--money that you've stashed in your company retirement plan that you'll pay taxes on upon withdrawal. You maybe will also have some Roth IRA assets, which are tax-free during retirement. And then those taxable assets are advantageous and, arguably, a little better for you than the tax-deferred assets in retirement because you'll only pay capital gains on your distributions; you won't owe taxes on the entire kitty. So, that's another key reason that most people should consider saving inside of a taxable account instead of the other types of wrappers.


Stipp: So, number one, have these kinds of accounts in your tool kit and consider them. The number-two mistake to avoid is not being careful about what you put in a taxable account. This is a concept known as "asset location."

Benz: That's right. So, generally speaking, you want to keep taxable bonds outside of a taxable account because those income distributions that they make are taxed at your ordinary income tax rate. REITs and commodities both tend to be categories that you want to keep outside of a taxable account because they have heavy tax consequences.

In terms of what to keep inside of a taxable account, you would want to think about municipal bonds--to the extent that you have bonds in that portfolio. Index funds also tend to be a good fit, in that they have very low turnover. These would be index equity funds. Individual stocks as well. And you'd want to be careful to the extent that you have actively managed funds; I'd want to probably keep them outside of my taxable account--in some sort of a retirement account.

One reason--and we've seen a great illustration of this recently--is that these funds can make big distributions on a year-to-year basis that aren't necessarily correlated with your own gains in the fund. I was recently just looking at some funds in our database with high tax-cost ratios. Longleaf Partners (LLPFX), for example, in the past year, has had a 3% tax-cost ratio. That means you can sort of add it to the expense ratio. That's your total cost of owning this fund, close to 4%. That's a really high levy that you would pay to own this fund inside of a taxable account.

T. Rowe Price has had some other very good funds that have also dished out very big distributions to shareholders. So, focus on tax efficiency. Generally speaking, index funds and tax-managed funds will be a better fit, to the extent that you own equity funds in your portfolio.

Stipp: And, of course, because these are taxable accounts, there are some steps you can take to minimize your tax hit in these accounts. It would be a mistake to avoid those.

Benz: That's right. Ideally, folks should be keeping an eye on their cost basis--keeping track of the amount that they paid for their shares. And you can periodically use some techniques to help improve your tax positions. One thing that people can do during bear markets--it's a little less relevant now that we've had such a great rally--you can pick through and see if you have holdings that are selling below your purchase price. You can sell them, harvest those losses; you can use them to offset capital gains when they occur, or you can use them to offset up to $3,000 in ordinary income.

One technique that is perhaps more advantageous right now is called tax-gain harvesting, and this is applicable for people who are in the 10% and 15% tax brackets. That means that they pay zero capital gains taxes currently. So, for them, one idea is that they can look at positions that are, in fact, highly appreciated, sell them, rebuy them if they want to, and effectively reset their cost basis to the new higher level. So, if at some point they are on the hook for capital gains taxes, they will pay taxes on that smaller spread.

Stipp: And another mistake to avoid is actually a rule of thumb that some folks might follow in retirement, which is to use those taxable accounts up first and save the tax-advantaged for later; but it could be a mistake to just dogmatically follow that rule.

Benz: That's right. There is a lot of great information out there about sequencing withdrawals in retirement. You typically hear that taxable assets go first, followed by tax-deferred accounts, and Roth IRA assets go last in the queue. And that's all right as a general framework, but for retirees to successfully reduce their tax burden on a year-by-year basis, one of the best ways to go about it is to really look at each year individually rather than, say, deplete all of your taxable accounts early in retirement.

That way, if you do run through all of your taxable accounts, unfortunately you won't be able to take advantage of those low capital gains rates on those withdrawals in the future. If the taxable account is all gone, you won't be able to avail yourself of those relatively low withdrawal taxes.

Stipp: And if you are in those really low tax brackets, there might not be any tax potentially. So, it's important to have that as a tool maybe later on in retirement as well. Another mistake is people thinking they're only going to withdraw from taxable accounts, but there might be very good reasons to actually add money to taxable accounts in retirement.

Benz: One of the best reasons to do so is if you are post-age 70 1/2, you are in retirement, and you are taking required minimum distributions from your IRAs and your 401(k)s. Sometimes people will say, "Well, gosh, this RMD that I must take is taking me over my planned distribution rate--it is giving me a higher withdrawal rate than I actually want to take." In that case, it makes a lot of sense, even during retirement, to not just spend that money but reinvest it in a taxable account. You can even reinvest it in a Roth IRA account if you have some sort of earnings from work; but if you don't, you need to put that money back into a taxable account.

So, for a lot of people who are making heavy withdrawals from their IRAs and 401(k)s, reinvesting in a taxable account would be as a sensible and desirable strategy.

Stipp: The last [mistake to avoid] is not paying heed to the benefits, potentially, of a taxable account in your estate plan.

Benz: That's right. So, one of the big benefits of holding taxable assets and considering them part of your estate plan is that when your heirs inherit those assets from you, they receive what's called a step-up in their cost basis. That means that, upon your death, their cost basis becomes the security's price at the date of death.

So, it's a really valuable tool if you have highly appreciated assets or anticipate having highly appreciated assets within your accounts. They will oftentimes find a good home in your taxable account because of that step-up in basis. So, it's certainly something to discuss. If you are working with an attorney or a financial advisor, you should discuss what your ultimate plans are for those assets; that can help you figure out which types of assets to put where.

Stipp: Taxable accounts often take second seat to retirement accounts, but they have lots of utility, as you demonstrate here. Thanks for joining me, Christine.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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