When are tax-advantaged investments most appropriate?
The primary factors that make tax-advantaged investments preferable to an investor are:
- The investor is in a high-income tax bracket,
- The investor expects to remain in a high tax bracket for at least several years, and
- The investor is not able to invest all available funds inside retirement accounts.
The first two factors reflect the idea that tax-advantages investments often offer lower pre-tax expected returns than fully-taxed investments of comparable risk. Therefore an investor does not want to “pay” for tax-advantages investments (in the form of generally lower risk-adjusted pre-tax expected returns) when the investor does not really need the tax advantages. For example, fixed income investors in low tax brackets are usually better off focusing on investments that are fully taxable such as CDs. The last of the three factors is critical since even investors in very high tax brackets do not require investments with tax advantages if they can place all of their available money inside products such as retirement programs (e.g., IRAs and 401k plans) that offer both tax deferral and tax deductions.
Reduction of the long-term income tax burden from investing is one of the most powerful but often most under-appreciated keys to successful investing. Many investors can enhance long-term after-tax financial growth by keeping their otherwise highly-taxed investments such as bonds and real estate investment trusts inside their retirement funds while holding municipal bonds and low-dividend common stocks in their taxable accounts.