Most people prefer certain tax-advantaged accounts such as IRAs, 401(k)s or 403(b)s for their retirement or long-term goals. While some types of assets are well suited to these accounts, other types of investments make much more sense for traditional taxable accounts. Knowing the difference can help bring you closer to your financial goals.

Understand How Your Investments are Taxed

Where you own investments matters because of how they are taxed. Certain investments, such as stocks, can generate capital gains. Long-term capital gains—gains on stocks held for more than one year—are generally taxed at a maximum rate of 20%. In contrast, short-term capital gains, where the investment is held less than a year, are taxed at your ordinary-income tax rate, which currently maxes out at 39.6%.

Some types of investments generate dividend income. You will need to pay attention to the tax rules for dividends, which belong to one of two categories:

  • These dividends are paid by U.S. corporations or qualified foreign corporations. Assuming you have met the applicable holding period requirements, qualified dividends are taxed similar to long-term gains, currently maxing out at 20%.
  • These dividends, which include most distributions from real estate investment trusts (REITs) and master limited partnerships (MLPs), receive a less favorable tax treatment. Similar to short-term gains, nonqualified dividends are taxed at your ordinary-income tax rate, which currently maxes out at 39.6%.

Tax-Efficient Options: One of Your Best Bets

Investments that lack tax efficiency are normally best suited to tax-advantaged vehicles. Conversely, the more tax efficient an investment, the better it is suited for taxable accounts.

Municipal bonds ("munis"), either held individually or through mutual funds, are one of the most tax-efficient investments you can own. Their income is exempt from federal income taxes and sometimes state and local income taxes as well. Because you do not get a double benefit when you own an already tax-advantaged security in a tax-advantaged account, holding munis in your 401(k) or IRA could result in a lost opportunity.

Similarly, tax-efficient investments such as passively managed index mutual funds or exchange-traded funds, or long-term stock holdings, are generally appropriate for taxable accounts. Over time, these securities are more likely to generate long-term capital gains, whose tax treatment is relatively favorable. Securities that generate more of their total return via capital appreciation or that pay qualified dividends are also better taxable account options.

Take Advantage of Income in the Right Way

Some of the best investments to hold tax-advantaged accounts are those that tend to produce much of their return in income, for one. This category includes corporate bonds, especially high-yield bonds, as well as REITs, which are required to pass through most of their earnings as shareholder income. Most REIT dividends are nonqualified and therefore taxed at your ordinary-income rate.

Actively managed mutual funds are another type of investment where it is more beneficial to hold in a tax-advantaged account. These funds tend to have significant turnover, meaning their portfolio managers are actively buying and selling securities, which typically creates short-term gains that ultimately get passed through to you. As short-term gains are taxed at a higher rate than long-term gains, these funds would be less desirable in a taxable account.

Beyond Tax Implications

The discussion above contains suggestions for taxable and tax-advantaged accounts. However, your situation might require a different approach. For example, you may need more liquidity in your taxable account than you do in your 401(k) account. In this case, you might decide to hold a high-turnover equity fund or high-yield bond investments in the taxable account because you value flexibility more than favorable tax treatment.

With any investment strategy, make sure to keep in mind the benefits and risks, including the risk that your investments may lose value. Ask your financial advisor to help you make the best choices for your situation.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.