You should consider taxes, as well as rate of return, when picking retirement investments

Climbing out of the COVID-19 abyss that investment balances fell into in March, many segments of global stock and bond markets have responded strongly and enter December with solid gains for the full year. How much of those gains that you get to keep, however, is unknown until you consider the impact of taxes.

You can only spend from your after-tax returns, so your measure of progress needs to reflect taxation, but this is where investment performance can show an incomplete result. Your account statement might indicate a rate of return, but you are likely sharing a portion of that return with the government and not all shareholders are paying the same tax rates.

The types of investments you own, and the account types in which you own them, could make a meaningful difference in after-tax return. That is especially true for people who own investments outside of retirement accounts, such as in taxable brokerage accounts.

In general, investors can position for better after-tax returns by optimizing where they hold different types of investments. Typically, that means holding investments with the highest expected returns in Roth IRAs or equivalent accounts that are tax free if certain requirements are met. Investments that generate relatively little taxable income (such as municipal bonds and stock market index funds, or non-dividend-paying stocks) are best for non-retirement brokerage accounts. That leaves an emphasis on income-paying investments (most bonds, real estate investment trusts, dividend-paying stocks and actively-managed mutual funds) for pre-tax retirement accounts like the Traditional IRA or 401(k). In most pre-tax accounts, all withdrawals are taxed at the owner’s applicable ordinary income rate, regardless of whether the withdrawal is comprised of original contributions, capital gains or income.

An underused option to improve after-tax returns is to not hold actively-managed mutual funds in taxable brokerage accounts. When holding actively-managed mutual funds in brokerage accounts, investors (primarily in stock funds) are presented with an annual taxable distribution of capital gains. When mutual funds buy and sell investments over the course of the year, they realize capital gains (and sometimes losses). The net gains are passed on to shareholders of these funds (usually in mid-December each year). Even if these distributions are automatically re-invested in new shares and not received as cash in the account, investors who hold these funds in non-retirement accounts are taxed on these distributions annually.

This year’s distributions, particularly for growth stock funds with the strongest performance, are expected to be higher than usual, in some cases as large as 10 percent of the balance of the mutual fund. When distributions of capital gains or dividends are paid out, the per share price of the mutual fund declines because the net asset value of the fund has been reduced. That means that unless you reinvest these distributions in new shares, it is effectively like having taken a withdrawal from your balance in the mutual fund.

The higher the turnover of investment holdings in the mutual fund portfolio each year, the larger the taxable distribution is likely to be. Index funds generally have little trading and turn over under 5 percent of the portfolio, leading to lower taxable distributions. Active mutual funds, however, frequently turn over 25 percent or more of the portfolio each year, sometimes much more.

Some mutual funds (usually including tax-managed in their name) are sensitive to the tax impact they pass through to shareholders, but most of the largest mutual funds are not managed in that way. In many cases, the portfolio manager of the mutual fund pays no regard to tax efficiency because the fund might be held by multiple types of investors with different tax preferences.

Two investors (perhaps a non-profit endowment and a high-income individual) with the same number of shares in a mutual fund, purchased and sold on the same day, could realize large differences in their after-tax return depending on their applicable tax rates for ordinary income and/or capital gains.

Unless you prefer to pick individual stocks or bonds, the more tax-efficient form of pooled investments to own in non-retirement accounts are exchange-traded funds (ETFs). These investments are similar in form to a mutual fund in that they typically own a basket of dozens to thousands of underlying investments. They usually track an index or rules-based criteria to include stocks or bonds of certain types.

The unique creation and redemption process for shares of an ETF allows them to avoid realizing capital gains through their trading activity and passing the associated tax costs on to shareholders. Even if the intent is simply to invest in an index like the S&P 500, the ETF version of that investment will usually be more tax-friendly than the mutual fund, increasing after-tax returns.