The Most Tax-Efficient Investment
Thursday, May 26, 2016

An AAII member recently asked, “What is the most tax-efficient investment?" Before you answer, stop and give the question some thought. The answer is not as straightforward as it may seem.

A few factors influence the tax efficiency of investing. One, of course, is the type of investment. Municipal bonds receive very favorable tax treatment, particularly if they are held until maturity.

A stock held for the long term can also be very tax-efficient. Since it is held for more than one year, it will qualify for long-term capital gains. An individual stock also gives the investor the ability to sell shares in increments. The latter allows any capital gains to be recognized over time, thereby limiting the size of the tax bill for any calendar year. Losses can also be strategically realized to reduce taxes. Mutual funds, even those managed in a tax-efficient manner, do not give shareholders any control over the timing of distributions.

Another factor is the type of account used. A Roth IRA is funded with aftertax dollars. Once taxes are initially paid (albeit at ordinary income tax rates), no additional taxes will be due. All capital gains accrue tax-free. Similarly, all income received will be tax-free. Even withdrawals are tax-free, subject to certain restrictions regarding age and holding periods.

Health savings accounts (HSAs) offer similar advantages, though with tighter restrictions regarding withdrawals. Capital gains and income accrue tax-free in traditional IRAs. Withdrawals are taxed at ordinary income rates, but those tax rates may be lower in retirement for those earning high incomes during their working years.

Then there is the strategy. An active trading strategy will realize more capital gains, and very possibly short-term capital gains taxed at ordinary income rates. Dividends are taxed at ordinary income rates if the stock is held for the less than the mandatory 61-day period to qualify for the reduced 15% tax rate (20% for high-income earners). Even an exchange-traded fund can be tax-inefficient if it is frequently bought and sold.

The final, and perhaps biggest, influence is the type of account an investment is held in. Referred to as asset allocation, this strategy uses the tax rules to your advantage. Place the least tax-efficient investments and use the least tax-efficient strategies in your tax-preferred accounts. Use your taxable accounts for the most tax-efficient investments and strategies. IRAs (traditional and Roth) are good for avoiding the tax bite of corporate bonds, mutual funds that are not tax-efficient, and investing strategies with higher levels of turnover. Traditional brokerage accounts are better suited for index funds, tax-efficient exchange-traded funds, long-term stock holdings and municipal bonds. A simple rule of thumb is to place investments that are taxed at your ordinary income tax rate in traditional and Roth IRAs.

Realize there is no single golden rule that will apply in every situation. Some judgment calls will need to be made based on your various accounts and investments. For example, losses realized in a taxable account can be used to offset gains; losses realized in IRAs cannot. If you are unsure of what the optimal strategy for your situation is, it can be worth the cost to speak with a tax professional.

More on AAII.com

The Week Ahead

The U.S. financial markets will be closed on Monday. On behalf of everyone at AAII, I wish you a happy and sunny Memorial Day.

Just three members of the S&P 500 will report earnings next week as first-quarter earnings season wraps up: Medtronic (MDT) on Tuesday, Michael Kors Holdings (KORS) on Wednesday and Broadcom (AVGO) on Thursday.

The week’s first economic reports will be April personal income and outlays, the March S&P Case-Shiller housing index, the May Chicago PMI and the Conference Board’s May consumer confidence survey, all of which will be released on Tuesday. Wednesday will feature the May ADP Employment Report, the May PMI manufacturing index, the May ISM manufacturing index, April construction spending and the Federal Reserve’s periodic Beige Book. May jobs data (including the unemployment rate and the change in nonfarm payrolls), April international trade, April factory orders and the May ISM non-manufacturing index will be released on Friday.

Only two Federal Reserve officials will make public appearances: Federal Reserve Board Governor Jerome Powell on Thursday and Chicago president Charles Evans on Friday.

What’s Trending on AAII
  1. Dividend Safety Signs and Warning Flags

  2. Chasing Dividend Yield for Income: Three Reasons to Be Wary

  3. Why Buy Bonds If Interest Rates Will Rise?

AAII Sentiment Survey

The percentage of individual investors optimistic about short-term gains occurring in the stock market is at its lowest level in 11 years. At the same time, the percentage of investors describing their outlook as neutral is at its highest level in 16 years, according to the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, declined 1.6 percentage points to 17.8%. This is the lowest level of optimism recorded by our survey since April 14, 2005 (16.5%). It is also the 29th consecutive week and the 62nd out of the past 64 weeks that bullish sentiment has been below its historical average of 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, jumped 6.3 percentage points to 52.9%. Neutral sentiment was last higher on April 12, 1990 (56.0%). Neutral sentiment has now been above 40% for 12 consecutive weeks and above its historical average of 31% for 17 consecutive weeks, as well as for 69 out of the past 73 weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 4.7 percentage points to 29.4%. The historical average is 30%.

Since the AAII Sentiment Survey started in June 1987, a neutral sentiment reading above 50% has only been recorded 28 times. Only six of those readings were recorded after 1989 (January 1991, July 1991, August 1994, February 2003, December 2015 and this week). The remaining 22 readings are all from the approximate two-year span of December 1987 through October 1989. On average, the S&P 500’s 26- and 52-week returns following such occurrences were 8.4% and 20.5%, respectively.

Even rarer is having bullish sentiment below 20% and neutral sentiment above 50% on the same week. This week is just the sixth time such a combination has happened. It previously occurred four times in 1988 and once in 1989. On average, the S&P 500’s 26- and 52-week returns following those five occurrences were 11.2% and 25.7%, respectively.

More information is available on the AAII Blog. This morning we posted a table showing every occurrence neutral sentiment was above 50% and the market’s subsequent returns, as well as a table showing the six weeks with bullish sentiment below 20% and neutral sentiment above 50%. In addition, last week we published a listing of the previous 30 sub-20% bullish sentiment readings and the S&P 500’s subsequent returns. Keep the small sample size and the dates of those readings (especially with neutral sentiment) in mind when reviewing the data.

Giving individual investors cause for concern is the slow pace of U.S. economic growth and uncertain global economic growth, terrorism and global unrest, lackluster corporate earnings, the prevailing level of valuations, the forthcoming election and monetary policy. Some AAII members, however, are encouraged by sustained domestic economic growth, corporate earnings and still comparatively low energy prices.

This week’s special question asked AAII members how first-quarter earnings have influenced their outlook for stock prices. Slightly more than one out of four respondents (27%) said that quarterly results have not altered their outlook. Many said they don’t alter their expectations based on quarterly results, while several others pointed to other factors (namely the November elections and monetary policy) as having a larger impact. Nearly 22% viewed first-quarter earnings as not being good or supportive of current stock prices. Just 5% of respondents feel more positive in reaction to first-quarter earnings.

Slightly more than 7% of respondents simply described their outlooks as pessimistic without mentioning earnings. Several others described market volatility and the upcoming presidential election as impacting their outlook.

Here is a sampling of the responses:

  • “Corporate earnings are slowing and/or stagnating. This will have a negative impact on stocks in general.”
  • “Way too much Fed speak for stocks to go up no matter what earnings are.”
  • “Expecting stocks to retreat until after the November election.”
  • “I feel earnings have been better than expected, so I’m slightly more bullish.”
  • “No influence. I do not pay a lot of attention to short-term earnings and projections.”


This week’s Sentiment Survey results:

Bullish: 17.8%, down 1.6 points
Neutral: 52.9%, up 6.3 points
Bearish: 29.4%, down 4.7 points

Historical averages:

Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!