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Retirement vs. Taxable Accounts: What Goes Where?

March 20, 2013
Jonathan Clements, Director of Financial Education, Citi Personal Wealth Management

You might have both regular taxable accounts and also retirement accounts, such as a 401(k) plans and Individual Retirement Accounts. But which investments should you hold in which?

Everybody's financial situation is different, of course. Still, you might look to hold tax-inefficient investments in your retirement accounts, where any earnings can grow tax-deferred or, in the case of a Roth IRA or Roth 401(k), potentially tax-free. Meanwhile, for your taxable account, you might steer clear of investments that generate ordinary income, which can be taxed at a maximum 39.6% federal rate in 2013, and instead favor investments that could deliver qualified dividends and long-term capital gains, both of which are taxed at a maximum 20%.

For instance, actively managed stock funds often do a fair amount of trading that leads to large taxable distributions, including short-term gains that are subject to ordinary income-tax rates. But if these funds are in a retirement account, you don't have to worry about portfolio turnover leading to big tax bills. Other candidates for your retirement account include taxable bonds, which generate a lot of immediately taxable income, and real-estate investment trusts, which pay dividends that are taxed as ordinary income.

What about your taxable accounts? You might lean toward investments that are more tax-efficient, such as stock-index funds, tax-managed funds, long-term individual stock holdings, and municipal bonds and bond funds. That said, you shouldn't let the tax tail wag the investment dog. Yes, it's good to save on taxes. But it's more important to manage risk by being broadly diversified--and that might mean holding tax-inefficient investments in your taxable account.

INVESTMENT PRODUCTS: NOT FDIC INSURED • NO BANK GUARANTEE • MAY LOSE VALUE


Citigroup, Inc. and its affiliates do not provide tax or legal advice. You should seek advice based on your particular circumstances from an independent tax advisor. To the extent that this material or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Diversification does not protect against loss or guarantee a profit.

Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer's credit rating, or creditworthiness, causes a bond's price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.

Depending on your state of residency, some bonds may be exempt from state and local taxes; however, interest may be subject to the federal Alternative Minimum Tax.

REITs are subject to special risk considerations similar to those associated with the direct ownership of real estate. Real estate valuations may be subject to factors such as changing general and local economic, financial, competitive, and environmental conditions. REITs may not be suitable for every investor.

Dividend income from REITs will generally not be treated as qualified dividend income and therefore will not be eligible for reduced rates of taxation.

©2013 Citi Personal Wealth Management is a business of Citigroup Inc., which offers investment products through Citigroup Global Markets Inc. ("CGMI"), member SIPC. CGMI and Citibank, N.A. are affiliated companies under the common control of Citigroup Inc. Citi and Citi with Arc Design are registered service marks of Citigroup Inc. or its affiliates.

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