Tax-Efficient Income in Taxable Accounts: What You Need to Know
When people think about tax efficiency, retirement accounts like IRAs and 401(k)s usually come to mind first. Many investors are surprised to learn that taxable brokerage accounts can allow them to take advantage of significant tax-efficiencies.
In fact, taxable accounts offer several ways to earn tax-efficient investment income, including municipal bond interest, qualified dividends, and long-term capital gains. These types of income are taxed at lower rates than ordinary income — and in some cases, may not be taxed at all.
Understanding how tax-efficient income works in taxable accounts can help you make more informed investment decisions and keep more of your returns over time.
How Taxable Brokerage Accounts Are Taxed
Before exploring the advantages, it helps to understand how investment income in taxable accounts is generally taxed.
The three most common types of investment income are:
Interest income, typically taxed at ordinary income tax rates
For example, income from high-yield savings and money market funds
Dividend income, which may be taxed at either ordinary or tax-efficient rates
Capital gains, which are only taxed when investments are sold and may be taxed at either ordinary or tax-efficient rates depending on how long you’ve held the investment
Not all investment income is taxed equally. Certain types of income qualify for lower tax rates or tax exemption, making taxable accounts more tax-efficient than many investors realize.
1. Municipal Bond Interest: Tax-Free Income for Many Investors
Municipal bonds are issued by state and local governments to fund public projects such as schools, roads, and infrastructure. One of their most important features is that municipal bond interest is generally exempt from federal income tax.
In some cases, municipal bond interest may also be exempt from state income tax if you live in the state where the bond was issued.
This makes municipal bonds one of the most well-known sources of tax-efficient income in taxable accounts.
For example:
If you earn $4,000 in municipal bond interest, you may owe no federal income tax on that income.
By contrast, $4,000 in interest from a corporate bond or savings account would typically be taxed at your ordinary income tax rate. (If you’re in the 24% tax bracket, you’d only keep $3,040.)
Because of this tax treatment, municipal bonds can be especially valuable for investors seeking tax-efficient income, particularly those in moderate to higher tax brackets.
2. Qualified Dividends: Lower Tax Rates on Stock Income
Dividends are payments made by companies to shareholders. While some dividends are taxed at ordinary income tax rates, qualified dividends are taxed at long-term capital gains tax rates.
For many investors, qualified dividend tax rates are:
0% for lower taxable income ranges
15% for most investors
20% for the highest income levels
These rates are significantly lower than most ordinary income tax rates.
Investing in qualified dividend paying stocks (whether individually or via a fund) means investors can earn ongoing income from their portfolios while benefiting from preferential tax treatment on qualified dividends.
3. Capital Gains: Tax Deferral and Lower Tax Rates
One of the most powerful tax advantages of taxable accounts is how capital gains taxes work.
Capital gains taxes are only triggered when you sell an investment for a profit. This creates two important tax advantages: tax deferral and lower tax rates.
Tax Deferral: You Control When You Pay Taxes
If your investment increases in value but you do not sell it, you do not owe capital gains tax yet.
For example:
You invest $25,000 in a stock or fund
The value grows to $40,000
You have a $15,000 unrealized capital gain
If you continue holding the investment, you owe no capital gains tax at that time
This allows your full investment balance to remain invested and compounding, which can significantly improve long-term after-tax returns.
This feature makes taxable accounts surprisingly tax-efficient for long-term investors.
Lower Long-Term Capital Gains Tax Rates
When you sell an investment held for more than one year, the gain is taxed at long-term capital gains tax rates, which are lower than ordinary income tax rates.
For many investors, long-term capital gains tax rates are:
0% for lower taxable income ranges
15% for most investors
20% for the highest income levels
This favorable tax treatment is one of the key reasons taxable brokerage accounts remain an important part of a tax-efficient investment strategy.
Why Taxable Accounts Are More Tax-Efficient Than Many Investors Expect
While retirement accounts offer important tax benefits, taxable brokerage accounts provide flexibility and tax advantages of their own.
Taxable accounts allow investors to benefit from:
Tax-free municipal bond interest
Lower tax rates on qualified dividends
Lower tax rates on long-term capital gains
Control over when investment gains are realized
The ability to defer capital gains taxes indefinitely
Investors also receive a step up in the cost basis of the investment upon their passing. This benefits your heirs as they can sell the investment at that time with little to no taxable gain.
This combination makes taxable accounts a valuable complement to retirement accounts, particularly for long-term investing and income (cash flow) planning.
Tax-Efficient Investing Is About Structure
Tax efficiency is not about chasing complexity. Often, it comes from understanding how different types of investment income are taxed and structuring your portfolio accordingly. Over time, awareness of these tax efficiencies can improve your after-tax returns and support your long-term financial goals.
I recommend that you speak with a professional before taking action in your portfolio to ensure that any changes are aligned with your specific goals and your tax situation. If you are looking for a professional to discuss your portfolio’s tax efficiency with, consider booking a strategy session with Coriander Financial Group.
