Where you hold an investment matters

You'll probably be reviewing your investment portfolio at year-end for tax and rebalancing purposes. As part of your review, check to be certain you are holding your specific investments in the right type of account. Your goal is to hold investments that produce ordinary taxable income in tax-deferred accounts and to hold those that produce tax-free or tax-favored income in your regular taxable accounts.

Consider this situation. If you hold tax-free municipal bonds in a tax-deferred retirement account, you are "sheltering" interest income from taxes that never would be taxed in the first place. Withdrawals from the retirement account will be taxed as ordinary income at rates up to 35%, and that includes interest from the municipal bonds. The result is that normally tax-exempt earnings eventually become subject to income tax.

Another example: Long-term capital gains are taxed at lower rates than interest income. So investments generating interest might be better held in retirement accounts, while investments generating capital gains might be better held in taxable accounts. Remember, withdrawals from retirement accounts (other than Roth IRAs) are taxed at ordinary income rates even if the income comes from long-term capital gains.

Tax-deferred retirement plans should outperform an investment account that is exposed to annual taxation. But if you're not careful where you hold specific types of investments, you could end up with less rather than more income.