7 Investments to Keep Out of Your Taxable Account

Taxable bonds and bond funds. Most of a bond's return is interest income, and that income is taxed at your ordinary income rate, not the lower capital gains and qualified dividend rates that apply to most stock gains. High-yield bond funds generate especially large amounts of current income, which makes them a particularly poor taxable-account fit. Treasury Inflation-Protected Securities are a specific trap: you're taxed each year not only on the stated interest but also on the inflation adjustment to principal, income you receive on paper long before you ever see the cash, sometimes called phantom income. If you're in a higher bracket and need to hold bonds in a taxable account for a shorter-term goal, municipal bond interest is exempt from federal income tax, and a state-specific muni fund can also avoid state income tax, which is often the better after-tax choice there.

Multi-asset funds: target-date funds and balanced funds. These hold a taxable bond sleeve as a matter of design, and their allocation either stays fixed or gets more conservative over time on a schedule the fund manager sets, not you. That glide path requires selling appreciated stock holdings to fund the shift into bonds, which can trigger capital gains distributions you didn't ask for and don't get to time. A handful of tax-managed balanced funds have kept this cost low through careful management, but the structural exposure to forced rebalancing sales doesn't go away, it's just been managed well so far.

Actively managed equity funds. A fund manager who sells a winning position to fund a redemption, rotate a strategy, or respond to a manager change realizes a capital gain that gets distributed to every shareholder still holding the fund at year-end, including you, whether or not you personally sold anything. Years of net outflows from active funds toward index funds and ETFs have made this worse industry-wide: managers increasingly have to sell appreciated holdings to meet redemptions, and some funds have become serial distributors of large capital gains as a result. Broad-market index funds and ETFs are structured to avoid this almost entirely, which is the main reason they're dramatically more tax-efficient in a taxable account, not because the underlying stocks are different.

High-dividend-paying stocks and dividend-focused funds. Dividend income isn't discretionary the way a capital gain is. If you hold an appreciated stock that pays no dividend, you control exactly when you realize the gain, including never, if you'd rather pass it to heirs with a step-up in basis. A dividend payer sends you taxable income on the company's schedule regardless of what you'd prefer, every quarter, whether or not you wanted the cash or the tax bill that year.

REITs and REIT funds. REITs are legally required to distribute at least 90% of their taxable income to shareholders every year, so a large share of your total return from a REIT arrives as a mandatory cash distribution, not a gain you can choose to defer. Most of that distribution is also taxed as ordinary income rather than at the lower qualified dividend rate, because REIT dividends generally don't meet the qualified dividend holding-period and income-type requirements. Both factors compound in a taxable account: high income, taxed at your highest rate.

Commodities futures funds. Funds that track commodities typically do it through futures contracts, and futures held past year-end are marked to market for tax purposes under IRC Section 1256, regardless of whether you actually sold anything. Section 1256 contracts are also taxed on a fixed 60% long-term, 40% short-term split no matter how long you actually held the position, which means a big chunk of your gain gets taxed at short-term ordinary rates even if you held the fund for years.

Alternatives funds. This is a broad, mixed bag of strategies, and tax efficiency varies widely across it, but several common alternative strategies involve frequent trading, derivatives, or complex structures that generate taxable events independent of your own buy-and-hold decisions. Given that many alternatives funds also carry modest return profiles to begin with, a meaningful tax drag can consume a disproportionate share of what you actually earn.

As a general rule, use your taxable account for broad-market index funds, individual stocks you plan to hold, and municipal bonds if you're in a higher bracket. Use your IRA, 401(k), or Roth for the bond sleeve, the REIT allocation, the actively managed fund you believe in, and the dividend or alternatives strategy you want exposure to.

This is a placement decision, not an ownership decision. None of these seven categories are bad investments to hold, they're just a bad fit for the account type that taxes their income and gains every year regardless of your own plans.

• Assuming a fund is tax-efficient because it's labeled conservative or income-focused. Bond funds, REIT funds, and high-dividend funds are usually the least tax-efficient categories precisely because they're designed to generate current income.
• Buying TIPS in a taxable account for inflation protection without realizing you'll owe tax on the inflation adjustment to principal well before you receive that money.
• Holding an actively managed fund in a taxable account for years without issue, then getting hit with a large, unplanned capital gains distribution the year a new manager takes over or shareholder redemptions spike.
• Chasing dividend yield in a taxable account without accounting for the fact that you don't control when that income arrives or how much of it counts as ordinary income versus qualified.