Tax-Efficient Funds and Asset Location

Most investors spend their energy choosing what to own and almost none deciding where to hold it. Yet once you have money in more than one kind of account, the same portfolio can be arranged so that it pays noticeably less tax, with no change in risk and no new purchases. This chapter covers two linked decisions: how to recognise a fund that is cheap to own in a taxable account, and how to place each holding in the account that taxes it least. The asset location calculator runs the arrangement for your own accounts.

What makes a fund tax-efficient

A fund held in a taxable account costs you tax whenever it pays you something, whether you wanted the payment or not. The tax-efficient fund is the one that pays you little you did not ask for.

Low turnover. A fund that rarely sells its holdings rarely realises gains it must distribute. Broad index funds, which change holdings only when the index does, usually have low turnover; many actively managed funds sell a large part of their portfolio each year.

The exchange-traded fund structure. When investors leave a mutual fund, the fund may have to sell holdings to pay them, realising gains that the remaining shareholders are taxed on. Most exchange-traded funds instead hand over shares of the underlying stocks to the large institutions that redeem them, which lets the fund shed low-basis shares without a taxable sale. As a result, many stock ETFs go years without distributing a capital gain. Some mutual fund companies offer an ETF share class of the same portfolio with the same advantage.

Qualified rather than ordinary income. A stock fund whose dividends are mostly qualified is taxed at long-term capital gains rates. Bond funds, real estate investment trusts and high-yield funds pay mostly ordinary income, taxed at your full bracket.

Red flags in a taxable account. A history of large December capital gain distributions, high turnover, a large share of short-term gains in past distributions, and a high tax cost ratio in a fund research service. Buying any fund shortly before its yearly distribution means paying tax on gains you did not share in; fund companies publish estimated distribution dates and amounts in the autumn.

The principle behind asset location

Each kind of account treats the same income differently.

• Taxable brokerage account. Interest and ordinary dividends are taxed each year at your full rate. Qualified dividends and long-term gains get the lower rates. Losses can be harvested (chapter 4). Heirs receive a stepped-up cost basis (chapter 7).
• Traditional 401(k) or IRA. Nothing is taxed while it stays inside, but everything that comes out, including what would have been a long-term gain, is taxed as ordinary income.
• Roth IRA or Roth 401(k). Nothing is taxed inside, and qualified withdrawals are tax-free, so growth there is never taxed at all.

From that follows the usual ranking. The least tax-efficient holdings, those paying ordinary income, benefit most from shelter and go in the tax-deferred account first. The holdings you expect to grow the most go in the Roth, since that growth is never taxed. Broad stock index funds, whose income is modest and mostly qualified, and municipal bonds, which are tax-exempt already, are the most comfortable in the taxable account.

What placing bonds well is worth

The cost of holding something in a taxable account is roughly its taxable yield multiplied by your tax rate on that yield, every year. That yearly cost can be treated like a fee.

Take $100,000 of bonds yielding 4.5%, held for 20 years by someone in the 24% bracket. Sheltered, it grows to about $241,171; held in a taxable account, where the interest is taxed each year, it reaches about $195,925. Holding them in the taxable account costs about $45,246.

The same amount in a stock index fund returning 7.0%, of which a 2% dividend is taxed at 15% each year, loses much less to tax in a taxable account: about $21,131 over the same period. So when only one of the two can be sheltered, sheltering the bonds saves more. (The stock fund's gains are still taxed when sold, which these examples leave out; that deferred tax is one more reason stocks tolerate a taxable account well.)

The ranking can flip. When bond yields are very low and expected stock returns high, or when the Roth is small, the arithmetic changes, and a household that will live mostly on Social Security in a low bracket may find the tax-deferred advantage smaller than assumed. That is why a calculator beats a fixed rule.

A placement routine you can follow

1. List every account with its balance and type: taxable, tax-deferred, Roth, HSA.
2. Set the overall mix first. Asset location never changes how much you hold in stocks and bonds overall; it only changes where each part sits. Decide the mix with the asset allocation calculator.
3. Fill the tax-deferred accounts with the least tax-efficient holdings: taxable bonds, real estate investment trusts, high-yield and actively traded funds.
4. Fill the Roth with the holdings you expect to grow most, often stock funds, including small-company and international stock if you hold them.
5. Put what remains in the taxable account, choosing tax-efficient index funds or ETFs. International stock funds have one extra reason to sit here: the foreign tax credit for taxes they paid abroad can only be claimed in a taxable account.
6. Rebalance with new money and inside the sheltered accounts first, where selling triggers no tax, and only sell in the taxable account when you must. The rebalancing calculator shows what to move.

Trade-offs worth knowing

Asset location makes each account's balance look different: the tax-deferred account full of bonds will grow slowly while the Roth full of stocks grows fast and swings more. Judge the household portfolio as a whole, not each account. It also makes the portfolio harder to manage across accounts, and a household that may need to spend from the taxable account soon may want some bonds there for stability. Finally, the benefit depends on future tax rates nobody knows; it is a strong tendency, not a guarantee.