Principles of Tax-Efficient Fund Placement

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Bogleheads Investing Start-Up Kit: Implementing an Investment Plan

For Introduction to Investing and Asset Classes see Bogleheads Investing Start-Up Kit.

If your investments are all tax-deferred (or tax-free), you do not need to worry about fund placement issues. If you have a taxable account, you need to consider tax efficiency in deciding what fund to put in which account, which can have a profound effect after many years of compounding.

Contents

General Strategy

  1. Choose your basic asset allocation (stocks/bonds/cash) before worrying about taxes.
  2. If possible, put your most tax-inefficient funds in your tax-advantaged accounts (IRA, Roth IRA, 401(k), 403(b), etc.).
  3. If you would have to hold a tax-inefficient fund in a taxable account, consider a more tax-efficient alternative, such as a stock index fund rather than an active fund.

Order of Funds by Estimated Tax Efficiency

  1. Very inefficient
    • High-yield bonds
    • Real estate/REIT
    • Any high-turnover active stock fund
    • Small-cap active fund
  2. Moderately inefficient
    • Small-cap or value index (without ETF class)
    • Large-cap active fund
    • Bonds (consider municipal bonds or I bonds in taxable)
    • Small-cap value ETF, or index fund with ETF class
    • Large-cap value ETF, or index fund with ETF class
    • Small-cap or mid/cap growth/blend ETF, or index fund with ETF class
    • Small-cap international ETF, or index fund with ETF class
  3. Efficient
    • Emerging markets index
    • Tax-managed small-cap
    • Large-cap growth/blend index or total U.S.market index
    • Large-cap international index (if not a fund of funds)
    • Tax-managed large-cap
    • Tax-managed international

Using the Order

Any fund in the "Efficient" category is fine in a taxable account. In the "Moderately inefficient" category, you should consider an alternative but not necessarily use one; in particular, if you have to hold bonds in a taxable account in order to meet your target allocation, you should hold them. Do not hold funds in the "Very inefficient" category in a taxable account.

There is nothing wrong with holding a tax-efficient fund in your tax-deferred account if it fits your portfolio; in particular, the only decent option in many 401(k) plans is an S&P 500 index. However, if your 401(k) has no good fund in a tax-inefficient asset class, you have to consider the tax costs when deciding whether to hold only as much as you can put in your IRA or hold some in your taxable account.

Explanation for the estimated order

The tax cost of holding a fund depends on how much the fund generates in taxable distributions, and the tax rate on those distributions. For long-term holdings, estimation of tax costs necessarily depends on assumptions about future tax policy, such as that long-term gains will continue to be taxed at a lower rate than short-term gains or bond interest; or that the tax preference for "qualified dividends" will extend into the distant future; or that retirement plan distributions will not receive tax preferences at some future date.

Bond funds are tax-inefficient because their gains are almost all in ordinary income. Municipal bond funds have a hidden tax cost; while their gains are not taxable, they earn less than corporate bond funds of comparable risk. REITs, although they trade as stocks, are required to distribute almost all their income, and the income is taxable at the non-qualified dividend rate except for a small portion (historically about 15%) which is non-taxable because it compensates for depreciation of the property. (For details on the tax consequences of this return of capital distribution, refer to Vanguard REIT Index Tax Distributions).

Stock funds can be tax-inefficient if they generate a lot of capital gains, particularly short-term gains; they are also less efficient if they pay high dividends (although under current tax law, if most of the dividend stream is a "qualified" dividend, the tax burden is reduced.) Actively managed stock funds with high turnover sell most of their stocks with gains, generating large taxable gains. Even low-turnover active funds tend to generate more gains than index funds in the same asset class.

Index funds must also sell stocks which leave the index. Since small-cap or value stocks which rise in price tend to become large-cap or growth stocks, small-cap and value indexes generate capital gains. Tax-managed funds (which are willing to deviate from the index to minimize taxes), ETFs, and funds with an ETF class can eliminate many of these gains. Value indexes are less tax-efficient than growth or blend indexes because they have higher dividend yields.

If all else is equal, international funds have a small tax advantage over US funds, because they are eligible for the foreign tax credit. (Funds of funds, such as Vanguard Developed Markets Index Fund,[1] are not eligible for the credit. Use Vanguard Total International Stock Index Fund, Vanguard FTSE All-World ex-US Index Fund or Vanguard Tax-Managed International Fund instead.) All else is not necessarily equal; if an emerging market is reclassified as developed, an emerging-markets index fund will have to sell all its stock in that country, infrequently generating a large capital gain. A fund including both developed and emerging markets such as Vanguard FTSE All-World ex-US Index Fund avoids this risk.

A visual guide

Image:Taxeff.gif

Links

Academic Papers


Notes

  1. ↑ The Developed Market Index fund will transition to individual stock ownership over the 2009 fiscal year. The fund will thus become eligible for the foreign tax credit and will be suitable for taxable accounts. See this announcement of the change in investment policy.

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Tax Considerations
Tax Basics Tax Basics • Tax News Sources • Foreign tax credit
Strategic Tax Considerations Principles of Tax-Efficient Fund Placement • Tax-Adjusted Asset Allocation
Tax Management Whether to Reinvest Dividends in a Taxable Account • Delaying reinvestment of dividends • Timing of transactions to reduce taxes • Placing Cash Needs in a Tax-Advantaged Account • Donating Appreciated Securities
Tax Loss Harvesting Tax Loss Harvesting • Wash sale • Cost basis methods • Specific Identification of Shares
Tax Data IRS Tax Statistics • Vanguard Funds: Distributions


Managing Your IRA
Managing Investments Investment Policy Statement • Principles of Tax-Efficient Fund Placement • Target Date Retirement Funds • Vanguard LifeStrategy Funds
IRA Transfers IRA Rollovers and Transfers • IRA recharacterization • Net Unrealized Appreciation - NUA • Inheriting an IRA • Inheriting a Roth IRA
IRA Withdrawals Required Minimum Distribution • IRA Distribution Tables • SEPP:Substantially Equal Periodic Payments
Retrieved from "http://www.bogleheads.org/wiki/Principles_of_Tax-Efficient_Fund_Placement"
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