Tax-efficient fund placement

Last major update: 05/15/08

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-deferred accounts (IRA, 401(k), 403(b)).
 * 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
 * 2) *High-yield bonds
 * 3) *Real estate/REIT
 * 4) *Any high-turnover active stock fund
 * 5) *Small-cap active fund
 * 6) Moderately inefficient
 * 7) *Small-cap or value index (without ETF class)
 * 8) *Large-cap active fund
 * 9) *Bonds (consider municipal bonds or I bonds in taxable)
 * 10) *Small-cap value index (with ETF class)
 * 11) *Large-cap value index (with ETF class)
 * 12) *Small-cap international ETF
 * 13) *Small-cap or mid/cap growth/blend index (with ETF class)
 * 14) *Emerging markets index
 * 15) Efficient
 * 16) *Tax-managed small-cap
 * 17) *Large-cap growth/blend index or total U.S.market index
 * 18) *Large-cap international index (if not a fund of funds)
 * 19) *Tax-managed large-cap
 * 20) *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.

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 most of their income as taxable dividends rather than keeping it.

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. 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 also 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 Total International Index Fund are not eligible for the credit; in a taxable account, use 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.