Tax-efficient fund placement

🇺🇸

 is an issue facing investors holding assets in multiple accounts, both tax-advantaged and taxable accounts. The tax code recognizes different sources of investment income which are taxed at different rates, or, are taxed at a later time (tax "deferred"). An asset's tax efficiency (the impact of taxes on an investment) is affected by both its expected return and the tax rate on such return.

Some fund types, like total market stock index funds, are extremely tax-efficient, because they produce low dividends (that are mostly qualified) and capital gains. By contrast, bond funds can be extremely tax-inefficient, because the interest they produce every year is taxed at your full marginal tax rate. Other tax-inefficient investments are REITs, small value funds, and actively managed funds that frequently churn their holdings. Put tax-inefficient funds into tax-advantaged accounts to the extent possible.

All investors must pay their legally required taxes. This article describes how to minimize taxes through appropriate placement of investments in tax-deferred or taxable (pay taxes now) accounts.

General strategy
Due to the complexity of tax regulations and the multitude of possible investment scenarios, the suggestions in this article do not apply to everyone. While there is no "one rule fits all" concept, the strategies presented here are mostly intended to provide guidance to investors in the accumulation phase (saving for retirement).

In considering asset location keep the following points in mind:


 * If your investments are all in tax-advantaged accounts, fund placement will not have a large impact on your returns. Tax-advantaged accounts include tax-deferred accounts, such as traditional 401(k), 403(b), and Traditional IRA, and the tax-free Roth versions of those accounts such as Roth IRA.
 * If you have a taxable account, you should first consider whether it is better to move the money into a tax-advantaged account by contributing more to a tax-advantaged account.
 * If you are already contributing the maximum to every tax-advantaged account available to you, and you have additional funds to invest, you need to consider tax efficiency when choosing your funds.
 * Investors should always establish an emergency fund first, and then fund their work-based retirement account, HSA, or IRA before their taxable accounts. Tax-advantaged accounts are the most tax-efficient accounts, which should not be overlooked.

See Prioritizing investments for more on the above points.

If you have both tax-advantaged (retirement) and taxable accounts, you generally want to hold less tax-efficient assets in a tax-advantaged account and more tax-efficient assets in a taxable account. You must consider both the return and the tax rate. With higher bond yields conventional wisdom is to hold bonds in tax-advantaged accounts. Today low yields are common, and a bond fund with an expected return of less than 1% can be more tax efficient than a stock fund with an expected return of 7% even though the bond fund's return is taxed at a higher rate. It is best to understand the basic principles and then apply them to your situation.

Advantages of taxable accounts
The advantages for holding stocks in a taxable account include:


 * Lower tax rates. In tax-advantaged accounts, all investments are taxed equally (not at all in a tax-free account, or only on withdrawal in a tax-deferred account). In taxable accounts, almost all the return on bonds are taxed at your full rate every year, but most of the return on stocks is tax-favored:
 * Increases in stock prices do not lead to any tax until the stocks are sold, which offers an additional means of deferring taxes.
 * When the stocks are sold, the tax is usually at the lower rate for long-term capital gains.
 * If the stocks pay dividends, they are taxed every year, but qualified dividends are taxed at a lower rate.
 * Ability to harvest losses.
 * Ability to donate appreciated shares to charity, avoiding all taxes.
 * Estate planning; there is a potential for stepped-up cost basis upon death.

For example, suppose that you hold $10,000 in a stock index fund for 30 years, and it yields 2%, all qualified dividends are taxed at 15%, while earning 6% in increased stock prices for a pre-tax return of 8%. Every year, you pay 0.30% tax on the dividend, and reinvest the other 1.7%. After 30 years, you have $92,570, with a basis of $28,230 including reinvested dividends. When you sell, you pay $9,651 tax on the $64,340 capital gain, for a final value of $82,719, an annual return of 7.30%. Despite the 15% tax rate, your returns were only 9% less than the tax-free rate because you deferred taxes on the capital gains. If you harvested losses, donated some of the stock to charity, or left some to your heirs, your return would be even higher.

The advantages for holding bonds in a taxable account include:


 * Bonds have a lower expected return than stocks, and hence sometimes a lower tax cost.
 * Switching placement when necessary does not incur a large capital gains tax. If you hold stocks in a taxable account instead, large built-up unrealized capital gains makes it very difficult to switch even if switching would otherwise be beneficial.
 * Nominal treasury bonds, TIPS, and in-state muni bonds are not subject to the state income tax.
 * The effective tax rate on muni bonds is usually much lower than the highest marginal tax rate on ordinary income.
 * Interest from muni bonds is not included in Adjusted Gross Income (AGI), which determines eligibility for many income tax deductions and credits, whereas dividends and capital gains are included in AGI.

Tax rates
Tax rates are tabulated below: Mutual fund distributions and the tax consequences of selling funds are explained below:
 * Short-term capital gains distributions are made from realized gains on securities held for one year or less. Short-term gains are taxed at ordinary income tax rates up to 39.6%. Mutual fund short-term gain distributions are included in a fund's ordinary dividend distribution; therefore, capital losses may not be subtracted from these distributions when computing taxes.
 * Long-term capital gains distributions are made from realized gains on securities held for more than one year. They are reported on tax Schedule D along with any other capital gains, and can be reduced by capital losses.
 * Qualified dividends are the ordinary dividends.

A portion of your ordinary dividend may be nonqualified because it can include items like these:
 * Taxable interest. When a mutual fund receives taxable interest, the income gets paid out as a dividend. It is a dividend when it goes out of the mutual fund, but it was not a dividend when it came into the mutual fund, so it cannot be a qualified dividend.
 * Nonqualified dividends. Your mutual fund may receive dividends that are nonqualified. For example, the mutual fund may sell shares just 35 days after buying them, but after receiving a dividend. The mutual fund has to hold the shares at least 61 days to have a qualified dividend. Any amount the mutual fund receives as a nonqualified dividend gets paid to you as a nonqualified dividend.
 * Short-term capital gain. When a mutual fund has a short-term capital gain, it pays this amount to the mutual fund shareholders as an ordinary dividend.
 * Holding mutual fund shares less than 61 days. You should also be aware that any dividend you receive on mutual fund shares held less than 61 days is a nonqualified dividend, even if the mutual fund reports that amount to you as a qualified dividend. You do not have to buy the shares 61 days before the dividend is paid, but the total amount of time you hold the shares (including time before and after the dividend) has to be at least 61 days.

Almost all of the dividends distributed by equity REITS come in the form of non-qualified dividends. Non-qualified dividends are taxed at marginal income tax rates.


 * When you sell at a loss you will either offset capital gains which would have otherwise been taxed at your capital gains rate or you will offset income (up to $3,000 maximum per year) which would have otherwise been taxed at your marginal income tax rate, or both. If you offset capital gains that would have otherwise not been taxed at all (because your capital gains tax rate is 0%) then this part of the tax loss harvest may be an outright loss.
 * The Affordable Care Act imposes a Medicare surcharge of 3.8% on all net investment income (NII) once the taxpayer's adjusted gross income exceeds $200,000 (single) or $250,000 (married); while this tax is not part of the income tax, it has the same effect on investors as a higher tax rate. The NII tax begins to apply to individuals falling in the 33% tax bracket. Thus the top effective marginal tax rate is 23.8% on qualified dividends and long-term gains, 43.4% on ordinary investment income.

Tax efficiency of various asset classes
The table below illustrates the approximate tax efficiency ranking of various asset class funds.

Given reasonable assumptions, the "Very inefficient", "Moderately inefficient", and "Efficient" categories separate fairly clearly. The exact ordering within the categories depends not only on future tax policy, but also on assumptions about turnover, future returns, dividend yields, and qualified dividends.

A more complete discussion of bonds and bond funds, balanced funds, and stocks and stock funds follows.

See for specific examples of several mutual funds and ETFs.

Tax efficiency of bonds
Some investors see bonds or bond funds as tax-inefficient because almost all of the return comes from the dividend yield, which is fully taxed as ordinary income. In contrast, stocks get most of their return from price appreciation, which is not taxed until the stocks are sold and is taxed at the capital-gains tax rate. Therefore, these investors regard bonds as being less tax-efficient than stock index funds (which rarely sell stock) and hold bonds in tax-advantaged accounts when possible. However, low-yielding bonds do not have much return to be taxed, and since they do not grow as fast as other investments, an equal percentage lost from an investment is a smaller dollar loss; this makes low-yielding bonds somewhat more tax-efficient. Therefore, some other investors do just the opposite: they hold stocks with a higher expected return in tax-advantaged accounts when possible. You have to strike a balance between the expected return and the tax rate.

Treasury bonds are exempt from state taxes, and thus are tax-inefficient for federal taxes but may be desirable taxable investments for investors who pay high state taxes but low federal taxes. TIPS have the same tax-efficiency as their treasury bond equivalents; however, since taxes need to be paid annually on the inflation component, which is not received until the bond matures or is sold, this cash flow problem creates an additional reason to hold individual TIPS (as opposed to a fund) in a tax-advantaged account.

Municipal bond funds have a hidden cost; while their interest incomes are not subject to federal tax, they usually earn less than corporate or treasury bond funds of comparable risk. (The risk may be of a different type; intermediate-term municipal bonds have more credit risk than long-term treasury bonds, but less interest-rate risk, and thus may have a similar after-tax yield.) There are special rules regarding the taxation of Social Security benefits - municipal bond interest in a taxable account may result in additional Social Security benefits being taxable.

Tax efficiency of balanced funds
Balanced funds (stocks and bonds) are very popular among individual investors. These funds hold a variety of asset classes in one simple fund instead of several. They have a variety of names such as balanced, lifestyle, or target retirement funds. Since these funds include both stocks and bonds their tax efficiency sits somewhere between stocks and bonds.

If you have a balanced fund in a taxable account, you cannot sell only the bonds (to hold bonds in a different account, or to hold fewer bonds, or to hold a different type of bonds); you have to sell the whole fund, which can result in realizing a capital gain.

In a taxable account, the bond dividends will get taxed at ordinary income rates; in addition, the investor loses the option to harvest losses of individual asset classes. The more efficient strategy is to own the individual asset classes in separate funds and in their most tax-efficient locations.

Tax efficiency of stocks
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 both small-cap and value stocks can migrate to a large-cap or a growth stock index when they rise in price, small-cap and value indexes tend to generate realized 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 realized gains. Value indexes are less tax-efficient than growth or blend indexes because they have higher dividend yields; small-cap funds have lower dividend yields but fewer qualified dividends.

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). Under the 2018 tax law changes, some of the income from REITs is treated as qualified business income; only 80% of that income is taxed.

If all else is equal, international funds have a small tax advantage over US funds, because they are eligible for the foreign tax credit. 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 or [ Vanguard Total International Index Fund] avoids this risk.

Assigning asset classes to different accounts
Treat your entire portfolio as a whole (include spouse).


 * Consider what you already own. It may be inadvisable to pay additional taxes just to get a more tax efficient location. Even if your current location is not ideal it may be better to stick with certain aspects of it. This could mean keeping tax inefficient investments in a taxable account. Over time you can reduce the effect of a historically imposed asset location by not automatically reinvesting taxable distributions. Take any distributions in cash and reinvest them in a tax efficient manner.

Step 1: Categorize your portfolio's tax efficiency
Understand the tax consequences of holding each of your chosen investment assets based on the tax-efficiency of each asset class.

Step 2: Place your least tax efficient funds first
Fill your tax-advantaged accounts with your least efficient funds. Exhaust these accounts before putting these funds into your taxable account; if you run out of room, consider more tax-efficient alternatives, such as a stock index fund rather than an active fund or a muni bond fund rather than a total-market bond fund. An example portfolio with three asset classes (a total market US stock market index fund; a total market international stock market index fund, and an intermediate taxable bond fund,) is shown below. Note that in this scenario, we assume bond interest rates have a higher tax cost than stock investments.

Step 3: Placing international stock funds in the taxable account
It is sometimes possible to get tax credit for foreign taxes paid from international stock funds, but this opportunity is lost in tax-advantaged accounts. If all else is equal, the existence of the credit may make it advantageous to prioritize these funds in the taxable account. Whether or not the foreign tax credit is sufficient depends on such factors as the the percentage of the fund's foreign source income component, the foreign tax rate, the percentage of the foreign dividends that are qualified, and the the US marginal tax bracket of the fundholder.

Step 4: Place high growth stock funds
If all else is equal (and it often is not, because you may have different options in your 401(k) and your Roth IRA), it is slightly better to have the fund with the highest expected return in your Roth account or HSA, because these accounts are free from Required Minimum Distributions (RMDs), are not counted as income for making Social Security taxable, and probably are less subject to the risk of changing tax rates.

Step 5: Place tax efficient funds last
Tax-efficient funds are fine in any account. Regular rebalancing of your stock/bond ratio is particularly easy if you have enough room in your tax-advantaged accounts to hold some of your tax-efficient stock fund, because the stocks and bonds can be exchanged without tax consequence. Rebalancing in a taxable account is often best done by investing new money so that capital gains can be avoided.

Criticisms of this tax placement strategy
Due to higher returns, equities have the potential to expand tax-advantaged space, leading to higher tax savings later on despite higher tax bills in the present. This is particularly true at the presently low bond yields, when the tax penalty from bonds in taxable is not as high as it has been in the past.

The situation may change in retirement, when the funds are withdrawn for income (decumulation phase). It is possible under some combinations of lifetime investment results and lifetime individual tax situations to be better off doing the opposite of the strategy recommended here.

This article may be biased towards investors who can fill tax-advantaged space and are looking to invest more. However, some investors (especially those just starting out) are unable to fill all this space. This can make this strategy confusing and possibly counterproductive if, for example, someone is buying international equities in taxable space without filling tax-advantaged space just to get the foreign tax credit.

This article states that cash and low-yielding bonds are tax efficient, but then contradicts this somewhat by then classifying "most bonds" as tax inefficient. When interest rates are low, bonds are more tax-efficient. If bonds are tax-efficient now, and then yields rise to make them less tax-efficient, you can go from bonds in taxable to bonds in tax-advantaged with little, no, or negative tax cost; therefore, it is reasonable to hold bonds in a taxable account now and switch later if appropriate. In contrast, switching from stocks to bonds in taxable will result in a significant tax cost.

Appendix: comparison of hypothetical tax costs
For buy and hold investors, 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 the expected returns and 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. The following tax costs math helps identify high tax cost candidates for tax-advantaged accounts.

Table 1 assumptions use historical data available from Vanguard's index funds in the Vanguard fund distributions tables, which is used as a guide for qualified dividends, and the relative yields of value, small-cap, and tax-managed funds. Future capital gains are uncertain, but the table now assumes that all ETFs will avoid capital gains, as most ETFs have done so. Interest for bond funds is based on historical rates, not current rates, because the numbers are easy to measure; a bond which has a 6% yield loses 1.32% to taxes in a 22% tax bracket whether that is the current yield on a short-term bond or a long-term bond. The "tax cost" listed for municipal bonds is the hidden cost, the amount an investor loses in returns to avoid paying the tax; it is based on an assumption that municipal bonds yield 75% as much as taxable bonds of comparable risk.

Moreover, Table 1 is based on the assumption that foreign dividend yields will remain higher than US yields, as has been true since 2008; foreign yields are assumed to be 1.5 times US stock yields (before foreign taxes are withheld). ''If foreign yields become equal to US yields, then the tax costs of foreign funds must be multiplied by 2/3. Thus, in the table, US and foreign funds are about equally tax-efficient, but if foreign yields become lower, foreign funds will be somewhat more tax-efficient.''

There are two types of tax costs: the cost you pay every year, and the costs you pay when you sell. Bond funds have little or no tax cost when you sell, since almost all the return from bonds is from interest. When you sell a stock fund, you will pay capital-gains tax on the difference between the total amount you invested (including reinvested dividends) and the current value.

Table 2 indicates the additional cost for the capital-gains tax when you sell, assuming that you pay taxes on the distribution and reinvest the after-tax portion of the distribution; since it is a one-time cost, the effect is annualized. For example, if you hold an investment for 30 years and lose 10% to taxes when you sell, that is equivalent to losing 0.35% every year. Thus, if you sell the fund, your cost will be the sum of the Table 1 and Table 2 costs. However, you would not pay the Table 2 cost on any stock which you either leave to your heirs or donate to charity, and thus may not pay that cost on your full investment. In particular, you might estimate your total tax cost by using the low-return line in Table 2; if stock returns are high, you will have a large taxable account and will reduce the tax cost by taking longer to deplete it or by not spending it all during your lifetime.

The tables use a 15% tax on qualified dividends and capital gains for an investor in the 22% bracket, and 23.8% (including the 3.8% Medicare surtax) on qualified dividends and capital gains, 40.8% on ordinary investment income, for an investor in the top 37% bracket. The final column of the second table (in the top tax bracket) assumes a tax rate of 0.46% for the tax-efficient fund, and 1.50% for the tax-inefficient fund. The foreign tax credit is added to the dividend yield before computing taxes; for example, if a fund had $100 withheld in foreign taxes on dividends, and you pay $20 in taxes on the withheld dividends, you get a $100 credit for a net benefit of $80. Although not tabulated, keep in mind that investors in the lower tax brackets (12% or lower) pay no tax at all on qualified dividends and capital gains, and reap higher after-tax returns, outside of tax-exempt municipal bonds, in all asset classes.

Example
An investor in the 22% marginal tax bracket wants to compare the tax efficiency of a total-market index fund and a bond fund yielding 3% (0.66% tax cost). Since these funds are likely to be sold at some point, we can use Table 2 to project an estimate of the range (depending upon whether future returns are low or high) of the total annualized cost. The estimate shows that holding the bond fund in a tax-deferred account is likely to be slightly better over a long holding period; if the stock market returns are high, most of the stock will not be sold.

Blog posts

 * Tax Efficiency: Relative or Absolute?, by forum member tfb.