Talk:Tax-efficient fund placement

I don't agree with the idea that an Emerging Stock Market Index is very tax efficient. Once a country transitions between emerging to developed, all the companies in the emerging market index would have to be sold and bought in a different index. Possibility for lots of capital gains. (NYCPete)

When this happens, it will lead to a lot of capital gains. If South Korea were promoted from emerging to developed, then since it is 15% of Emerging Markets Index and probably 5% of the basis, that would mean a 10% capital gain distribution, all long-term, and a 1.5% tax bill. However, that is a fairly rare event; if it happens once every ten years, the annualized tax cost would be 0.15%. The other tax disadvantage of emerging markets is that the dividends are only 2/3 qualified, which is currently a tax cost of 0.12% in the top tax bracket. The sum of those two extra tax costs is just about equal to the tax savings from the foreign tax credit; therefore, emerging market indexes are not quite as good in a taxable account as developed or US market indexes, but the difference is small enough that emerging markets should still be placed in a taxable account in preference to anything else. Grabiner 11:54, 25 May 2008 (EDT)

Based on expected tax rates
I think there should be a comment here that this placement recommendation is making some basic (and well reasoned) assumptions about future tax law. What do you think? --Edge 20:39, 29 May 2008 (EDT)


 * Good idea, and I have added a sentence. Grabiner 23:19, 29 May 2008 (EDT)

I would suggest deleting the return-of-capital section; it is useful in the REIT page, but it is too large a part of this page, and it isn't the main point of the page. A correction mentioning that almost all, rather than all, of the REIT income is taxable might be useful. Grabiner 23:39, 3 June 2008 (EDT)


 * The table is gone now, but I would still suggest deleting the return-of-capital section as a separate section, with a wording in the main text such as, "REITs 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." Grabiner 22:19, 4 June 2008 (EDT)

This article needs some introduction for the context. For example if all your accounts are tax deferred accounts, don't even worry about any of these.


 * Done; this also allowed me to point out that the principles are still important even if all your investments are taxable.Grabiner 23:17, 6 June 2008 (EDT)

Bringing the ordering up to date
With the established record of ETFs, I believe we should move non-value ETFs (and Vanguard funds with an ETF class) up to the Efficient category. (Value ETFs should stay in the middle category until it is determined what happens to qualified dividends in 2011; they won't be tax-efficient if their high dividend yields are taxed at your full tax rate.) I would also suggest either deleting or updating the pictorial guide, which was good at the time it was writted but predates ETFs (and thus tax-efficient small-cap index funds).Grabiner 03:01, 28 April 2010 (UTC)


 * From my perspective, the tabular list (Order of Funds by Estimated Tax Efficiency) is too difficult to understand. I suspect this is why the pictorial guide was created in the first place. If you can suggest an updated hierarchy using simplified categories, I can update the guide. I don't have the original image, but I do have PowerPoint. --LadyGeek 02:18, 29 April 2010 (UTC)


 * The pictorial guide is older than the tabular list, and if we update both, then the pictorial guide can match the tabular list.Grabiner 01:40, 30 April 2010 (UTC)

I deleted the original pictorial guide, but created a similar layout with the existing tabular list (and new arrow). To me, this is easy to read. The table is ready for editing. ETFs have recently become very popular, so this list needs an evaluation to be sure it's current (I don't have the background to do it). --LadyGeek 01:37, 6 May 2010 (UTC)


 * And I removed the preference for tax-deferred over tax-free for the most tax-inefficient assets; this was never correct. (It may be better to put higher-returning assets in a Roth, but that is not the same issue.) Grabiner 02:55, 6 May 2010 (UTC)


 * I think the pictorial diagram looks good now, except for the big gap at the top (at least on my screen width); can anyone fix that on the wiki?Grabiner 03:12, 6 May 2010 (UTC)

I modified centered the table vertically inside the cell, scaled the arrow, and added a cell for better separation. I left comments in the code to show what I did. Edit the page or look at the history to view. --LadyGeek 01:40, 7 May 2010 (UTC)

Reordering of page
I think the order of funds by tax-efficiency (with the colored arrow) should be put back near the top, followed by the explanation, as it is the most important point for most readers. We can discuss the theory further down in the page, but the order should be where newbies will see it.Grabiner 12:49, 29 January 2011 (EST)

I moved the table usage directly after the table itself, the sections should go: Overview, general strategy, fund placement table, how to use the table, detailed explanation. Also note that the fund placement table is used in Investing FAQ for the Bogleheads Forum. It was already out of sync, so I changed that page to utilize the table source from here (wiki's transclusion operation).--LadyGeek 12:29, 30 January 2011 (EST)

Controversial?
The reason for the controversy should be noted. If there will never be a consensus, perhaps the controversy marker should be removed and just state that the placement is subject to judgment. The detailed explanations are very helpful. --LadyGeek 12:29, 30 January 2011 (EST)
 * forum link--Blbarnitz 13:46, 30 January 2011 (EST)

Bond taxation
The 4th paragraph in "Hypothetical tax costs for comparison" states: "Bond funds are tax-inefficient because their gains are almost all in ordinary income."

This is unclear to me, what gain aspect is inefficient? Bond fund gains / losses are treated the same as a mutual fund - Tax Treatment on a Bond Mutual Fund. Is the intent to say that the dividends are treated as ordinary income, which is taxed at the marginal rate, and therefore represent an inefficiency (?).

I don't understand capital allocation as described in the same article. Is allocation something an investor would never see(?).

"When a mutual fund actually adds value, this is considered a capital gain. The gains can be distributed or allocated. Most mutual funds distribute the capital gains. On a traditional mutual fund, capital gains qualify for some preferred tax treatment if they are distributed in the long term. Short term capital gains are treated as ordinary dividends, though. It is rare for a mutual fund, specifically a bond mutual fund, to use capital allocation. This would actually raise the value of the principal of your bond. If this occurs, however, the taxes would need to be filed as an allocation and not a distribution."

Bond Basics could also use some clarification. "How" bonds are taxed should be added before the "Where bonds are ranked in tax order".

I'm hesitant to update these sections myself, as I'm unclear on the subtleties involved.

--LadyGeek 21:33, 1 February 2011 (EST)

There is little tax difference between bonds and bond funds. The issue with bonds is that almost all the gains from bonds are taxed at your full tax rate; in contrast, most of the gains from stocks are deferred, and when taxed, are taxed at the capital-gains rate.

Here's a link to Fairmark's explanation of capital allocation. A fund is allowed to pay the taxes itself, rather than make a taxable distribution to fundholders. (However, a fund which does this creates an unnecessary tax cost for investors who hold it in tax-deferred account, which is why few funds do this.)Grabiner 20:10, 2 February 2011 (EST)

A few items were unclear with this latest update:
 * The meaning of gain for a bond fund. I believe the intent is for dividends.
 * The capital-gains rate implication is for long-term capital gains, which leaves out short-term gains.

"Bonds or bond funds are tax-inefficient because almost all their gains are taxed as ordinary income; in contrast, much of the return from stocks is from price appreciation, which is not taxed until the stocks are sold, and is taxed then at the capital-gains rate if the stocks were held more than a year. Municipal bond funds have a hidden cost; while their interest incomes are not subject to federal tax, 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)." I used the discussion from Bond Basics and broke up the paragraph into separate bond, mutual bond funds, and REIT (placed after stocks). However, I'm unsure on the intent of index fund as used here: "Therefore, bonds are widely regarded as being less tax-efficient than stock index funds and should be held in tax-deferred accounts when possible." Should this say stock funds instead of stock index funds? --LadyGeek 21:21, 3 February 2011 (EST)

I mean stock index funds; the tax advantage of a stock index fund over a bond fund is that almost all capital gains are deferred, and this doesn't happen for most active stock funds. The low-turnover active fund has tax costs of 0.85%/0.95%/1.35% in the table, which is comparable to the 1.50% tax cost of a municipal bond fund once you consider the capital-gains tax to be paid when you sell the stock fund. I did add a clarification.Grabiner 22:32, 3 February 2011 (EST)

Proposed improvements
A general suggestion: Make a revised version of this discussion Strategies for Tax-Efficient Fund Placement (removed link to non-existent page, --LadyGeek 19:00, 16 May 2011 (EDT)) as a separate page, and leave the "Principles" page mostly as is. This will allow one page to discuss the procedure, and another to discuss the more complicated details such as the reason that an emerging markets index is less tax-efficient than a developed markets index. (The corrections below, with my comments, can be made to both pages.)Grabiner 00:46, 23 April 2011 (EDT)

Grabiner and LadyGeek - You folks are terrific! And fast. I'll move over to that other page to reply to your comments. I hope to reply this evening but I am not fast yet.--Stickman 23:28, 24 April 2011 (EDT)

Friends, I love the wiki and use it often. I want to suggest improvements to this page...as a super-neophite wiki editor. Here are the reasons I am proposing changes, followed by my specific suggestions: Here are the specific changes I propose to replace all content up to the section called "Explanation for the estimated order". Please leave me a note if you'd like me to modify any of the pictures.
 * 1) We need to explain what "tax efficient" means at the beginning.
 * 2) The Chart can be simplified to be more useable
 * 3) Add balanced funds.  These are commonly held and cannot be found on chart.
 * 4) Eliminate the distinction between mutual funds and ETFs.  This distinction clouds the main point, and the words "or index fund with ETF class" just raise unanswered questions.
 * 5) Re-order the TIPS from ambiguous to inefficient.  These were previously considered less efficient than REITS but somehow moved to the moderate category.  I think it was correct in a previous version of this chart given the liability on phantom income (the inflation component).
 * 6) Flip axis.  Intuitively graphs go from low to high (least to most) as you go up the y-axis.
 * 7) Change the general strategy and instructions to be more informative
 * 8) Add the placement of international funds
 * 9) Differentiate the treatment of tax-free vs tax-deferred accounts

Grabiner 00:33, 23 April 2011 (EDT)
 * 1) I agree; this definition is useful.
 * 2) I agree with two simplifications.
 * 3) The problem with classifying balanced funds is that the tax efficiency depends on what they hold and how they are managed.  However, as a single category, they would be between large-cap active funds and bond funds, since they are usually a combination of both.
 * 4) The distinction between mutual funds and ETFs is now less important than it used to be; I will still leave the category for non-ETF indexes, because some of them do exist, but remove it elsewhere.
 * 5) TIPS have the same efficiency as other Treasury bonds.  All the gain from either TIPS or Treasuries is taxed when earned; the tax on phantom income just means that you do not get to defer the gain from the increased principal value of TIPS.  (For example, if you have a bond worth $10,000 yielding 5% and a TIPS worth $10,000 yielding 2% with 3% inflation, both will become worth $10,500 pre-tax and $10,375 after-tax in a 25% tax bracket.)  REITs are probably less tax-efficient than non-junk bonds in the long run; most of their yield is taxable and non-qualified, and they are expected to grow faster than bonds, increasing the amount of taxable income in the future.  (There is a similar explanation in the table of estimated costs.)
 * 6) Flipping is fine, with the text reversed; we can also reverse the table.
 * 7) Some of your general strategy comments seem to be based on an old version of the list
 * 8) International funds are already included, and they are slightly more tax-efficient than similar domestic funds because of the foreign tax credit
 * 9) Tax efficiency is irrelevant in the decision whether to place a fund in tax-deferred or tax-free accounts, which is why they are lumped together in the current list (but weren't in the old list).  If you have a stock index fund and an active stock fund, it doesn't matter which one goes in your 401(k) and which one goes in your Roth IRA.  (The difference in risk and returns may be relevant; see Tax-Adjusted Asset Allocation for the discussion of that issue.)

I flipped the Y-axis by reversing the text order. The arrow color should stay the same. By convention, "bad" things are red, "good" things are green (or a less bright color). Note the tag in the wikitext. This table is included on other pages; modifications should be made with this in mind.

Stickman - The "Sig" toolbar button (4th from right) inserts your signature. Select "Sig", then "Show preview" to see the effect. FYI - Wikipedia convention is to insert your signature when discussing topics for ease of identifying the editor. (This is a minor administrative detail, but discussions are easier to follow.) --LadyGeek 09:33, 23 April 2011 (EDT)

(introduction from the top of page)
Not all investment income is taxed the same. If you have both taxable and tax-advantaged accounts, you generally want to hold bonds in a retirement account and stocks in a taxable account. The advantages for holding stocks in a taxable account include This article introduces the concept of tax efficiency so that investments that generate high levels of income that is taxed at ordinary income rates are held (when possible) in tax-advantaged accounts. In practice, the size of the tax-advantaged accounts often prevents the ideal strategy from being realized. But these steps will lead you to your most tax-efficient fund placement, which can generate a dramatic return after many years of compounding.
 * lower tax rates for qualified dividends and long-term capital gains
 * opportunity for tax-loss harvesting
 * stepped-up cost basis upon death
 * gifting appreciated assets

Step 0: Asset allocation without regard to taxes
Consider your portfolio as a whole (include spouse) and determine your risk level (% stocks / %bonds) and desired asset allocation before considering taxes.

Step 1: Determine Tax Efficiency
Understand the tax consequences of holding each of your chosen investment assets. For example, bonds returns are generally taxed at ordinary income rates. Most stock dividends are "qualified dividends" with a lower tax rate, but REIT funds distributions are an exception. REIT distributions are taxed like ordinary income. Holding TIPS in a taxable account generates a tax liability on "phantom income" (the inflation component) that the owner does not receive until that bond is sold. Note also that tax exempt municipal bonds and savings bonds (series EE and series I) can only be held in taxable accounts.

Step 2: Place Least Efficient Funds
Fill your tax-deferred accounts with your least efficient funds first. If this fills up, then put the funds in your tax-free accounts (e.g. Roth IRA). Exhaust both of these before putting these funds into your taxable account, and only after you have considered whether there might be some more tax-efficient alternatives. This is illustrated with an example portfolio with three asset classes.

Step 3: Place International Stock Funds
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. It is worth doing this, although it is not a large amount. Even when held in a taxable account, some funds do not qualify for this foreign tax credit if they are a "fund of funds". This is really part of the previous step; the foreign tax credit is part of the tax efficiency, and should be explained there.Grabiner 00:37, 23 April 2011 (EDT)

Step 4: Place high growth stock funds
Since a Roth IRA is forever tax-free, this space is most valuable for your fund that has the highest expected growth. This may be correct, but the reason has nothing to do with the principles of tax-efficient fund placement, and is too complicated to explain here. Putting the fund with the highest expected growth in your Roth IRA increases both the risk and return of your portfolio, so it isn't necessarily better. (You can eliminate the difference with Tax-Adjusted Asset Allocation so that you value $10,000 in a traditional IRA which you will withdraw in a 25% tax bracket as equal to $7500 in a Roth.)

If all else is equal (and it often isn't, because you 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, because the Roth is free from RMDs and probably is less subject to the risk of changing tax rates. Grabiner 00:42, 23 April 2011 (EDT)

Step 5: Efficient funds are fine anywhere
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-deferred account to hold some of your tax-efficient stock fund because the stocks and bonds can be exchanged without tax consequence.

Explanation for the estimated order
no changes to current version from here on

Further Discussion (after major update)
In Comparison of hypothetical tax costs, first paragraph, I changed "guess" to "estimate" as shown below - it sounded better. However, the implementation is unclear in Table 1. This statement is confusing. How are future capital gains used in Table 1?

"Future capital gains are estimates, not necessarily based on recent values; it is not necessarily reasonable to assume that a small-cap ETF which has never distributed a capital gain will continue to do that forever."

--LadyGeek 09:15, 1 May 2011 (EDT)


 * Capital gains on funds which you still hold are included in Table 1 (the gains that VSS has distributed and that other small-cap ETFs might distribute). Capital gains on sales are included in Table 2, and those calculations involve assumptions which are already in the table; if the stock market returns 8% and your stock fund pays 2% qualified dividends taxed at 15%, then Table 2 shows the annualized cost.

Grabiner 20:38, 1 May 2011 (EDT)
 * However, I did mean "guesses" when I wrote that paragraph; I do not have a good basis for estimation of the distributions on ETFs because ETFs have not been around long enough. In contrast, there is a good basis for estimating the relative yield of US and foreign stock funds, because there is years of data, and only in the last few years have foreign yields been higher.

I'm still confused on the wording. Are you saying that ETFs are based on guesses, but the other fund classes are as stated? Perhaps reversing the wording order would make this clear:

From (reverted "estimates" back to "guesses"): 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 guesses, not necessarily based on recent values; it is not necessarily reasonable to assume that a small-cap ETF which has never distributed a capital gain will continue to do that forever. 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 1.5% to taxes in a 25% tax bracket whether that is the current yield on a short-term bond or a long-term bond. To: Capital gains on funds which you still hold are included in Table 1. Capital gains on funds sold are included in Table 2, and those calculations involve assumptions which are already in the table. For example, if the stock market returns 8% and your stock fund pays 2% qualified dividends taxed at 15%, then Table 2 shows the annualized cost.

Table 1 assumptions: Qualified dividends and relative yields for value, small-cap, and tax-managed funds use historical data from Vanguard's index funds in the Vanguard fund distributions tables as a guide. ETFs do not have a good basis of estimation due to a relatively short period of historical performance (add a table note indicating what was used - this needs to be quantified since there is no spreadsheet posted). Interest for bond funds is based on historical rates, not current rates, because the numbers are easy to measure; for example, a bond which has a 6% yield loses 1.5% to taxes in a 25% tax bracket whether that is the current yield on a short-term bond or a long-term bond.

"...it is not necessarily reasonable to assume that a small-cap ETF which has never distributed a capital gain will continue to do that forever." - I'm probably missing the point why this is stated.

If you would like to post the spreadsheet itself, and need assistance, send me the file. I'll upload it to Google Docs.

--LadyGeek 23:16, 1 May 2011 (EDT)


 * The distinction I am making is between numbers which are based on historical data (75% qualified dividends for most international funds has been consistent for several years), and numbers which must be guessed because there is inadequate data (whether small-cap ETFs will distribute capital gains, and whether VSS will distribute less in gains than it has over the last two years). I would like the wording to reflect the difference in reliability.

Grabiner 20:28, 2 May 2011 (EDT)
 * I have no spreadsheet to post; Table 1 was based on computations made by hand, and Table 2 was calculated from a spreadsheet (which I didn't save) but copied into the article by hand because the numbers are not dynamic. I could make Table 2 into a spreadsheet later.

Request for correction to Slide2
I corrected the introduction to Slide2 (in Step 2) to explain that tax-inefficient assets should be in either the tax-deferred or tax-free account, with no preference; therefore, I would like to see a revised Slide2 with arrows from bonds to both accounts. Step 4 then determines where the bonds should actually go, but includes the caveat "all else being equal". (Many investors have an S&P 500 index as the only good 401(k) option and therefore should hold their US stocks in a 401(k).) Grabiner 23:21, 4 May 2011 (EDT)


 * Thanks for your comments and this suggestion. I have modified the picture.  Please review and approve.--Stickman 11:08, 5 May 2011 (EDT)


 * Excellent; this makes the point exactly as I wanted it made.Grabiner 21:49, 5 May 2011 (EDT)