Tax-efficient fund placement

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.

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.

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 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).

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 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; small-cap funds have lower dividend yields but fewer qualified dividends.

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.

Hypothetical tax costs for comparison
Given any reasonable assumptions, the "Inefficient", "Moderately Inefficient", and "Efficient" categories separate fairly clearly. The exact ordering within the categories, and between "Efficient" and "Very Efficient", depends not only on future tax policy, but also on assumptions about dividend yields and qualified dividends.

There is historical data for 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.

However, the table is based on the assumption that US and foreign dividend yields will be equal; before foreign taxes; that is, US and foreign large-cap funds both pay 2% in dividends, but foreign funds have 0.15% of that withheld as foreign taxes. In recent years, developed markets have had higher yields; if foreign yields are actually 1.5 times US yields, then the tax costs of foreign funds must be multiplied by 1.5. Thus, in the table, the foreign funds are more tax-efficient than US funds in the same category, but if foreign yields are higher, they could be less tax-efficient.

Bond funds are slightly more tax-efficient than the table indicates, which is why they are in the "Moderately Inefficient" category despite the high tax cost Bond funds can be sold with little or no capital gain; the capital gains due on sale of a stock fund increase the tax cost. For example, if 20% of the value of a stock fund is the initial balance and reinvested dividends, and you sell it after 30 years, you will pay tax at 15% on 80% of the value, which is 0.4% annualized. In addition, bond funds grow more slowly than stock funds, and thus the taxes do not increase as rapidly.

Taxes on the table are computed at a tax rate of 15% on long-term gains, and on qualified dividends (except in the "no QDI" column, which applies if the tax reduction on qualified dividends expires and the rate is 35%). 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.

Using the order
Any fund in the "Efficient" or "Very 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, you should hold as much in bonds as your risk tolerance indicates, even if you have to pay an extra tax cost by holding some of the bonds in a taxable account. If it is necessary to hold bonds in a taxable account, you must decide whether to use taxable or tax-exempt bonds. Morningstar's Tax-Equivalent Bond Calculator can help make this determination.

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.

Tax rates
Mutual fund distributions will be taxed according to the tax laws governing the investment over the holding period of the investment, which are subject to change. The actual tax imposed will depend upon each individual's tax rate and the timing of purchases and sales. The federal tax rates applicable to mutual fund distributions and investor sales of securities for the period 2008 - 2012 are outlined below. Keep in mind that investment income may also be subject to state and local taxation.
 * 1) 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 35%. 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.
 * 2) Long-term capital gains distributions are made from realized gains on securities held for more than one year. Long-term gains are taxed at 0% for taxpayers in the 10% and 15% tax brackets and at 15% for taxpayers in the 25%, 28%, 33%, and 35% tax brackets. (These tax rates are mandated for 2008-2012.) They are reported on tax Schedule D along with any other capital gains, and can be reduced by capital losses.
 * 3) Qualified dividends are the ordinary dividends that are subject to the same 0% or 15% maximum tax rate that applies to net capital gain. They should be shown in box 1b of the Form 1099-DIV you receive. Qualified dividends are subject to the 15% rate if the regular tax rate that would apply is 25% or higher. If the regular tax rate that would apply is lower than 25%, qualified dividends are subject to the 0% rate.
 * 4) 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.

Dividend tax rates
For details on determining qualified dividends refer to Fidelity: Qualified Dividends