Placing cash needs in a tax-advantaged account

Introduction
If you have a sizable taxable account, it is possible to place a cash needs requirement, such as an emergency fund or home down payment, in a tax-advantaged account and improve the overall tax efficiency.

How it works
Suppose you have $15,000 in your portfolio with additional $5,000 as emergency fund. Then you could have:


 * Taxable
 * $10,000 tax-efficient stock index funds


 * Tax-advantaged account, such as 401(k)
 * $5,000 money market fund <- emergency fund
 * $5,000 bond fund

Let's say you need $5,000 in emergency. Then you sell $5,000 from the stock index funds in your taxable account and then exchange the money market fund to similar stock funds in your tax-advantaged account. You are left with:


 * Taxable
 * $5,000 tax-efficient stock index funds


 * Tax-advantaged account, such as 401(k)
 * $5,000 stock funds
 * $5,000 bond fund

Notice that you have not changed the asset allocation at all.

Why it works
The tax efficiency of holding your cash needs in a tax-advantaged account comes in two forms.

While you do not need the cash, tax-efficient stock index funds generally yield 2% or so, which are all or mostly qualified dividends; most of the return is from capital gains which are not taxed until you sell. Depending on the interest rate, a typical money market fund yields anywhere from 2% to 5%, and the dividends are all non-qualified dividends. In addition, you can do Tax Loss Harvesting on the stock funds.
 * While you do not need the cash

When you sell a part of the tax-efficient stock index funds, you realize either losses or long-term capital gains. Losses can be deducted on your tax return after offsetting capital gains, if any. Long-term capital gains are taxed more favorably than non-qualified dividends.
 * When you need the cash

Candidates for tax-efficient stock index funds
Both of the following funds are good candidates to invest cash needs in, but there are others that are just as good.


 * Vanguard FTSE All World ex US Index Fund
 * Vanguard Total Stock Market Index Fund

Fine points

 * Use Specific Identification of Shares. Sell tax lots with losses or tax lots with the highest cost basis that have long-term capital gains.  If you do not use Specific Identification of Shares, it's difficult to minimize tax.
 * Avoid a wash sale. If you sell shares of the tax-efficient stock index funds with losses and buy "substantially identical" securities in your the tax-advantaged account (within 30 days before or after the sale), that is a wash sale.  Losses cannot be deducted at all in this case.  Therefore, you need to find a fund which is not substantially identical to purchase in your tax-advantaged account; preferably, it should be similar, such as an active fund in the same asset class as the index.
 * Make sure your taxable account is large enough. If your taxable account is not large enough, say twice as large as the cash needs, then you may not have enough money in your taxable account during a market downturn.  Keep in mind that the stock market tanking by 50% is not uncommon.  For this reason, you may be able to keep a small amount of cash needs, say  an emergency fund, in tax-efficient stock index funds, but you may not want to keep a large amount of cash needs, say a home down payment fund, in such potentially volatile investments, unless you have a large taxable retirement portfolio as well.  Keep in mind that the market could go down by more than 50%, and that is a risk of this technique.
 * Make sure you have shares that you can sell with long-term capital gains. Otherwise, you may have to sell shares with short-term capital gains.  In some states, short-term capital gains are taxed more heavily than ordinary income, which negates the benefit of placing cash needs in a tax-advantaged account.  For this reason, you may want to wait for 12 months before you place cash needs in a tax-advantaged account if you are starting a taxable account now.
 * Do not put it all in Vanguard's tax-managed funds immediately. Vanguard's tax-managed funds have a 1% redemption fee if shares are redeemed within 5 years of the purchase.  For this reason, it's not a good idea to invest cash needs in  Vanguard's tax-managed funds unless you are unlikely to need the cash until you have held the funds for five years.  (After five years, you can usually avoid the fee; Vanguard will charge the redemption fee as if you sold your fee-free shares first even if you use a different method for tax purposes.)