Placing cash needs in a tax-advantaged account

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 of an investment portfolio.

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 exchange the money market fund for similar stock funds in the money market fund 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
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.

When you 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.

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

US Domestic:
 * Vanguard Total Stock Market Index Fund
 * Vanguard Large-Cap Index Fund

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

The Principles of tax-efficient fund placement article prefers placing international stocks in the taxable account. Each pair is suitable for tax loss harvesting and avoiding  wash sales.

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, or a fund tracking a different index.  If you prefer to hold the original fund in your tax-advantaged account, you may switch after 31 days.
 * Make sure your taxable account is large enough. Keep in mind that the stock market tanking by 50% is not uncommon. 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. For this reason, you may be able to keep a small amount of cash needs (e.g. sized for emergency needs) in tax-efficient stock index funds, but you may not want to keep a large amount of cash needs (e.g. a home down payment fund) in such potentially volatile investments, unless you have a very large taxable retirement portfolio. You are at risk from a large market drop, such as 50%, if the taxable account doesn’t provide enough cushion.
 * 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.