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. 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.