Tax-efficient fund placement

All investors must pay their fair share of taxes. Investors should also know that the tax code recognizes different sources of investment income which are taxed at different rates, or, are taxed at a later time (tax "deferred"). Investors can organize their portfolios in a way which minimizes taxes. Tax efficiency is a measure of how well investors can minimize their taxes while generating high returns. A high tax efficiency means that minimal taxes are paid.

If your investments are all in tax-advantaged accounts, fund placement will not have a large impact on your returns. Tax-advantaged accounts include tax-deferred accounts, such as 401(k) and 403b, and tax-free accounts such as Roth IRA. If you have a taxable account, you need to consider tax efficiency when choosing your funds. Investors should always establish an emergency fund first, and then fund their deductible retirement account or Roth IRA before their taxable accounts. Tax-advantaged retirement accounts are the most tax-efficient accounts, which should not be overlooked.

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:


 * 1) Tax-deferred accounts convert long-term capital gains into ordinary income upon distribution; long-term capital gains have, at most times, been taxed at a lower rate than ordinary income.
 * 2) Qualified dividends are currently (until Dec. 31, 2012) taxed at a lower rate.
 * 3) Long-term capital gains are only due when realized, which offers an additional means of deferring taxes.
 * 4) Ability to  harvest losses.
 * 5) Ability to  donate appreciated shares to charity, avoiding all taxes.
 * 6) Estate planning; there is a potential for stepped-up cost basis upon death.

This article shows you how to reduce your taxes by strategically placing your investments into appropriate accounts. In practice, the size of the tax-advantaged accounts often prevents the ideal strategy from being fully implemented. But, after many years of compounding, appropriately placing most of your portfolio can generate a significant increase in your return.

Preparation: Consider your entire portfolio without regard to taxes
Treat your entire portfolio as a whole (include spouse). Determination of your asset allocation (% stocks / %bonds), which sets your portfolio's level of acceptable risk, is the single most influential decision you can make on your portfolio's performance. Only consider taxes after you have configured your total portfolio.

Step 1: Categorize your portfolio's tax efficiency
Understand the tax consequences of holding each of your chosen investment assets. For example:
 * Bond returns are generally taxed at ordinary income rates. Municipal bonds are generally exempt from federal income tax, but they have an effective tax cost because they yield less than corporate bonds of comparable risk. Treasury bonds are exempt from state income tax.  The tax cost from a bond investment will depend on both the tax rate and the interest rate; lower-yielding bonds have less interest to be taxed.
 * Most stock dividends are "qualified dividends" with a lower tax rate, but REIT funds distributions are an exception - they are taxed like ordinary income. The tax cost on stock dividends will depend on the tax rate and the dividend yield. Yields are usually higher for value stocks than for growth stocks.
 * Capital assets (which include stocks and bonds) are subject to capital gains taxes when sold. Short term gains (less than one year) are taxed at marginal tax rates; long term capital gains (longer than one year) are taxed at lower rates. If the fund manager sells securities in a mutual fund for a net gain, the gains are distributed (and taxable if the fund is held in a taxable account) to shareholders as either short term or long term gains distributions. Investors are likewise subject to capital gains taxes when they sell mutual fund shares in a taxable account.

Note that tax exempt municipal bonds, savings bonds ( series EE  and series I), and Vanguard tax-managed funds are only suitable for taxable accounts.

Approximate Tax Efficiency Ranking for Major Asset Classes

Step 2: Place your least tax efficient funds first
Fill your tax-advantaged accounts with your least efficient funds. Exhaust these accounts before putting these funds into your taxable account; if you run out of room, consider more tax-efficient alternatives, such as a stock index fund rather than an active fund. An example portfolio with three asset classes is shown below.
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 * +An Example using Three Asset Classes
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Step 3: Place international stock funds in taxable account
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".
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 * +(Example) Consider Foreign Tax Credit
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Step 4: Place high growth stock funds
If all else is equal (and it often isn't, because you may 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 Required Minimum Distributions (RMDs),  is not counted as income for making Social Security taxable, and probably is less subject to the risk of changing tax rates.
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 * +(Example) High Growth Stock Fund Placement
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Step 5: Place tax efficient funds last
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-advantaged accounts to hold some of your tax-efficient stock fund, because the stocks and bonds can be exchanged without tax consequence. Rebalancing in a taxable account is often best done by investing new money so that capital gains can be avoided.
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 * +(Example) Tax Efficient Fund Placement
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Explanation for the estimated order
For buy and hold investors, 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.

Bonds or bond funds are tax-inefficient because almost all of the return comes from the dividend yield, which is fully taxed as ordinary income. In contrast, stocks get most of their return from price appreciation, which is not taxed until the stocks are sold and is taxed at the capital-gains tax rate. Therefore, bonds are widely regarded as being less tax-efficient than stock index funds (which rarely sell stock) and should be held in tax-advantaged accounts when possible. However, low-yielding bonds do not have much return to be taxed, and since they do not grow as fast as other investments, an equal percentage lost from an investment is a smaller dollar loss; this makes low-yielding bonds somewhat more tax-efficient.

Treasury bonds are exempt from state taxes, and thus are tax-inefficient for federal taxes but may be desirable taxable investments for investors who pay high state taxes but low federal taxes. TIPS have the same tax-efficiency as their treasury bond equivalents; however, since taxes need to be paid on the inflation component, which isn't received until the bond matures or is sold, this cash flow problem creates an additional reason to hold individual TIPS (as opposed to a fund) in a tax-advantaged account.

Municipal bond funds have a hidden cost; while their interest incomes are not subject to federal tax, they usually earn less than corporate or Treasury bond funds of comparable risk. (The risk may be of a different type; intermediate-term municipal bonds have more credit risk than long-term Treasury bonds, but less interest-rate risk, and thus may have a similar after-tax yield.)

Balanced funds (stocks and bonds) are very popular among individual investors. These funds hold a variety of asset classes in one simple fund instead of several. They have a variety of names such as balanced, lifestyle, or target retirement funds. Since these funds include both stocks and bonds they can never be efficiently placed. In a tax-advantaged account, the stocks will lose the special benefits they possess in a taxable account. In a taxable account, the bond dividends will get taxed at ordinary income rates; in addition, the investor losses the option to harvest losses of individual asset classes. Balanced funds are fine for smaller investments held in a tax-advantaged account but should usually be avoided in taxable accounts. The more efficient strategy is to own the individual asset classes in separate funds and in their most tax-efficient locations.

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.

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).

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 realized 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 realized 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.

Given 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.

Comparison of hypothetical tax costs
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.

Moreover, Table 1 is based on the assumption that US and foreign dividend yields will be equal; before foreign taxes; that is, US and foreign total-market 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.''

There are two types of tax costs: the cost you pay every year, and the costs you pay when you sell. Bond funds have little or no tax cost when you sell, since almost all the return from bonds is from interest. When you sell a stock fund, you will pay capital-gains tax on the difference between the total amount you invested (including reinvested dividends) and the current value.

Table 2 indicates the additional cost for the capital-gains tax when you sell, assuming that you pay taxes on the distribution and reinvest the after-tax portion of the distribution; since it is a one-time cost, the effect is annualized. For example, if you hold an investment for 30 years and lose 10% to taxes when you sell, that is equivalent to losing 0.35% every year. Thus, if you sell the fund, your cost will be the sum of the Table 1 and Table 2 costs. However, you would not pay the Table 2 cost on any stock which you either leave to your heirs or donate to charity, and thus may not pay that cost on your full investment. In particular, you might estimate your total tax cost by using the low-return line in Table 2; if stock returns are high, you will have a large taxable account and will reduce the tax cost by taking longer to deplete it or by not spending it all during your lifetime.

Taxes in both tables are computed at a tax rate of 15% on long-term gains (except in the "rate rises to 20% column", which applies if that tax reduction is allowed to expire), 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. Although not tabulated, keep in mind that investors in the lower tax brackets (15% or lower) pay lower federal tax rates on investment income for the period 2003 - 2012, and reap higher after-tax returns, outside of tax-exempt municipal bonds, in all asset classes.

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