Placing cash needs in a tax-advantaged account
This article contains details specific to United States (US) investors. It does not apply to non-US investors.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.
 | Placing emergency funds in volatile accounts can be risky. Consider that the stock market may drop 50% when you need the money the most, forcing you to withdraw from the tax-advantaged account.[1] As a result, the taxable account should be twice as large as your cash needs. If it is smaller, keep a proportional portion of your cash needs in cash. |
How it works
Suppose you have $15,000 in your portfolio with additional $5,000 as an 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 (your emergency fund)
$5,000 bond fund
Now, suppose you need $5,000 in an emergency. You sell $5,000 from the stock index funds in your taxable account and exchange the money market fund for 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.[note 1]
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 tax loss harvest 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. You can deduct losses 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 in which to invest cash needs, 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 is difficult to minimize tax. In some cases, you might pay more tax on short-term capital gains than on ordinary income, which negates the benefit of placing cash needs in a tax-advantaged account. For this reason, you may want to wait for twelve months before you place cash needs in a tax-advantaged account if you are starting a taxable account now.
Avoid a wash sale. If you sell shares of the tax-efficient stock index funds with losses and buy "substantially identical" securities in your tax-advantaged account (within 30 days before or after the sale), that is a wash sale. You cannot deduct losses 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. The market could actually go down by more than 50%, and that is a risk of this technique if the taxable account does not provide enough cushion. For this reason, you may be able to keep a small amount of cash needs (for example, enough for an emergency) in tax-efficient stock index funds, but you may not want to keep a large amount of cash needs (for example, a home down payment fund) in such potentially volatile investments, unless you have a very large taxable retirement portfolio.
Notes
- ↑
White Coat Investor commented in this Bogleheads forum post: "Buying a house in 2-4 years; what do I do with my mutual funds?" on the transfer from an existing investment in equity to a safer option for a house down payment:
The main thing is to consider your options in the event of a huge bear market. If the market drops 50%, what will you do? Here are some choices:
- Don't buy the house and just keep renting until the stocks recover and future savings gets you back to where you want to be.
- Maybe houses will be cheaper in an economic downturn and you can still buy it with your decreased amount.
- Maybe houses will be cheaper and you can use a mortgage with < 20% down, leaving your investments intact.
- Maybe you won't buy a house at all.
For some people, for whom these options aren't good choices, should sell their stocks now and put the money in CDs. But there are many people for whom these other options are very realistic alternatives. For them, keeping some or all of the money in stocks is probably okay. The expected return is higher, even if the actual return may not be.
See also
References
- ↑ Bogleheads forum topic: "Emergency funds". December 26, 2010
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| Vanguard money market funds | ||