Placing cash needs in a tax-advantaged account

From Bogleheads

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.[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 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


  • 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. In some cases, 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.
  • 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. The market could actually go down by more than 50%, and that is a risk of this technique if the taxable account doesn’t provide enough cushion. 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.

See also


  1. White Coat Investor commented in this Bogleheads forum topic: "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:

    1. 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.
    2. Maybe houses will be cheaper in an economic downturn and you can still buy it with your decreased amount.
    3. Maybe houses will be cheaper and you can use a mortgage with < 20% down, leaving your investments intact.
    4. 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.


  1. Bogleheads forum topic: "Emergency funds", Dec 26, 2010