Tax-efficient fund placement
Template:Bogleheads Investing Start-Up Kit Template:Tax Considerations Sidebox If your investments are all tax-deferred (or tax-free), you do not need to worry about fund placement issues. If you have a taxable account, you need to consider tax efficiency in deciding what fund to put in which account, which can have a profound effect after many years of compounding.
- Choose your basic asset allocation (stocks/bonds/cash) before worrying about taxes.
- If possible, put your most tax-inefficient funds in your tax-advantaged accounts (IRA, Roth IRA, 401(k), 403(b), etc.).
- If you would have to hold a tax-inefficient fund in a taxable account, consider a more tax-efficient alternative, such as a stock index fund rather than an active fund.
Order of Funds by Estimated Tax Efficiency
|Least Tax Efficient
Using the Order
Any fund in the "Efficient" or "Very Efficient" category is fine in a taxable account.
In the "Moderately inefficient" category, you should consider an alternative but not necessarily use one. In particular, you should hold as much in bonds as your risk tolerance indicates, even if you have to pay an extra tax cost by holding some of the bonds in a taxable account. If it is necessary to hold bonds in a taxable account, you must decide whether to use taxable or tax-exempt bonds. Morningstar's Tax-Equivalent Bond Calculator can help make this determination.
Do not hold funds in the "Very inefficient" category in a taxable account.
There is nothing wrong with holding a tax-efficient fund in your tax-deferred account if it fits your portfolio; in particular, the only decent option in many 401(k) plans is an S&P 500 index. However, if your 401(k) has no good fund in a tax-inefficient asset class, you have to consider the tax costs when deciding whether to hold only as much as you can put in your IRA or hold some in your taxable account.
Explanation for the estimated order
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; or that retirement plan distributions will not receive tax preferences at some future date.
Bond funds are tax-inefficient because their gains are almost all in ordinary income. Municipal bond funds have a hidden tax cost; while their interest incomes are not subject to federal tax, they earn less than corporate bond funds of comparable risk. 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).
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.
Index funds must also sell stocks which leave the index. Since small-cap or value stocks which rise in price tend to become large-cap or growth stocks, small-cap and value indexes generate 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 gains. Value indexes are less tax-efficient than growth or blend indexes because they have higher dividend yields.
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.
- Tax Equivalent Bond Calculator, from Morningstar
- Robert M. Dammon, Chester S. Spatt, and Harold H. Zhang, Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing, Journal of Finance, June 2004.
- Robert M. Dammon, James Poterba, Chester S. Spatt, and Harold H. Zhang, Maximizing Long-Term Wealth Accumulation:It?s Not Just About "What" Investments To Make, But Also "Where" To Make Them, TIAA-CREF Institute, No. 86, September 2005.
- Colleen M. Jaconetti, Asset Location For Taxable Investors, Vanguard Investment Counseling & Research, 09/12/2007
- William Reichenstein, Asset Allocation and Asset Location Decisions Revisited, Summer 2001.
- William Reichenstein, Tax Efficient Saving and Investing, TIAA-CREF Institute, February 2006.
- William Reichenstein, Non-qualified Annuities in After-tax Optimizations, Ifid Conference, May 11, 2005.
- William Reichenstein, Ph.D., Baylor University and TIAA-CREF Institute Fellow, Tax-Efficient Sequencing Of Accounts to Tap in Retirement,TIAA CREF Institute, Trends and Issues, October, 2006