Tax Efficient Mutual Fund Placement For Maximum Return

After choosing your asset allocation, it is still important to think carefully about where to place each type of investment. After all, what you actually keep is your return after taxes. For example, a stock index fund that tracks the S&P 500 will have low turnover and primarily pay qualified dividends which are taxed at the lower long-term capital gains rate (max 15%). On the other hand, REITs and bonds tend to distribute a significant amount of their return annually as unqualified dividends, which are then taxed as ordinary income (max 33%). Therefore, you should try to take advantage of your tax-sheltered accounts as much as possible by placing the least tax-efficient assets there.

Below is a chart that shows the major asset classes sorted by tax efficiency. It is based on information from the fine books Bogleheads’ Guide To Investing and The Four Pillars of Investing.

Chart of Relative Tax Efficiency of Assets

Let me clarify the chart above. You should start with the least tax-efficient assets and place them in your pre-tax accounts (Regular 401ks, 403bs, Traditional IRAs) first. Then the next least efficient assets should into the post-tax accounts (Roth IRA, Roth 401k). Only what is left after this should end up in taxable accounts.

In general, bonds should go into tax-deferred accounts, leaving stocks for your taxable accounts. There are even special “tax-managed” mutual funds which work hard to minimize any capital gains distributions and are designed specifically to be placed in taxable accounts.

This article is part of my Rough Guide To Investing.

Comments

  1. Wow, this is a great post. I love it when information is easy to understand with just a glance! Thanks,
    NCN

  2. Thanks NCN! I just added some information to the chart that shows that you should work your way from Traditional 401ks/IRAs to Roth 401ks/IRAs to taxable accounts.

  3. I’ve seen this information before in the Diehards forum and other places, but sometimes a picture really is worth a 1000 words. Well done.

  4. Can someone explain why, regular IRAs are better for bonds then ROTHs. I would think ROTHs, expect for the original dollars you up in, you are never taxed. IRAs are taxed on withdrawal, but not on the original dollars.

    Is the up front tax saving that much better when investing in bonds?

  5. CreditShack says:

    Why on earth are individual stocks held in brokerage (“stock trading”) accounts less tax efficient than most mutual funds? Turnover rate even for index funds is nonzero.

    Individual holdings are zero turnover, which would put them in the same vicinity as tax managed funds.

  6. cool! ez to read.
    Anyone has an opinion on if it is a good deal to reinvest dividends and capital gain? or payout.

  7. Morningstar offers an interesting alternative approach to tax efficient asset allocation. See the link pasted below. The argument is based on what Morningstar calls “new research” which says that under certain conditions (typically for long-term investment of over 15 years) the tax burden generated by the growth of stocks outweighs the tax burden generated by bond income. Therefore, for long term investors at least, putting stocks in a tax efficient accounts and taxable bonds in tax inefficient accounts is the right move.

    I am skeptical, but it’s always interesting to hear a new perspective.

    link

  8. Why are pre-tax and post-tax accounts ranked differently? Are you making assumptions about future tax rates?

  9. ** This does not address whether you should contribute to Roth or Traditional accounts in the first place. That is another discussion. This only addresses where you should put assets after you have already contributed to them. **

    This is how I understand the rationale between pre- and post- tax accounts.

    Pre-tax accounts (Traditional 401k/IRAs) will be taxed at the ordinary income rate upon distribution, no matter what is inside. Thus, you would want to keep anything that can produce something that would be taxed at a lower rate (like certain stock dividends and long-term capital gains) as far away from those as possible. Why turn something that would otherwise be taxed at 15% into something that’s taxed at up to 33%?

    Distributions (both principal and gains) from post-tax accounts (Roth 401k IRAs) are designed never to be taxed again, so while you will still want to put tax-inefficient assets in there to let things compound without the annual tax “haircut”, it’s not quite as critical.

    Tax deferred accounts are designed save you from the tax hit at least once, either on the way in or out, so you would want to save whatever is the most efficient for your taxable account.

  10. The Morningstar link is intriguing. I would have to run some scenarios myself. The book Boglehead’s Guide To Investing has a similar scenario starting with 50/50 stocks/bonds and run for 30 years, but the results support their conclusion to keep tax-inefficient assets in tax-deferred accounts. So it appears the numbers can be manipulated either way.

    The M* “test” period of 20 years ending in 1998 is a bit concerning… stocks certainly did well vs. bonds during this timeframe. I would like to see a larger study with rolling 30 year periods with different tax rate assumptions.

  11. Regarding stock trading accounts – If you took everyone’s brokerage accounts as whole, how many do you think would have less turnover than an index fund?

    For example, VFINX’s turnover rate is 7%. How many people hold all their individual stocks for an average length of 14 years? I would guess less than 5% of account holders, if that.

  12. Here is a question I often pose on diehard forums but never seem to get a good answer to. I understand the rationale behind sticking least efficient in non-taxable accounts (like a 401k that you have a large annual contribution limit to), but I’m not sure that it makes sense to me with a Roth.

    The problem I see is that ROTH contributions are so limited, and the return is so great (no tax ever), that you would want this type of account to have the maximum return/growth possible. Therefore, if the return on bonds is an average 5% and stocks is an average 8% (these are just hypotheticals), you would prefer the stock over the bond in the ROTH – even though you would be forgoing some tax-efficiency in the present, for greater tax savings in the future. That said, we don’t know what the future will bring (which will outperform, stock/bond), so would it not make sense to treat the ROTH as a small microcosm and use the same asset allocation that we assume will provide the best risk/return for our entire portfolio? This is how I’ve treated it in the past, and I still have yet to hear a compelling argument against it?

    Anyone have any insight why this may be faulty logic?

  13. James – I think you are absolutely right. While I understand the rationale behind Jonathan’s and really – the Diehard Forum’s post, I don’t understand why you would want to go for the highest yielding/gaining return over the long haul. I think this advice is simply WRONG for a person that is 25 years old and just starting to invest. However, the argument that this post makes is VERY compelling for the 65 year old that is attempting to have their portfolio outlast their lifespan.

    If James and I are completely wrong…please put us in our place. However, I would strongly argue that this is terrible advice for the new investor that has many years left until retirement. Go for the long term historical return of 10-11% in an all stock or 90/10% portfolio. I bet you come out on top over the long haul versus taking this advice about sticking High Yield Bonds in your Roth for 30+ years.

  14. I’ll do some other scenarios later, but here is p.141 of Boglehead’s.

    Assumptions:
    total stock return, annually: 10%
    dividend yield 1.5% (so share appreciation is 8.5%)
    bond return, annually: 7%
    dividend + long term capital gains tax 15%
    income tax rate 25%

    Start:
    $100,000 total, $50k stocks, $50k bonds
    You only have $50,000 available in tax-deferred accounts (pre-tax/401k)

    After 30 years:
    stocks in taxable, bonds in deferred, after tax total = $1,005,451.

    bonds in taxable, stocks in deferred, after tax total = $886,430.

    I’m not saying this is definitive, this is just their example. Future changes in tax policy could easily affect this. There is also no Roth in the equation.

    But using these assumptions, which I think are reasonable, it would be better to place the stocks in taxable. I’m sure if you assume 12% stock return and 5% bond return the results will be different.

  15. Taxable vs. Roth, not from book

    Same Assumptions as above

    Same Start as above, except $50k in taxable and $50k in Roth-type accounts

    After 30 years:
    stocks in taxable, bonds in Roth, after tax total = $1,100,604.
    ?
    bonds in taxable, stocks in Roth, after tax total = $1,104,548.

    In this case, putting stocks in the Roth wins out barely. If the horizon was longer than 30 years, it would do better. If the horizon was less than 30, it would be worse. Again, this based on specific assumptions, and the 30 year marker here could be longer or shorter in reality.

    These are very preliminary results, but perhaps this “rule”, like many others, has it’s share of exceptions.

  16. I really need to get back to “real” work, but…

    Asset Location: A Generic Framework for Maximizing After-Tax Wealth

    “Optimal location is shown to depend on the client’s particular financial profile (taxes, cash flows), prevailing tax laws, and on the tax characteristics of the asset classes in their portfolio.”

    “High-return, high-tax-efficiency classes do much better in a taxable account, while high-return, low-efficiency classes do better in an IRA. Low-return classes can be placed in either account, since the difference in end-wealth will be small. Low return and very high efficiency classes, such as muni bonds, should be located in taxable accounts. For medium return and efficiency classes, a customized analysis may be needed to find the optimal location that maximizes end-wealth.”

  17. Nice post. However, I believe the difference between traditional IRA and Roth IRA is mis-understood widely, including this article. The right way to do this IMHO is to deduct 25% or whatever you think your final tax bracket is from the traditional IRA/401k, then treat it the same as the Roth. Otherwise, by putting bond in traditional and stocks in Roth, you are just cheating yourself by underweighting the actual bond percentage to achieve higher returns and think you get the benefit from tax saving. In a bear market, you might hurt yourself.

  18. Cool, nice overview of tax efficiency. Thanks for the cheat sheet!

  19. what is your real work jonathan? I’m not sure if i ever found that information..

  20. I feel like this is incomplete because tax-efficiency isn’t the only thing to care about. The time horizon for the different investments is also important. From that perspective, retirement assets (which won’t be used for years) should have riskier assets (like stocks) while taxable accounts (which are often useful in the short-term) should have some of the less risky assets (like bonds). And while these considerations might line up for certain kinds of assets (e.g. high-yield bonds from poor credit risks), it seems clear they often don’t…

  21. In the end, each individual’s propensity for risk or their aversion to risk is different and so this BROAD measure of asset placement will vary according to differences in lifestyles, much like the variances we’ve seen in the responses to this blog. That said, i think this diagram provides an excellent basis for determining asset allocation (thanks Jonathan).
    As for Roth IRAs, individuals in the higher marginal tax brackets (currently 28% and above) are generally excluded from Roth contributions or conversions anyway, so they normally wouldn’t benefit from the Roth unless they’ve made contributions in the past.

  22. LazyIndexer says:

    I agree with Bigfoot. I dont’ think you need to distinguish between pretax and posttax retirement accounts. You pay income tax on it only once in either case (when you put it in, or when you take it out). If the tax rates are the same, the future investment value is also the same.

  23. This is an excellent post! I don’t know how you are able to decipher this stuff into digestable form but great job! now I have to figure out how to apply this to my own accounts.

  24. You might enjoy my post on the subject of asset location, which contains abstracts and links to three papers on this subject:

    Asset Location

  25. Sweet. I included this post in my latest Tax Carnival (#12)

  26. I like this style of writing. Its simple, to the point and has a picture. Good job.

  27. Just call me Big Chris says:

    This is dumb and I dont like it. For those of us in lower tax brackets the tax efficiency thing is exaggerated. Taxable bonds may work OK in taxable account. Some balanced funds too. Try MAPOX fund

  28. I think this is a fantastic discussion and am only a bit remorseful I had not seen it sooner. In particular, I am very interested in how in how to best allocate mutual funds between Roth IRA and Traditional IRA accounts. I spent some time reading the various material provided (which mostly focused on taxable vs non-taxable options) and took the additional step of calling a licensed advisor with T. Rowe Price to get their take. While I am still going through the thought process, some observations / comments:

    1) Predicting the future is fundamental to this exercise (ex: will taxes go up / down, will I be in a lower / higher tax bracket when I retire, will stocks or bonds provide better returns…and by how much, etc) and can have a significant impact on decision.

    2) Interesting to me that many of the articles / discussions out there focus mostly on taxable vs non-taxable. My goal has always been to max out on the 401k and Roth IRA first. Since I am unable to do that, I don’t have any “extra” to be invested outside of them in taxable accounts. That is not to say I do not have free cash (in fact I have a good chunk of my portfolio in it), but would not invest it in anything but liquid instruments like a money market, etc. Perhaps that is something I should reconsider?

    3) I believe that taxes have only one way to go from here, and that is up. The recent tax laws including the provision to switch to a Roth IRA in 2010 leads me to believe that others much richer / more knowledgeable than I believe the same thing and will be shifting their funds that way in anticipation of tax hikes in the future

    4) I also believe stocks will continue to outperform bonds over the long term (at least I’m sure investing that way).

    5) Utilizing my assumptions in #3 & 4 and the fact I will be investing for almost 30 more years, I think that putting your best returning, least tax-efficient equity funds (versus bonds) into a Roth IRA is the most tax advantaged way to split your allocation between Roth and Traditional IRAs.

    Thanks again for a great topic / discussion.

  29. i found this on google when i asked for the
    implications of taxed versus nontaxed mutual
    funds…now all funds are in taxed mutual funds
    and i try to decide whether to move to nontaxed;
    from BA bankers i learned that 31% tax bracket
    was the breakeven to switch to nontaxed mutual
    funds…buit my question is the implications of
    moving the funds to nontaxed mutual funds:
    what do i need to evaluate

    ((i am not in love with your posting on your website,
    but do if you must, i prefer instead to receive an
    answer to my email))

  30. Here’s another resource:

    http://www.bogleheads.org/wiki....._Placement

    Large Cap International in taxable accounts has the advantage of Foreign Tax Credits, and in a year like 2008 you can take a tax loss (reinvest the money in a similar fund after selling)

  31. good post. picture explains the whole story.

  32. Daddy Paul says:

    Too many investor do not think about tax implications. Many start inside of IRA’s where they don’t have to worry. When they go to a taxabe account many are shocked.

  33. Johnathan, given that bond funds are only yielding 2%; does it change the Asset Location as mentioned in this article http://thefinancebuff.com/tax-.....olute.html ?

Trackbacks

  1. AllFinancialMatters » Blog Archive » JLP’s Weekly Roundup XL says:

    [...] EDITOR’S CHOICE: Jonathan has put together a handy little graphic that explains Tax Efficient Mutual Fund Placement. [...]

  2. [...] EDITOR’S CHOICE: Jonathan has put together a handy little graphic that explains Tax Efficient Mutual Fund Placement. [...]

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    [...] looked at Jonathon’s chart for tax efficient investing, and international stocks are marginally more tax-efficient than small-caps, but all index funds do [...]

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    [...] My Money Blog has a good visual diagram of this ranking (although it is reversed from the way I listed it). [...]

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