Asset Location Optimization - Tax-Efficient Fund Placement | White Coat Investor (2024)

By Dr. James M. Dahle, WCI Founder

Asset location is determining which of your assets to place into tax-free (Roth), triple tax-free (HSA), tax-deferred, and taxable accounts. It has been estimated that doing this properly can boost returns by as much as 0.75% per year. 0.75% a year can make a big difference over many years, enough so that many investors prefer to manage their investments themselves rather than paying an amount less than that to an advisor.

Discussions of asset location are all over the place. What most investors want is a prescribed list of what types of investments go into what type of account that they can simply plug and chug with. The Bogleheads and others have attempted to do this many times over the years. It usually looks something like this:

Over the years, thankfully this list and the accompanying text on their (our?) wiki has become less dogmatic and thus more accurate, although I'm sure there are plenty of multi-family syndicate investors shaking their head at seeing real estate all lumped into one location when all or most of their investment income is currently covered by depreciation.

I've hit this topic several times over the years. The more controversial I made the titles, the more attention I got. The post labeled “Bonds Go In Taxable” was particularly enjoyable even though many people never got past the title. However, today I'm going to do fewer calculations and stick with the major principles. While the calculations change all the time as tax brackets, your income, yields, assumptions about the future, and other variables change, the principles are fairly static.

Remember that “tax-advantaged” or “tax-protected” are simply blanket terms that include both “tax-deferred” accounts like a 401(k) and “tax-free” accounts like a Roth IRA.

Principle #1 of Asset Location

The Higher the Expected Return, the More Likely the Asset Should Be in a Tax-Protected Account

As a general rule, you want your investments to be protected from taxation as they grow. The tax drag of having to pay taxes on dividends and capital gains each year is significant. Even the minimal tax protection offered by a low-cost annuity or a non-deductible tax-deferred contribution can eventually overcome the poor tax treatment received upon withdrawal if the investment is held long enough. So as a general rule, you want as much of your portfolio in a tax-protected account as possible without doing something stupid.

This is done primarily by maxing out contributions to those accounts and doing Roth conversions. However, a smaller effect can be had by placing asset classes with a high return (at least an expected high return) preferentially into those tax-protected accounts. For example, if you have a $100K Roth IRA and a $100K taxable account and you let them ride for 10 years and then withdraw and spend all the money in one year, putting a perfectly tax-efficient investment that makes 8% in the Roth IRA and another perfectly tax-efficient investment that makes 3% in the taxable account leaves you with more money than doing the opposite. (Assumes a 23.8% LTCG tax rate including PPACA taxes.)

High Returning Asset in Roth IRA

=FV(8%,10,0,-100000)+((FV(3%,10,0,-100000))-100000)*0.762+100000 = $342,099

Low Returning Asset in Roth IRA

=FV(3%,10,0,-100000)+((FV(8%,10,0,-100000))-100000)*0.762+100000 = $322,702

With less than perfectly tax-efficient investments like the ones in our world, the difference would be even larger than the 6% difference seen here.

In the case of a negative return, you REALLY want that asset class in a taxable account. Selling for a loss in a tax-protected account doesn't do you a bit of good, but in a taxable account capital losses can be used to offset capital gains and up to $3,000 per year of ordinary income and carried forward indefinitely. Essentially, Uncle Sam shares your losses with you.

Clearly, you want your highest returning assets inside your tax-protected accounts. This results in a higher tax-protected/taxable ratio and overall higher long-term returns.

Principle #2 of Asset Location

The Lower the Tax-Efficiency, the More Likely the Asset Should Be in a Tax-Protected Account

This is perhaps the most obvious principle and most investors can readily grasp it. Some investments are more tax-efficient than others. For example, if you hold a stock such as Berkshire-Hathaway that does not pay out dividends, you won't pay any taxes on it until it is sold, and if you hold it for at least one year, you will pay taxes on gains at long term capital gains rates–a maximum of 23.8% including the PPACA taxes. That's a very tax-efficient investment.

A less tax-efficient investment would be a lump of gold. This is taxed at your ordinary income tax rate at least until it hits the cap of 31.8% including the PPACA taxes. A typical bond fund would be even less tax-efficient. Not only is the lion's share of the return taxed at your ordinary income tax rates, but it is distributed every year. Real estate taxation can be highly variable. A debt fund is just as tax-inefficient as a bond fund. Most of the return from REITs also gets taxed at ordinary income tax rates, although it may qualify for the 199A deduction. A real estate equity property (or fund) may be able to shelter all of its income using depreciation. It might even be able to shelter income from other properties. Yes, the depreciation is recaptured upon selling the property (but at a maximum rate of only 25%), but nobody says you have to sell it. Even if you have to get rid of it, you might be able to exchange it for another property. If you're generating lots of short term capital gains (actively managed mutual funds or day-trading stocks) you're an idiot you probably want to do so inside a tax-protected account.

At any rate, in case this principle isn't totally obvious, I'll include a little math demonstrating it. We'll assume two investments, each earning 8%, one of which pays out its return every year at ordinary income tax rates (37%) and the other which benefits from the lower LTCG rates paid out only when the investment is sold. (i.e. perfectly tax-inefficient vs perfectly tax-efficient)

Tax-Inefficient Asset in Roth IRA

=FV(8%,10,0,-100000)+((FV(8%,10,0,-100000))-100000)*0.762+100000 = $404,203

Tax-Efficient Asset in Roth IRA

=FV(8%,10,0,-100000)+(FV((8%*0.63),10,0,-100000)) = $379,404

Doing this properly boosts your cumulative return by 6.5%. Now, obviously most investments are not perfectly tax-efficient or inefficient, but the principle holds.

Principle #3 of Asset Location

The More Likely You Are to Avoid Paying Capital Gains Taxes, the More Likely You Should Put Capital Gain Assets in Taxable

What do I mean by this? Well, let me use a personal example. I give a lot of money away to charity each year. Rather than give cash, I donate appreciated shares. (Incidentally, I now do it via a Donor Advised Fund for reasons explained at the link.) I get the full charitable donation to take on Schedule A, and neither the charity nor I have to pay any capital gains taxes on those shares. This has the effect of continually flushing the lowest basis shares out of my portfolio.

Even more powerfully, I tax loss harvest any losses. This allows me to continually build up capital losses that can be used to offset capital gains and up to $3,000 per year in ordinary income. Harvesting the losses and donating the gains means I pretty much won't ever pay capital gains taxes.

Selling high basis shares preferentially when you do need to sell, designating low basis shares for your heirs (who will get a step-up in basis), and exchanging investment properties rather than selling them can have similar effects on the tax-efficiency of a taxable account. The more tax-efficiently you can invest your account, the lower the tax consequences of having “capital gain assets” (i.e. assets where most of the return comes from capital gains) in a taxable account.

For this example, let's consider a very low bond yield environment (munis pay 1%, taxable bonds pay 1.5%, stocks pay 7%) where an investor might normally choose to put bonds in a taxable account. First, we'll look at what happens if the investor pays LTCG taxes. We'll assume the highest tax brackets and perfect tax-efficiency for the stocks.

Stocks in Roth IRA, Muni Bonds in Taxable

=FV(7%,10,0,-100000)+FV(1%,10,0,-100000) = $307,177

Bonds in Roth IRA, Stocks in Taxable

=FV(1.5%,10,0,-100000)+((FV(7%,10,0,-100000))-100000)*0.762+100000 = $289,751

This is the classic example that drove the Bogleheads nuts. It demonstrates that at very low yields, the classic rule of thumb of putting bonds in tax-protected accounts can be incorrect. But what if the second investor doesn't actually have to pay capital gains taxes because of the techniques mentioned above?

=FV(1.5%,10,0,-100000)+FV(7%,10,0,-100000) = $312,769

He actually IS better off with bonds in a tax-protected account even when he otherwise would not be.

Principle #4 of Asset Location

The More Volatile the Investment, the More Likely It Is Better in Taxable

This is a tricky one to do anything with. You are more likely to be able to tax loss harvest a volatile investment and since you can only tax-loss harvest in a taxable account, it stands to reason that more volatile investments belong in a taxable account. The problem with this approach is its interaction with the other principles. A more volatile investment often has higher expected returns (and thus shouldn't be in a taxable account.) It is also more likely to need frequent rebalancing, which incurs transaction costs in a taxable account. In some cases, such as volatile speculative instruments, the investment is less tax-efficient (as you may be paying ordinary income tax rates or collectible tax rates.) Plus, capital losses have a different value to different taxpayers. If you already have $700K in capital losses you're carrying over year to year, a few thousand more probably isn't going to make much difference. But all else being equal (which it never is), a volatile investment goes in taxable.

Principle #5 of Asset Location

Place High Expected Return Assets into Tax-Free Accounts But Recognize You Are Taking on More Risk

Lots of asset location guides will recommend you put stocks in Roth (tax-free) accounts and bonds in tax-deferred accounts. I don't have a problem with this recommendation and I generally follow it. What I have a problem with, however, is when people think this is some kind of free lunch. It isn't. The reason you expect a higher overall return by doing this is because you are putting more of your assets, at least on an after-tax basis, into a riskier asset class. Since you are taking on more risk, you should have a higher return!

Perhaps the best way to think of a tax-deferred account is to consider it as two separate accounts. The first belongs to you and is nearly identical to a typical tax-free account like a Roth IRA. The second belongs entirely to the government. You are simply investing it on their behalf for a few years before paying it in taxes. If you think of your tax-deferred accounts this way, it's easy to understand why this strategy is not a free lunch.

Let me demonstrate with another example. Let's assume two investors each put 50% of their portfolios into stocks (8% assumed return) and 50% into bonds (3% assumed return), but they do so in different accounts and let it ride for 10 years with no rebalancing.

Stocks in Roth Investor

=FV(8%,10,0,-100000)+((FV(3%,10,0,-100000))*0.63) = $300,559

Bonds in Roth Investor

=FV(3%,10,0,-100000)+((FV(8%,10,0,-100000))*0.63) = $270,404

As expected, you end up with less money because you invested the money that is actually yours less aggressively.

A similar effect happens with a Health Savings Account (HSA), at least if you are able to spend it on health care (otherwise, an HSA is much more like a tax-deferred account.) If you actually tax-adjusted all of your accounts and your asset allocation, this effect would disappear. Few investors (and advisors) are willing to do that (and I don't blame them.) This can also be a useful behavioral technique. Essentially, you are fooling yourself (or your advisor is fooling you) into taking on more risk than you could otherwise tolerate!

Principle #6 of Asset Location

If You Have an RMD Problem, Increase Your Tax-Free to Tax-Deferred Ratio

Although few doctors (and even fewer Americans) have the true Required Minimum Distribution (RMD) problem that financial salesmen have used to generate the fear that allows them to sell their wares, if you actually do it may be worthwhile spending some attention on minimizing that problem through wise asset location practices. These are generally people with very large tax-deferred accounts, well into the seven-figure range and/or other sources of taxable income in retirement. I'm not talking about someone collecting $40K a year in Social Security with a $1M IRA. I'm talking about a dual physician couple in their mid 40s who already have $5M in tax-deferred accounts and 10 rental properties.

An RMD problem is someone who is forced by the government to move assets out of their tax-deferred account and into their taxable account against their will. Starting at age 70.5 (although a bill raising this to 72.5 just passed the House at the time of writing), an investor is required to start taking Required Minimum Distributions from their tax-deferred accounts and Roth 401(k)s (but not Roth IRAs, one reason you should roll your Roth 401(k)s into Roth IRAs.) That's usually no big deal, because the amount of an RMD is typically less than the amount you probably want to pull out and spend anyway. But if for some reason you don't wish to spend that money, you end up pulling out the government's portion and sending it to them and then reinvesting your portion in a taxable account where it grows more slowly than it previously did due to the tax drag inherent in a taxable account. That's an RMD problem. It's hardly the end of the world and it usually means you're going to die the richest guy in the graveyard, but there are three things you can do to minimize it.

1. As soon as you realize you may have this issue, you put the low expected return investments (usually bonds) in that account so it grows slower and thus has lower RMDs.
2. Start doing Roth conversions. A Roth conversion is moving money from a tax-deferred account to a tax-free account, essentially pre-paying the taxes you would later pay when taking RMDs. In essence, it moves money from a taxable account (i.e. the money that would pay the taxes) into a tax-protected account. Instead of $300K in a tax-deferred account ($200K of which is yours and $100K of which is the governments) and $100K in a taxable account you end up with $300K in a tax-free account.
3. If you give to charity anyway, once you turn 70.5 give directly from your traditional IRA. This Qualified Charitable Distribution counts as all or part of your RMD that year. Since you're going to be leaving lots of money behind and probably at least some to charity, you might as well get started.

The Bottom Line – Quick List of Asset Location Steps to Take

Confused yet? If not, congratulations, you've got a great handle on how asset location works and probably have already done most of what can be done with your portfolio asset location strategy given your cloudy crystal ball about future tax rates and your future financial life. If you are confused, here is a quick list of the “high-yield” asset location steps to take:

1. If you are going to invest in muni bonds, do so in a taxable account. Their interest is federal and sometimes state tax-free.
2. If you have an investment with a high expected return that is very tax-inefficient (hard money loan fund earning 11% for instance) this is likely worth moving into a tax-protected account, even if you end up paying some fees/cost/hassle to do so.
3. Put your bonds in your tax-deferred accounts. Recognize this isn't a free lunch and it isn't necessarily the right thing to do at very low interest rates, but even when you're wrong, it won't matter much.
4. If you have to invest in a taxable account, the types of assets you want there include equity real estate, municipal bonds, and total market stock index funds. If your taxable to tax-protected ratio gets so large that you have to find another asset class to move into taxable, congratulations, you're going to be very rich. Quit worrying about stuff like this.
5. Max out your retirement accounts and consider Roth conversions.
6. REITs and their mutual funds probably still belong in a tax-protected account even if they would qualify for the 199A deduction.
7. Don't bother doing anything else. It's just as likely to be wrong as right and even if you're right, it won't make much of a difference.

What do you think? What have you done to improve your asset location? Comment below!