Minimal Investor 4 – Tax-Efficient Fund Placement


Written by Adam on October 5, 2018. Updated April 24, 2019.
16 min read. Leave a comment.

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Hey hey, and welcome back to lesson 4 of The Minimal Investor!

Lesson 3 Review

In the last lesson leaned towards the analytical. Understanding how to pick a fund amongst all the others you can choose is an incredibly important skill. Here’s a recap of what we did.

  • Choose a US Stock Market fund, an International Fund and a Bond Fund.
  • Filter for funds that have the lowest fees (index funds).
  • Look at how large the market cap is on the each of the similar funds.
    • Larger the market cap, the more other people are invested in it.
  • Look at the number of companies/bonds the fund invests in
    • The higher the number, the more diversified the fund it.

By going through this process in your brokerage, you should now have 3 funds that you want to invest in. If you’re using Vanguard, you can use the 3 funds that we talked about last week:

  • Vanguard Total Stock Market Index Fund Admiral or Investor Shares (VTSAX)
  • Vanguard Total International Stock Index Fund Admiral Shares (VTIAX)
  • Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX)

Lesson 4 – Tax-Efficient Fund Placement

There have been 4 moments when learning about investing for me personally when I did the math on something and was completely floored. Those 4 times were:

  • Compound Interest – Understanding how compound interest meant I could earn more from my investments than I could be working.
  • Diversification – How diversification means being solidly in the middle of the investing curve – performing as good or better than average.
  • Fees – How fees were eating HALF of my potential investment gains.
  • Account Choice – How choosing the wrong account for an investment can eat up to HALF my potential investment gains.

And the realization for today: At the end of this week, you should have a good understanding of what this last one means, and how you can plan accordingly.

Here’s how we’ll get there in lesson 4:

  1. What types of accounts are there?
  2. Why is this a problem?
  3. What are dividends?
  4. Which funds should go in which account? And Why?

This will be a little shorter week than previous ones!

1) What types of accounts are there?

Here in the US, there are 4 major types of accounts:


Only offered by a job. You put pre-tax money in a 401k, which lowers your taxes while you’re depositing money. Since you’re putting in pre-tax money, you’ll be able to put in a little more than if this was after tax. When you take money out of a 401k you’ll be taxed as though this were income from a job – which means the rate will depend on how much you take out.

The good: Often come with a company match, allowing you to pay fewer taxes while working (earning more), interest grows tax-free.
The bad: You’ll still pay a bunch of taxes when you withdraw. Depending on your company, there might be a 401k management fee, no control over funds to choose from.

Traditional IRA

Anyone can open up an IRA at most financial services companies. I prefer Vanguard for this (if you haven’t figured that out by now). You can deposit up to $5,500 in an IRA ($6,500 if you’re 50 or older) each year. Depending on your income, you may be able to deduct this investment from your taxes like a 401k. The rule is a little weird: if you don’t have a 401k from your work, you can deduct your IRA contribution. Otherwise, you can only do it if your income is in a specific range.

The good: For people without a 401k, or with income below a threshold, this allows you lower your taxes. You choose where this account is – allowing you to pick somewhere with lower fees. You can roll a 401k over to an IRA.
The bad: You’ll still pay taxes when you withdraw from this later on.

Roth IRA

Like an IRA, anyone can open up a Roth IRA – usually at the same place. Often, this will be offered with your 401k. I’d strongly recommend not using the same company as your 401k for this though, and instead, opening an account on your own at Vanguard (for The bad reasons above for 401ks). Roth IRAs are unique, because you put money into them after-tax, and get money out tax-free. These are my favorite account type, since you don’t pay taxes while the money is growing, or when you take money out when you retire.

The $5,500 limit for IRAs is for traditional + Roth, so if you put $5,500 in a Roth IRA for a year, you can’t put anything in a Traditional IRA.

The good: You’ve already paid taxes, so no need to pay anymore! Best account type for overall growth. Won’t pay capital gains taxes. Once the money is in, that’s 100% vested, taxed and yours (once you hit age 59.5).
The bad: Low limits, you’ve already paid taxes on it. Income limits mean you can’t use this if your income is above $110,000. Can’t access until you’re 59½.

Brokerage Account

After you’ve invested the max in the above accounts, then a brokerage account may be your last choice on where to invest. Brokerage accounts are a general all-purpose account (like a savings or checking account), but instead of holding cash, they hold investments. 

The good: You can put money in or take money out at any time. No limits. Not age restrictions.
The bad: You’ll pay taxes when you sell funds at a gain, which means you need to be careful what you choose. Dividends also will result in taxes.

In week 1 we looked at which accounts you use, but let’s look at this graphics again.


Which accounts should you be investing in?


  • Look at the order of accounts and figure out where you’ll be investing.

2) Why is this a problem?

Choosing the wrong account can eat into half of your total investment gains. To see that in action, let’s look at an example by comparing two people.

Both GoodSaver and BadSaver both have a tax-deferred account (a 401k) and a taxable account (a brokerage). They invest $50,000 in each account. The only difference is which funds are in which account.

GoodSaver: Invests in stocks in their brokerage account and bonds in their 401k.
BadSaver: Invests in bonds in their brokerage account and stocks in their 401k.

This is a small different – just swapping bonds and stocks. For both of these accounts here’s the flow they’ll follow:

  • Invest $50,000 in their brokerage and $50,000 in their tax-deferred account.
  • Wait 30 years for growth.
  • Cash it out and pay taxes.
  • Using the same tax and growth projections for each account. 

GoodSavers Investments

Here’s what their account would look like after 30 years.

GoodSaver Stocks in Taxable Bonds in Tax-Deferred Total
Beginning Value $50,000 $50,000 $100,000
Value after 30 Years $820,490 $380,613 $1,201,103
Taxes due on withdrawal $100,499 $95,153 $195,652
After-tax value $719,991 $285,460 $1,005,451

You can see that GoodSaver would pay $195,652 in taxes when they withdraw — no small amount! Their total after-tax value at the end will still be over $1 million though. In the end, GoodSaver paid about 16% in taxes.

BadSaver’s Investments

Their investments were slightly switched up – with bonds in a taxable account and stocks in a tax-deferred account.

BadSaver Bonds in Taxable Stocks in Tax-Deferred Total
Beginning Value $50,000 $50,000 $100,000
Value after 30 Years $232,078 $872,470 $1,104,548
Taxes due on withdrawal $0 $218,118 $218,118
After-tax value $232,078 $654,352 $886,430

The big thing that stands out immediately is that the “after-tax value” of BadSavers investments are $120,000 less! They also paid more taxes. So they paid more taxes upon withdrawal and the value of their account was lower? Why did GoodSaver end up with $120k more?

Reason 1: Taxes Each Year

The bond value of GoodSaver was higher ($380k vs $232k). This is because each year the bond was giving off dividends – money back into the account that would be reinvested in the bond. For the tax-deferred account, this money was automatically invested. For BadSaver, this was in a brokerage account, and they needed to pay taxes on those dividends EACH YEAR.

Taxes are a hidden killer for bonds. Bonds and other funds that give off dividends are best when placed in a tax-deferred account. In this example above, the value of the bond didn’t increase, so no taxes were due on withdrawal. However they did have a pay a ton in taxes, and that was all money that didn’t compound into growth.

Reason 2: Favoring growth in tax-deferred

BadSaver also did something else wrong – they grew their funds extremely high in their 401k rather than their brokerage. This is why their taxes were so much higher. Remember, when you cash out funds from a 401k, you’ll pay taxes based on how much you cash out. The more you cash out, the higher the taxes! The taxes due on the taxable account are considerably less since they’re charged at the capital gains tax rate (something we’ll dig more into in week 8).

Reason 3: You Probably Won’t Sell All At Once

Both accounts did this wrong actually. For me personally, I can’t think of a situation where I’d sell all at once. If instead, you withdrew a small amount each year, the tax implications would be less skewed – but there’s no situation in which this account choice would be preferred.

If you want to dig more into this topic, read my article on How to Choose Between 401k, Taxable and Roth IRA Accounts to Optimize Taxes.


  • Putting funds in the wrong account could eat into as much as half of your entire investment earnings!

3) What are Dividends?

Let’s look at three funds to see how they differ from a dividend/yield perspective — Vanguard Total Bond Market Index Adm (VBTLX), Vanguard Total Stock Mkt Idx Adm (VTSAX) and Vanguard REIT Index Admiral (VGSLX). Here are three quotes from Morningstar.


The key things to look for here when it comes to taxes are the “TTM Yield” and the “Turnover“. The TTM Yield is the “trailing twelve-month yield” — the amount returned to investors over the previous 12 months. This “amount returned” is different than growth in the fund price. This amount is flat out money back in a cash account of the owner of the fund.

TTM Yield
If you invested $100,000 in each of these over the last year, you’d have received $1,920, $2,450 and $3,290 in dividends. Within these dividends, there are qualified dividends and ordinary dividends which are taxed at different rates, and their own subject I’m not going to go into, except to say that ordinary dividends are taxed at your income rate, while qualified dividends are taxed at the capital gains rate (again more in week 8 on this).

The Turnover is a representation of how long the underlying assets in the fund stick around. A high turnover means that funds are bought and sold often within the fund. Generally, index funds that are matching an index will have a very low turnover, since the index isn’t changing. “Actively managed funds” (where a human intervenes) generally have a MUCH higher turnover. 

If a fund has a high turnover, it may have a high dividend as well. This is because the underlying assets from the fund are sold, and the gains are distributed in the form of dividends. 

These dividends are then taxed, potentially at your normal tax rate! The only times I’ve found where it makes sense to be making a high amount of dividends are in a tax-deferred account, or if you are using the dividends immediately and not reinvesting them. You probably won’t be able to get away with having no dividends in taxable accounts while you’re growing your investments (unless you don’t have a taxable account), but the less you do, the fewer taxes you’ll pay.


  • The higher the dividends and turnover, the more taxes you will pay.

4) Which funds should go in which account? And Why?

The takeaway here is that the reason GoodSaver made a lot a more money was due to their choice to put their dividend generating assets and growth assets into the correct accounts. The higher the yield and the higher the turnover, the more important it is to put that fund in a tax-deferred account. If you want to minimize your taxes, this is your path to it.

I’ll be honest, when I was working with a financial advisor they didn’t ever mention any of this to me. Taxes way down the line aren’t something that all financial advisors will always tell you about. If you are working with a financial advisor, having a chat about taxes can be just as important as having a chat about diversification and fees. It might even more beneficial to have a chat with a CPA or tax professional who knows more about this subject than a financial advisor would.

In the case above, the Bond fund generated a bunch of dividends each year for BadSaver, causing them to pay taxes on those dividends each year – resulting in a much lower account balance. GoodSaver didn’t pay taxes on dividends each year (since their funds were in a tax-deferred account), and because of that, they had a much higher balance at the end. This isn’t only a rule for bond funds though. Here are some of the different fund types and which accounts they would be most beneficial in.

Efficient Moderately inefficient Very inefficient
Low-yield money market, cash, short-term bond fundsTax-managed stock fundsLarge-cap and total-market stock index fundsBalanced index fundsSmall-cap or mid-cap index fundsValue index funds Moderate-yield money market, bond fundsTotal-market bond fundsActive stock funds Real estate or REIT fundsHigh-turnover active fundsHigh-yield corporate bonds
Taxable Account Tax-Deferred, 401k, IRA Tax-Deferred, 401k, IRA

These are broad strokes from the Bogleheads article on Tax-efficient fund placement, but help gives a starting point. This only looks at taxable vs tax-deferred. The other main account type, tax-free, is a difficult one to pin down on assets. Roth IRAs (tax-free accounts) are great for all types of assets. 


  • Put your highest dividend assets into tax-deferred or tax-free accounts.
  • Delay taxes whenever possible.

Unanswered Questions

Here are a few questions I haven’t found a good place to answer elsewhere. If you have a question about anything in this post, feel free to reply to this email. If you have a question a bunch of others probably do too!

I only have 1 account – what should I do?

Use it! Especially if it’s a tax-deferred account. The beauty of these accounts is that you won’t have to worry about taxes until you start taking distributions, so they’re an excellent place to learn how to invest without worrying about paying taxes each year. Try planning what a diversified portfolio would look like in this account – how much in a bond fund, an international fund, and a US Stock fund.

I only have a brokerage account. Won’t that mean paying a ton of taxes?

If you need to put a tax-inefficient fund in a non-tax advantaged account, try finding a substitute fund that pays fewer taxes for the bond fund. For example, instead of investing in “Vanguard Total Bond Market Index Fund Admiral Shares”, pick “Vanguard Intermediate-Term Tax-Exempt Fund Investor Shares”. It’ll be less diversified but more tax-efficient. This is the bond fund that I hold in my brokerage account. It tends to give off less (bad) dividends and more (good) dividends – meaning lower taxes. It says “tax exempt” but that doesn’t mean you won’t pay any taxes though – so be aware of that. I had around $70,000 in this fund last year and ended up paying around $500 in taxes on the dividends from this fund for the year. Keep that 1% in mind for budgeting.

Lesson 4 in Review

We may have got way more deeply into taxes than you ever wanted to go in this lesson. They’re not the sexiest subject, but knowing how to control taxes efficiently can be an amazing superpower. There’s no trickery here, or evasion tactics for getting out of paying taxes – just understanding how investing works and making smart choices.

The key points are simple: put your highest dividend (yield) funds in your most tax-advantaged accounts. With that, you’ll pay fewer taxes.

There’s a balance between diversification, taxes, and fees, and finding the ratio that works for your available accounts is what matters. It won’t always mean selecting the most diverse portfolio, or the lowest in fees. Sometimes taxes might be the biggest cost and it becomes more important to select a fund that lowers them. 

Next Lesson

Between lesson 3 (fees), when you choose which funds to invest in, and this lesson where you choose which funds, we’re ready to make our initial investment! In the next lesson, we’ll be walking through the buying process and talking about how to buy funds.

Do you have any questions on topics from this week? Feel free to reply to this lesson, or jump on Slack to chat (this is a new Slack group, so don’t be scared off if it’s just a few other Minimal Investor readers!).


About Adam

Hi, I'm Adam! I help millennials invest to reach financial independence sooner than they ever thought possible. Want to see what you could do to reach FI sooner? You're in the right place!

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