This post is the 3rd in the series “How to Be Brave and Start Investing“. First, we started with the Why Do You Want to Invest Now? of investing, and then moved on to Which Investment Accounts Should I Use?
In today’s post, I’ll focus on what types of funds to use in which account for the most tax-efficient fund placement. This topic may sound a bit dry, but over the course of a few decades investing, it could make a difference of hundreds of thousands of dollars difference in taxes.
By the end of this post, you’ll know why different fund types (stocks, bonds, international funds, real estate trusts, etc) should go in specific accounts, what to look for when evaluating funds to determine placement, and how much money you stand to save by making the right decision.
Why Fund Placement Matters
Let’s look at an example from The Bogleheads Guide to Investing. This is the example that blew my mind and made me realize this is important.
Stocks in Taxable, Bonds in Deferred Account
For this first example, assume we’re holding 50% stocks and 50% bonds. I wrote some about different fund types before if you want to read more about stocks vs bonds. Take a look at the following chart to see how taxes could work for this account and fun mix.
|Stocks in Taxable
|Bonds in Tax-Deferred
|Value after 30 Years
|Taxes due on withdrawal
The assumptions from Bogleheads are extremely rosy: Stock return 10%; Dividend Yield 1.5%; Dividend and Capital Gains tax 15%; Bond return 7%; Income tax 25%
We started with $100,000, invested it 50%/50% in stocks/bonds and after 30 years we have 12x as much — $1,201,103. At that time we sold all of it, and paid 16% in taxes. Now, there are a few things to keep in mind about this that are important:
You Probably Won’t Sell All At Once
For me personally, I can’t think of a situation where I’d sell all at once.
If You Sell Only a Little, You’ll Pay Fewer Taxes
In this situation, the tax implication was 16% due to a capital gains tax on the stocks, and an income tax on the bonds. However, if you’re making less than $37,450 (individual) or $74,900 (filing jointly), you’ll pay $0 on capital gains, and your tax-deferred withdraw will be in the 10%-15% range.
For the above scenario, if withdraw 3-1 stocks to bonds, and are taking out $60k/yr, you’ll be paying $0 taxes on the $45k in capital gains, and $1,500 taxes on the $15,000 withdrawn from the tax-deferred account. The next taxes on $60,000 would be $1,500, or 2.5%. If you have a mortgage, gave to charity, or any other deductions, you’ll pay even less.
The big takeaway here is that although this focuses on lowering taxes by tax-efficient fund placement, another great way is to withdraw funds a little at a time.
Bonds in Taxable, Stocks in Deferred Account
What if we switch up the above table and put bonds in the taxable account and stocks in the deferred account? Here’s what that looks like.
|Bonds in Taxable
|Stocks in Tax-Deferred
|Value after 30 Years
|Taxes due on withdrawal
Let’s take this column by column starting with bonds. The “value after 30 years” is different from the stocks in tax-deferred. In the 2nd scenario, the value of bonds is significantly less after 30 years because each year during that 30 years, the bonds were throwing on dividends that were being taxed that year. Because of that almost half of the earnings from the bonds are eaten up by taxes.
For the stocks in tax-deferred, the value is slightly higher in the tax-deferred account of the same reason. In scenario 1, the stocks column is taking a minor hit due to dividends being distributed and taxed for each of those 30 years. In scenario 2, we see what the value would with full reinvestment of dividends. The taxes for this column are wildly different — 2.5x the amount when stocks were in a taxable account. The reason for that is because the stocks are being taxed as regular income when withdrawn from the tax-deferred account, rather than being taxed as capital gains.
The takeaway from all this is that if there’s a lot of dividends, put them in a tax-deferred account – and if you can take advantage of capital gains then do so. Both of these scenarios are buy-and-hold – holding the funds longer than 1 year. If you were to hold funds less than 1 year, this would be completely different.
Understanding Yield and Dividends
Let’s look at two 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. 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 are taxed at the capital gains rate.
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” are ones where the funds’ group decides what that fund invests in. These 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 time it makes sense to be making a high amount of dividends is in the case that 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, but the less you do, the fewer taxes you’ll pay.
Which Assets in Which Accounts?
From the above, we know that the higher the yield and the higher turnover, the more important it is to put funds in a tax-deferred account. From the bonds vs stocks comparison, we also know that if a fund looks like it will grow a high amount, then we may be able to save money by having it a taxable account and taking the hit when it comes time to withdraw. Tax efficient fund placement can be broken down into 3 efficiency levels:
|Low-yield money market, cash, short-term bond funds Tax-managed stock funds Large-cap and total-market stock index funds Balanced index funds Small-cap or mid-cap index funds Value index funds
|Moderate-yield money market, bond funds Total-market bond funds Active stock funds
|Real estate or REIT funds High-turnover active funds High-yield corporate bonds
|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 for assets. Roth IRAs (tax-free accounts) are great for all types of assets.
Depending on your situation, it may make sense to put stocks, bonds or REIT funds in your Roth. For me, my Roth includes all of my REIT funds, followed by international bonds and some of the highest turnover and yield stock funds.
Your Next Steps
Try to look at where you have money invested in taxable, tax-deferred and tax-free accounts. Are your highest yield funds in tax-deferred accounts? Are you buying and holding for longer than 1 year? Are your funds with the highest turnover in tax-deferred or tax-free accounts?
If you do have money in taxable accounts now, making the change to this could help save you hundreds of thousands of dollars over the long term. If all of your investments are in tax-deferred or tax-free accounts then congratulations, you don’t have too much to worry about! However, even with just a 401k and a Roth IRA, it’s important to put bonds in the 401k and stocks in the Roth to minimize taxes later on.