How to Choose Between 401k, Taxable and Roth IRA Accounts to Optimize Taxes

The organization of your funds into taxable, tax-efficient and tax-free accounts has a huge impact on your taxes -- potentially costing you hundreds of thousands of dollars.

. 5 min read. Financial Independence, Investing.
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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 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

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 Less 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 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

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 less 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 taxable 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:

Efficient Moderately inefficient Very inefficient
  • 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
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 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 between 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.

7 comments

  1. Great article! I like how comprehensive and thoughtful you are for each article you make. It makes it very easy to refer your pages to people that want to understand more about the topics you cover.

    1. i think you have a typo. You’ve written: 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.
      I think you mean to say that a fund that will grow a high amount should be in a tax-deferred account.
      otherwise, very informative. thanks!

      1. I think it’s right actually! If a fund is going to grow a LOT, then it’s likely better in a taxable account. If a fund is going to give off dividends, then it’s better in a tax-deferred account.

        The reason comes down to tax bracket at the time the funds are cashed out. For gains (capital gains), you’ll be limited to about 15% for long-term gains on the brokerage account. For the tax-deferred one, the taxes upon withdraw could be more than 15%, since withdrawing from a tax-deferred account will be taxed based on how much you withdrawal at your ordinary tax rate (which would likely be higher.

        The two tables above might help inform this difference a little?

  2. oops, my mistake. Although I must say I’m confused, not because of your explanation but my own lack of knowledge. Bonds only produce dividends, is that right? and you say bond dividends can be taxed yearly but I don’t understand how. I have the VG total bond fund in a taxable account but everything is set to reinvest so how am I being taxed on bond dividends since i haven’t taken them out of the fund yet?
    also, in all my 401ks I’ve been offered i’ve never been given the option to invest in a good bond fund but I suppose I could do that in my roth IRA. I feel like I’m doing things wrong- most of my stocks (although they are mostly large cap index funds) are in my roth and 401K and my bonds are in my taxable account. the exact opposite of what you recommend! ugh. and switching it all now will just incur lots of capital gains, etc.
    thanks!!

    1. here’s why I’m confused.
      you say:
      If a fund has a high turnover, it may have a high dividend as well… and then you say high turnover funds with dividends should be in tax-deferred account. (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 less taxes you’ll pay.)

      but then you say:
      From the above, we know that the higher the yield and the higher turnover, the more important it is to put funds in a taxable account.

      but the total bond fund has a high turnover and so shouldn’t that be in a tax-deferred account as you state earlier? am i misunderstanding something?
      thanks.

      1. Ahh yeah, good point – I see the confusion in my wording, especially around the statement “we know that the higher the yield and the higher turnover, the more important it is to put funds in a taxable account.”. The higher the turnover there is, the more important it is that LOW turnover funds are in taxable accounts. I’ll update the article to reflect that one. Thanks for calling attention to it, as my wording there was easily confusing.

        Here’s a few dices into the other comments:

        > Bonds only produce dividends, is that right?
        They’ll always produce dividends yes, but they’ll also change in value some – but that’s not usually their major driver of value.

        > you say bond dividends can be taxed yearly but I don’t understand how
        Bond dividends in a tax-deferred account won’t be taxed, but you’ll still pay tax when you take out money (possibly at age 60). For bonds (or anything that has dividends) in a taxable account, you’ll get a statement at the end of the year from your brokerage, a 1099-DIV, that will highlight your “qualified dividends” and “non-qualified dividends” for the year. You’ll pay long-term capital gains tax on the “qualified dividends” and short-term capital gains tax rate on the “non-qualified dividends”. The higher the turnover on the fund, the more likely the dividends will be “non-qualified dividends” and the more likely you’ll pay the short-term capital gains tax rate.

        Even when you’re set to “reinvest”, the fund is still giving dividends to you that you can choose to take out as cash, reinvest, or invest in something else. That’s the moment when you’re “earned” the dividends, and are taxed for them.

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