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Asset Location Fundamentals (Which Investments to Own in Which Account)

A reader writes in, asking:

“Would you please direct me to where I can find your advice on asset location? In particular, is a Roth, Traditional IRA, or taxable account the best place to hold an International Equity ETF?”

Asset location (as opposed to asset allocation) is the question of which investments should go in which accounts. For example, if your portfolio includes Roth accounts, tax-deferred accounts, and taxable accounts — and you want your portfolio to include US stocks, international stocks, and bonds — which thing should go in which account?

To back up a step, in most cases, a taxable account is not the best place to hold any investment intended for retirement (other than muni bonds). That is, almost everything is better in a retirement account than in taxable. So if all of a person’s retirement investments can be held in retirement accounts, they usually should be.

When there must be a taxable part of the portfolio (e.g., because the amount you saved/invested per year exceeded the annual retirement account contribution limits), it becomes a question of determining which parts of your desired asset allocation are most tax-efficient. Or said differently, “out of my desired asset allocation, which parts are the least-bad to own in taxable?”

Asset Location: Stocks vs. Bonds

Stocks are usually more tax-efficient than bonds (i.e., they’re less bad to have in taxable than bonds are, usually). That’s because dividends and long-term capital gains are usually taxed at lower tax rates than bond interest. However, the tax efficiency of stocks relative to bonds depends not only on tax rates but also on yields (i.e., how much income each pays). As an extreme example, a bond paying 0% interest would be quite tax efficient, as it would generate no annual tax cost at all.

Municipal (“muni”) bonds are an exception to the above, because the interest they pay is completely exempt from federal income tax. And in many cases, muni bonds issued within a given state will be exempt from state income tax within that state as well. That’s why fund companies often offer state-specific muni bond funds.

Muni bonds should never be held in a retirement account. Though whether you should own muni bonds at all (rather than taxable bonds) depends on the difference in yields between muni and taxable bonds as well as your tax rate. (Essentially, when looking at a muni bond fund, you want to calculate the equivalent taxable yield. Then determine whether taxable bond funds with a similar level of risk have yields that are higher or lower than that.)

Asset Location Among Stocks (and Stock Funds)

Stocks with lower dividend yields are more tax-efficient than stocks with higher dividend yields (because again, the less income something pays, the more tax-efficient it is). So if your stock holdings are split between “growth” and “value,” growth is generally the better of the two to hold in taxable.

REITs are a particularly undesirable holding in taxable, because they pay high dividend yields and those dividends are taxed at a higher rate than qualified dividends.

Holding international stocks in taxable allows you to take advantage of the foreign tax credit.

Asset Location Among Bonds (and Bond Funds)

As noted above, muni bonds may be the best choice for somebody who has to hold bonds in a taxable account.

Among taxable bonds, Treasury bonds are exempt from state income tax, which makes them somewhat more tax-efficient if you live in a state with income tax.

Also, the safer a bond is, the lower its yield will be, and therefore the more tax-efficient it will be. Therefore:

  • Bonds with higher credit ratings will generally be more tax-efficient than bonds with lower credit ratings.
  • Bonds with shorter duration will generally be more tax-efficient than bonds with longer duration.

So, taken together, the above points indicate that short-term Treasury bonds tend to be quite tax-efficient, relative to a lot of other taxable bonds.

Other Asset Location Notes

When you own a mutual fund in a taxable account, each year you have to pay tax on your share of the capital gains that the fund realized whenever it sold anything over the course of the year. As a result, the more frequently a fund sells its holdings, the more capital gains you’ll have to pay tax on each year. Point being, funds with low portfolio turnover are more tax-efficient than funds with high portfolio turnover. In addition, the higher the rate of turnover, the greater the percentage of the gains that will be short-term rather than long-term. And that’s bad, because short-term capital gains are taxed at higher tax rates than long-term capital gains.

Index funds, therefore, tend to be more tax-efficient than actively managed funds. (Index funds — especially “total market” funds — have low turnover, because the investment strategy of the fund is just to buy and hold everything in the index rather than regularly buying and selling different stocks/bonds based on the fund manager’s predictions.)

“All in one” funds such as target-date funds tend to be tax-inefficient, for a few reasons:

  • Their bond holdings tend to be tax-inefficient. They’re often a “total bond market” fund or something similar. Most people who need to own bonds in taxable would be better off with either muni bonds or by focusing on tax-efficient taxable bonds (such as short-term Treasury bonds).
  • Even if the underlying funds have very low portfolio turnover, the outer layer (i.e., the fund that owns the underlying funds) creates an additional level of turnover as the fund rebalances between the underlying holdings. And that creates a tax cost. If the fund-of-funds ever decides to do a wholesale switch from one underlying fund to another, it can create a major tax cost to shareholders.
  • They reduce the opportunities for tax-loss harvesting. When the portfolio is split up among US stocks, international stocks, and bonds (or split up at an even more granular level), there can be tax-loss harvesting opportunities created when any one of those components goes down in value. With an all-in-one fund, collectively the whole thing has to go down in value (rather than just one part going down in value) to create a tax-loss harvesting opportunity.

Asset Location: Roth vs. Tax-Deferred

On the topic of which assets should go in Roth and which should go in tax-deferred, the general principle is that the assets with the highest expected returns should go in Roth accounts. This is because Roth accounts have no RMDs during the original owner’s lifetime, so if you have the choice of allowing one account or the other to grow most quickly, it’s best to have the Roth account growing most quickly.

One noteworthy exception would be cases in which a Roth IRA (or a portion thereof) is actually intended for near-term spending (e.g., because of the ability to take contributions back out of the account tax-free and penalty-free, you’re planning to use it in the near term for a home down payment). In such cases, volatile holdings would not make sense for the account.

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