Recently I received a voice mail message from a listener named David. (You can leave a voice mail message–doughroller.net/voicemail–with a question or topic for the show. Here’s what David asked:
“Yes, Rob, this is David from Round Lake, Illinois. I’d like to know what type of funds, ETF’s should I have in a regular tax brokerage account to reduced my taxes. I currently have stock ETF’s in a Vanguard balanced fund in it. Am I doing okay? Thank you.”
We can broaden David’s question into two parts:
- What investments are good for a taxable account?
- What kind of investments should you have in a retirement account?
But before I tackle this topic, I want to emphasize that I am not a tax expert. Like most other topics on this blog, my answers to David’s question will represent my opinions based on my own experience and third party resources, which I’ll provide at the end of this blog post.
Table of Contents:
Let’s begin with so what question. Why is asset location important? With the right asset location, and the right investment mix in a taxable account, studies have shown that you can increase your after tax return by somewhere between 10 and 50 basis points annually.
That increase may not seem like much, but as I have pointed out many times in the past, when you multiply that improvement over a lifetime of investing, it increases your investment pile significantly.
So let’s dig in. First, we need to think beyond just taxable and retirement accounts. To take full advantage of asset location, we need to consider three types of accounts:
- Taxable Accounts
- Roth Retirement Accounts
- Traditional Retirement Accounts
Why? The reason is that tax efficiency is about more than just whether we pay taxes now or later. It’s also about the tax rate will pay, and how much of our wealth will be taxed. With a Roth 401(k) or Roth IRA, we enjoy tax-free compounding. As a result, we want investments in a Roth that we think will grow the most.
With this in mind, here’s where I place my investments:
- Roth Retirement Accounts: High Risk/High Return Investments (e.g., emerging markets, small cap value)
- Traditional Retirement Accounts: Tax inefficient investments (bonds and REITS, actively managed funds with high turnover)
- Taxable Accounts: Tax efficient investments (index funds, munis, individual stocks)
There are some potentially complicating factors. As noted above with Roth accounts, it’s important to consider more than just the tax efficiency of an investment. We should also consider its potential growth and income. As a result, it may be preferable to keep short term bond funds in a taxable account. Yes they generate taxable income every year, much like a savings account, but the yields are so low that the tax consequences may be minimal.
Ultimately you have to come up with a strategy that fits your specific circumstances. Some live in states with high tax rates, others live in states with moderate taxes. The difference can matter. Some should consider estate planning as part of the analysis. Finally, keep in mind that even the experts don’t always agree on the proper asset location.
It can be a challenge to determine just how tax efficient a mutual fund is. As a general rule, index funds are more tax efficient than actively managed funds. That being said, Morningstar offers some excellent tools to help you determine the tax ramifications of mutual funds and ETFs.
- Turnover Ratio: Shows you how much of a portfolio is sold each year. The higher the ratio, generally, the less tax efficient the fund.
- Tax Adjusted Returns: Morningstar offers after-tax return estimates for the mutual funds it covers.
- Tax Cost Ratio: Similar to an expense ratio, Morningstar calculates the effects of taxes. The lower the number the better.