When faced with a choice of locating assets in either taxable or tax-advantaged accounts, taxable investors should have a preference for holding equities (versus fixed-income investments) in taxable accounts. But regardless of whether they hold stocks or fixed-income investments, investors should always prefer to first fund their Roth IRA or deductible retirement accounts (IRA, 401k or 403b) before investing any taxable dollars. Because tax-advantaged accounts are the most tax-efficient investment accounts, investors should always take maximum advantage of their ability to fund them. The one exception is the need to provide liquidity for unanticipated funding requirements.
There are six advantages to holding equities rather than fixed income in a taxable account:
Equities receive capital gains treatment while fixed-income investments are taxed at ordinary income tax rates. At least as of this writing, qualified dividends are taxed at a preferential rate.
Securities in taxable accounts receive a step-up in basis for the heirs at death, eliminating capital gains taxes, though not the estate tax. On the downside, securities with unrealized losses in taxable accounts receive a step-down in basis at death—a good reason to harvest losses when available.
Capital gains taxes are due only when realized. Investors have some ability to time the realization of gains. In addition, the advent of core funds, tax-managed funds, and exchanged-traded funds (ETFs) has greatly improved the tax efficiency of equity investing.
When there are losses in taxable accounts, the losses can be harvested for tax purposes. The more volatile the asset, the more valuable the option to harvest losses. Equities are more volatile than fixed-income assets.
Assets held in taxable accounts can be donated to charities. By donating the appreciated shares (the preference should be to donate the shares with the largest long-term capital gain), capital gains taxes can be avoided. Because equities have higher expected returns than fixed income assets, this option is more valuable for equities.
Taxes on dividends of foreign stock holdings are often withheld at the source. Investors can, however, claim a foreign tax credit (FTC) that can then be used as a credit against U.S. taxes. This credit is lost if the asset is held in a tax-advantaged account. Currently, the loss of the FTC leads to a reduction of returns of about 9 percent of the amount of the dividend. This figure can change over time and across funds due to changes in withholding rates, tax treaties, and asset allocation within a fund. Remember that if the investment in international assets is a "fund of funds" structure, no portion of the FTC can be passed on to the investor by the fund of funds. However, if more than half of the fund is invested in individual foreign securities and the remainder structured as a fund of fund, the fund will qualify for a FTC.
The strategy of preferring to hold equities in taxable accounts and fixed-income investments in tax-advantaged accounts has some exceptions:
REITs: Because their dividends are considered nonqualified (and, therefore, taxed at ordinary income-tax rates), real estate investment trusts (REITs) are a tax-inefficient equity asset class. In addition, the majority of the return on REITs is in the form of dividends, not capital gains. Since investors can hold tax-efficient municipal bonds in taxable accounts, those investors that value the diversification benefits of REITs should locate the REIT holdings in a tax-advantaged account.
CCF: Those investors who value the diversification benefit of a common contractual fund (CCF) should locate these assets in tax-advantaged accounts, even if that means holding fixed-income investments in taxable accounts. Again, tax-efficient municipal bonds can be held in taxable accounts.
The asset allocation for some investors will require their holding equities in both taxable and tax-advantaged accounts. Here is the order of preference for holding assets in a tax-advantaged account:
REITs and CCF
TIPS
Nominal bonds
Domestic equities—value
Domestic equities—small-cap
Emerging markets—value
Emerging markets—small-cap
Emerging markets—total market/core
International equities—small-cap
International equities—value
Domestic equities—total market/core
Domestic equities—large-cap
International equities—total market/core
The order of preference may be different for investors with access to tax-managed funds, such as those of Vanguard and Dimensional Fund Advisors. Because of their high degree of tax efficiency, they are the preferred choice for taxable accounts. ETFs can also be highly tax efficient: Their availability can also impact the pecking order.
Consider these additional points:
The more tax-efficient funds should be placed in the taxable accounts.
Tax-managed funds will generally be more tax efficient than funds not managed for tax efficiency.
The broader the definition of the asset class, the more tax efficient the fund is likely to be. For example, a total market fund will be more tax efficient than a narrow asset class fund, such as a small-cap fund. A small-cap fund that holds both value and growth will be more tax efficient than a small-cap value fund.
Large-cap funds are more tax efficient than small-cap funds.
Marketwide and growth funds are more tax efficient than value funds.
Multiple asset class funds (such as core funds and total stock market funds) are more tax efficient than single asset class funds due to lower turnover as stocks "migrate" from one asset class to another. For example, an international core fund holding both developed and emerging markets will be more tax efficient than one holding two separate funds. In addition to the reduction in forced turnover, rebalancing costs between individual asset classes will be reduced, and the core funds will not have to trade if a country is reclassified from an emerging market to a developed one.
The more volatile the asset class, the more valuable the tax option—the ability to harvest losses.
Because not all foreign dividends qualify for the lower tax rate applicable to qualified dividends, the amount of unqualified dividends a fund distributes should be considered.
Application. An investor has a total portfolio of $2 million: $1 million in a taxable account and $1 million in a tax-advantaged account. First, determine the appropriate asset allocation based on the investor's ability, willingness, and need to take risk. Assume it is 54 percent stocks, 3 percent REITs, 3 percent CCF, and 40 percent bonds.
Step One: Locate 3 percent ($60,000) allocations to both REITs and CCF, for a total of $120,000 to the tax-advantaged accounts. That leaves $880,000 yet to be allocated to the tax-advantaged accounts.
Step Two: Place the 40 percent of bonds ($800,000) in the tax-advantaged accounts. That leaves $80,000 of equities that can be held in the tax-advantaged accounts. Place the least tax efficient equities in the tax-advantaged account.
There is an alternative strategy to consider: Since fixed income is more attractive if you have a tax-advantaged account, you might consider maximizing that benefit by purchasing even more bonds in the tax-advantaged account. To accomplish this objective without lowering the expected return (need to take risk), lower the equity allocation (which lowers the expected return of the portfolio) and raise the exposure to the size and value risk premiums, thus restoring the portfolio's expected return to its original level. This both improves the portfolio's tax efficiency and reduces the potential dispersion of returns. You are trading off a lower opportunity for outstanding returns (a reduction in the size of the good fat right tail of potential distributions) in exchange for a lower risk of the potential for extremely negative results (a reduction in the size of the bad left fat tail of potential distributions). One potential negative: You increase tracking-error risk. (See Appendix A for further discussion of this strategy).
One mutual fund product that has proliferated in recent years, especially inside corporate retirement and profit-sharing plans, is the balanced, or lifestyle fund. The idea of the product is fundamentally sound: Create a fund of funds that invests in various asset classes. These funds can be structured to accommodate investors covering the full spectrum from aggressive (100 percent equity allocation) to very conservative (20 percent equity allocation). They provide the following benefits:
They allow investors to hold in one fund a diversified portfolio that can include exposure to both U.S. equities (large growth, large value, small, and small value) and international ones (international large and possibly including emerging markets).
They automatically rebalance to targeted exposures, providing discipline.
If the fund is not an all-equity fund, it will also rebalance between equities and fixed income, once again providing discipline.
However, there are some important negative features:
For investors with a choice of location (unless the fund is all-equity), combining equities and fixed income assets in one fund results in the investor holding one of the two assets in a tax-inefficient manner. If the fund of funds is held in a taxable account, the investor is holding the fixed-income assets in a tax-inefficient location. If the fund is held in a tax-advantaged account, the equities are being held in a tax-inefficient location.
If the fund is held in a taxable account the investor loses the ability to loss harvest at the individual asset class level.
If the fund is in a tax-advantaged account, the investor loses the ability to use any foreign tax credits generated by the international equity holdings. Even in a taxable account, as a fund of funds, the investor loses the ability to use the foreign tax credit.
If the fund is held in a taxable account the equities should be in tax-managed funds. We are not aware of any lifestyle or balanced fund that tax-manages the equity portion. This makes sense, since the fund does not know in which location it will be held. Finally, if the fund is held in a taxable account it is likely that the fixed-income portion should be in municipal bonds. Otherwise, there is a loss of tax efficiency.
Individually, these important negative features impact the after-tax return of the fund. Collectively, they can be very damaging. The bottom line is this: if the use of a balanced or lifestyle fund leads to an inefficient choice of location, its use should be avoided unless the investor is in a relatively low tax bracket.