Tax Efficiency of Assets

The guiding principle of asset location is to maximize the value of tax deferral by placing highly taxed assets in tax-deferred accounts. Investments that are less tax-efficient, which generate income taxed at higher ordinary rates or produce significant taxable events, should be placed in tax-advantaged accounts to defer or eliminate their tax impact.

The tax treatment of interest, dividends, and capital gains differs significantly. Interest from bonds and dividends from firms are taxed in the year they are received. In contrast, capital gains—increases in the value of stocks or bonds—are not taxed immediately. Taxation on capital gains is deferred until the asset is sold and the gain is realized.

This deferral acts like an interest-free loan from the government on the amount of the capital gains tax due. If an asset appreciates and is held for many years before being sold, the value of this “loan” can be substantial. Consequently, the present discounted value of the tax payment, when the asset is eventually sold, may be much lower than its nominal value, effectively reducing the tax rate below the statutory rate.

Furthermore, the effective tax rate on capital gains is further reduced by the “basis step-up” rule. Under current tax regulations, if an asset with an accrued capital gain is held until the owner’s death and then bequeathed, the recipient inherits the asset with a tax basis equal to its market value at the time of the donor’s death, or sometimes six months thereafter. This allows some capital gains to be entirely exempt from taxation, further lowering the effective capital gains tax rate.

The list of asset types, ranked from most tax-efficient to least tax-efficient, is as follows:

Efficient

Suitable for taxable accounts:

1.

Tax-exempt municipal bonds (beware of AMT and Social Security benefit-taxation impact)

2.

Low-yield money market, cash, short-term bond funds

3.

Tax-managed stock funds

4.

Large-cap and total-market stock index funds

5.

Balanced index funds

6.

Small-cap or mid-cap index funds

7.

Value index funds

Moderately inefficient

Prefer in tax-free, but can go into taxable:

8.

Moderate-yield money market, bond funds

9.

Total-market bond funds

10.

Active stock funds

Very inefficient

Place in tax-Free or tax-deferred

11.

Real estate or REIT funds

12.

High-turnover active funds

13.

High-yield corporate bonds

Bonds Taxable bonds are typically held in tax-deferred accounts such as traditional IRAs or 401(k)s because the interest from these bonds is taxed as ordinary income, which is often at a higher rate than the taxes on dividends and capital gains from stocks. By placing taxable bonds in these accounts, you can defer taxes until withdrawal, potentially benefiting from a lower tax rate at that time.

However, low-yielding bonds, which offer minimal returns, can be more tax-efficient due to their slower growth rate. This means that the same percentage loss from these bonds translates into a smaller actual dollar amount lost. As a result, some investors choose to place higher-yielding stocks in tax-advantaged accounts to maximize returns after taxes. Same applies to high yield stocks and stock funds, although qualified dividends are taxed at favorable rates.

Treasury bonds offer a unique tax advantage as they are exempt from state taxes. This can make them an attractive option for investors facing high state taxes but lower federal taxes. Similarly, Treasury Inflation-protected Securities (TIPS) are taxed like regular treasury bonds, but taxes must be paid annually on the inflation-adjusted portion of the bond’s value, which is not received until the bond matures or is sold. This creates a cash flow issue, making it advisable to hold individual TIPS in tax-advantaged accounts rather than through funds.

Municipal bond funds, while exempt from federal taxes on interest income, typically yield less than corporate or treasury bond funds of comparable risk. This is due to the different types of risks they carry; for example, intermediate-term municipal bonds generally have higher credit risk but lower interest rate risk compared to long-term treasury bonds, potentially leading to similar after-tax yields. Furthermore, the interest from municipal bonds held in taxable accounts may affect the taxation of Social Security benefits, and may affect taxation if you are subject to the Alternative Minimum Tax (AMT), potentially increasing the tax liability.

Mutual Funds and ETFs Balanced funds, which include both stocks and bonds, are popular among individual investors for their simplicity and diversification. These funds, often referred to as balanced, lifestyle, or target retirement funds, offer a tax efficiency that falls between that of stocks and bonds.

Stock funds can be tax-inefficient, especially if they generate substantial capital gains, particularly short-term ones. High dividend payouts can also reduce tax efficiency, though the impact is lessened if most dividends qualify for reduced tax rates under current law. Actively managed stock funds with high turnover rates tend to generate significant taxable gains due to frequent selling. In contrast, low-turnover active funds and index funds generally generate fewer taxable gains, making them more suitable for tax-sensitive investors. Investing in broad-market index funds or ETFs can be more tax-efficient compared to the higher tax costs associated with active management.

Index funds, which track specific indices, must sell stocks that are removed from the index. This can lead to realized capital gains, especially in small-cap and value indices, which are more likely to include stocks that transition to large-cap or growth indices as their prices increase. Tax-managed funds, ETFs, and funds with an ETF class can mitigate many of these gains. Notably, value indices are less tax-efficient due to higher dividend yields, whereas small-cap funds generally have lower dividend yields but fewer qualified dividends. See Table 11.2 “Comparison Of Mutual Fund’s Tax Efficiency” for examples.

International Funds International funds may have a slight tax advantage over U.S. funds due to eligibility for the foreign tax credit. However, this advantage can be offset by factors such as the reclassification of markets; for example, if an emerging market is reclassified as developed, an index fund may need to sell all its holdings in that country, potentially triggering large capital gains.

REITs, which trade like stocks, are required to distribute nearly all of their income to shareholders. This income is generally taxed at the non-qualified dividend rate. However, a small portion (historically around 15%) is non-taxable, as it represents depreciation of the property.

Where you hold different types of investments—taxable or tax-advantaged accounts—should depend on expected return, tax implications, and each investment type’s specific tax advantages or disadvantages.