By Dr. Jim Dahle, WCI Founder
Asset location is determining which of your assets to place into tax-free (Roth), triple tax-free (HSA), tax-deferred, and taxable accounts. It has been estimated that doing this properly can boost returns by as much as 0.75% per year. That 0.75% can make a big difference over many years, enough so that many investors prefer to manage their investments themselves rather than paying an amount less than that to an advisor.
Discussions of asset location are all over the place. What most investors want is a prescribed list of what types of investments go into what type of account that they can simply plug and chug with, so they can move on with their lives. The Bogleheads and others have attempted to do this many times over the years. It usually looks something like this:
Over the years, this list and the accompanying text on the Bogleheads' wiki have become less dogmatic and more accurate. I've hit this topic several times over the years. The more controversial I made the headlines, the more attention I got. The post labeled “Bonds Go In Taxable” was particularly enjoyable, even though many people never got past the title. But today, I'm going to do fewer calculations and stick with the major principles. While the calculations change all the time as tax brackets, your income, yields, assumptions about the future, and other variables change, the principles are fairly static.
Remember that “tax-advantaged” or “tax-protected” are simply blanket terms that include both “tax-deferred” accounts like a 401(k) and “tax-free” accounts like a Roth IRA.
Principle #1 of Asset Location
The Higher the Expected Return, the More Likely the Asset Should Be in a Tax-Protected Account
As a general rule, you want your investments to be protected from taxation as they grow. The tax drag of having to pay taxes on dividends and capital gains each year is significant. Even the minimal tax protection offered by a low-cost annuity or a non-deductible tax-deferred contribution can eventually overcome the poor tax treatment received upon withdrawal if the investment is held long enough. As a general rule, you want as much of your portfolio in a tax-protected account as possible without doing something stupid.
This is done primarily by maxing out contributions to those accounts and doing Roth conversions. However, a smaller effect can be had by placing asset classes with a high return (at least an expected high return) preferentially into those tax-protected accounts. For example, say you have a $100,000 Roth IRA and a $100,000 taxable account, and you let them ride for 10 years. Then, you withdraw and spend all the money in one year. Putting a perfectly tax-efficient investment that makes 8% in the Roth IRA and another perfectly tax-efficient investment that makes 3% in the taxable account leaves you with more money than doing the opposite. (This assumes a 23.8% LTCG tax rate, including PPACA taxes.)
High-Returning Asset in Roth IRA
=FV(8%,10,0,-100000)+((FV(3%,10,0,-100000))-100000)*0.762+100000 = $342,099
Low-Returning Asset in Roth IRA
=FV(3%,10,0,-100000)+((FV(8%,10,0,-100000))-100000)*0.762+100000 = $322,702
With less-than-perfectly tax-efficient investments like the ones in our world, the difference would be even larger than the 6% difference seen here.
In the case of a negative return, you REALLY want that asset class in a taxable account. Selling for a loss in a tax-protected account doesn't do you a bit of good. But in a taxable account, capital losses can be used to offset capital gains, and up to $3,000 per year of ordinary income can be carried forward indefinitely. Essentially, Uncle Sam shares your losses with you via tax-loss harvesting.
Clearly, you want your highest-returning assets inside your tax-protected accounts. This results in a higher tax-protected/taxable ratio and overall higher long-term returns.
Principle #2 of Asset Location
The Lower the Tax-Efficiency, the More Likely the Asset Should Be in a Tax-Protected Account
This is perhaps the most obvious principle, and most investors can readily grasp it. Some investments are more tax-efficient than others. For example, if you hold a stock like Berkshire-Hathaway that does not pay out dividends, you won't pay any taxes on it until it is sold, and if you hold it for at least one year, you will pay taxes on gains at long-term capital gains rates—a maximum of 23.8% including the PPACA taxes. That's a very tax-efficient investment.
A less tax-efficient investment would be a lump of gold. This is taxed at your ordinary income tax rate at least until it hits the cap of 31.8% including the PPACA taxes. A typical bond fund would be even less tax-efficient. Not only is the lion's share of the return taxed at your ordinary income tax rates, but it is also distributed every year. Real estate taxation can be highly variable. A debt fund is just as tax-inefficient as a bond fund. Most of the return from REITs also gets taxed at ordinary income tax rates, although it may qualify for the 199A deduction.
A real estate equity property (or fund) could shelter all of its income using depreciation. It might even shelter income from other properties. Yes, the depreciation is recaptured upon selling the property (at a maximum rate of only 25%), but nobody says you have to sell it. Even if you have to get rid of it, you could exchange it for another property. If you're generating lots of short-term capital gains (actively managed mutual funds or day-trading stocks), you probably want to do so inside a tax-protected account.
At any rate, in case this principle isn't totally obvious, I'll include a little math demonstrating it. We'll assume two investments, each earning 8%, one of which pays out its return every year at ordinary income tax rates (37%) and the other which benefits from the lower LTCG rates paid out only when the investment is sold. (i.e., perfectly tax-inefficient vs. perfectly tax-efficient).
Tax-Inefficient Asset in Roth IRA
=FV(8%,10,0,-100000)+((FV(8%,10,0,-100000))-100000)*0.762+100000 = $404,203
Tax-Efficient Asset in Roth IRA
=FV(8%,10,0,-100000)+(FV((8%*0.63),10,0,-100000)) = $379,404
Doing this properly boosts your cumulative return by 6.5%. Obviously, most investments are not perfectly tax-efficient or inefficient, but the principle holds.
More information here:
Building a Balanced Portfolio with Asset Location and Allocation
How to Build an Investment Portfolio for Long-Term Success
Principle #3 of Asset Location
The More Likely You Are to Avoid Paying Capital Gains Taxes, the More Likely You Should Put Capital Gain Assets in Taxable
What do I mean by this? Let me use a personal example. I give a lot of money away to charity each year. Rather than give cash, I donate appreciated shares. (Incidentally, I do it via a Donor Advised Fund.) I get the full charitable donation to take on Schedule A, and neither the charity nor I has to pay any capital gains taxes on those shares. This has the effect of continually flushing the lowest basis shares out of my portfolio.
Even more powerfully, I tax-loss harvest any losses. This allows me to continually build up capital losses that can be used to offset capital gains and up to $3,000 per year in ordinary income. Harvesting the losses and donating the gains means I pretty much won't ever pay capital gains taxes.
Selling high-basis shares preferentially when you do need to sell, designating low-basis shares for your heirs (who will get a step up in basis), and exchanging investment properties rather than selling them can have similar effects on the tax-efficiency of a taxable account. The more tax-efficiently you can invest your account, the lower the tax consequences of having “capital gain assets” (i.e., assets where most of the return comes from capital gains) in a taxable account.
For this example, let's consider a very low bond yield environment (munis pay 1%, taxable bonds pay 1.5%, stocks pay 7%) where an investor might normally choose to put bonds in a taxable account. First, we'll look at what happens if the investor pays LTCG taxes. We'll assume the highest tax brackets and perfect tax-efficiency for the stocks.
Stocks in Roth IRA, Muni Bonds in Taxable
=FV(7%,10,0,-100000)+FV(1%,10,0,-100000) = $307,177
Bonds in Roth IRA, Stocks in Taxable
=FV(1.5%,10,0,-100000)+((FV(7%,10,0,-100000))-100000)*0.762+100000 = $289,751
This is the classic example that drove the Bogleheads nuts. It demonstrates that, at very low yields, the classic rule of thumb of putting bonds in tax-protected accounts can be incorrect. But what if the second investor doesn't actually have to pay capital gains taxes because of the techniques mentioned above?
=FV(1.5%,10,0,-100000)+FV(7%,10,0,-100000) = $312,769
This investor actually IS better off with bonds in a tax-protected account even when they otherwise would not be.
Principle #4 of Asset Location
The More Volatile the Investment, the More Likely It Is Better in Taxable
This is a tricky one. You are more likely to have the ability to tax-loss harvest a volatile investment, and since you can only tax-loss harvest in a taxable account, it stands to reason that more volatile investments belong in a taxable account. The problem with this approach is its interaction with the other principles. A more volatile investment often has higher expected returns (and thus shouldn't be in a taxable account). It is also more likely to need frequent rebalancing, which incurs transaction costs in a taxable account. In some cases, such as volatile speculative instruments, the investment is less tax-efficient (as you may be paying ordinary income tax rates or collectible tax rates). Plus, capital losses have a different value to different taxpayers. If you already have $700,000 in capital losses you're carrying over year to year, a few thousand more probably isn't going to make much difference.
But all else being equal (which it never is), a volatile investment goes in taxable.
Principle #5 of Asset Location
Place High-Expected-Return Assets into Tax-Free Accounts, But Recognize You Are Taking on More Risk
Lots of asset location guides will recommend that you put stocks in Roth (tax-free) accounts and bonds in tax-deferred accounts. I don't have a problem with this recommendation, and I generally follow it. What I have a problem with, however, is when people think this is some kind of free lunch. It isn't. The reason you expect a higher overall return by doing this is because you are putting more of your assets, at least on an after-tax basis, into a riskier asset class. Since you are taking on more risk, you should have a higher return.
Perhaps the best way to think of a tax-deferred account is to consider it as two separate accounts. The first belongs to you, and it is nearly identical to a typical tax-free account like a Roth IRA. The second belongs entirely to the government. You are simply investing it on their behalf for a few years before paying it in taxes. If you think of your tax-deferred accounts this way, it's easy to understand why this strategy is not a free lunch.
Let me demonstrate with another example. Let's assume two investors each put 50% of their portfolios into stocks (8% assumed return) and 50% into bonds (3% assumed return), but they do so in different accounts and let it ride for 10 years with no rebalancing.
Stocks in Roth Investor
=FV(8%,10,0,-100000)+((FV(3%,10,0,-100000))*0.63) = $300,559
Bonds in Roth Investor
=FV(3%,10,0,-100000)+((FV(8%,10,0,-100000))*0.63) = $270,404
As expected, you end up with less money because you invested the money that is actually yours less aggressively.
A similar effect happens with a Health Savings Account (HSA), at least if you spend it on healthcare (otherwise, an HSA is much more like a tax-deferred account). If you actually tax-adjusted all of your accounts and your asset allocation, this effect would disappear. Few investors (and advisors) are willing to do that (and I don't blame them). This can also be a useful behavioral technique. Essentially, you are fooling yourself (or your advisor is fooling you) into taking on more risk than you could otherwise tolerate!
More information here:
6 Principles of Asset Location
Principle #6 of Asset Location
If You Have an RMD Problem, Increase Your Tax-Free to Tax-Deferred Ratio
Few doctors (and even fewer Americans) have the true Required Minimum Distribution (RMD) problem that financial salespeople have used to generate the fear that allows them to sell their wares. But if you actually do have that problem, it may be worthwhile to minimize that problem through wise asset location practices. These are generally people with very large tax-deferred accounts—well into the seven-figure range—and/or other sources of taxable income in retirement. I'm not talking about someone collecting $40,000 a year in Social Security with a $1 million IRA. I'm talking about a dual-physician couple in their mid-40s who already have $5 million in tax-deferred accounts and 10 rental properties.
An RMD problem is someone who is forced by the government to move assets out of their tax-deferred account and into their taxable account against their will. Starting at age 73 or 75 (depending on the year you were born), an investor is required to start taking RMDs from their tax-deferred accounts. That's usually no big deal, because the amount of an RMD is typically less than the amount you probably want to pull out and spend anyway.
But if you don't wish to spend that money, you end up pulling out the government's portion and sending it to them and then reinvesting your portion in a taxable account, where it grows more slowly than it previously did due to the tax drag inherent in a taxable account. That's an RMD problem. It's hardly the end of the world, and it usually means you're going to die the richest person in the graveyard. But there are three things you can do to minimize it.
- As soon as you realize you may have this issue, you put the low expected return investments (usually bonds) in that account so it grows more slowly and, thus, has lower RMDs.
- Start doing Roth conversions. A Roth conversion is moving money from a tax-deferred account to a tax-free account, essentially pre-paying the taxes you would later pay when taking RMDs. In essence, it moves money from a taxable account (i.e., the money that would pay the taxes) into a tax-protected account. Instead of $300,000 in a tax-deferred account ($200,000 of which is yours and $100,000 of which is the government's) and $100,000 in a taxable account, you end up with $300,000 in a tax-free account.
- If you give to charity anyway, you can give directly from your traditional IRA once you turn 70 1/2. This Qualified Charitable Distribution counts as all or part of your RMD that year. Since you're going to be leaving lots of money behind and probably at least some to charity, you might as well get started.
The Bottom Line – Quick List of Asset Location Steps to Take
Confused yet? If not, congratulations, you've got a great handle on how asset location works and probably have already done most of what can be done with your portfolio asset location strategy (especially given your cloudy crystal ball about future tax rates and your future financial life). If you are confused, here is a quick list of the “high-yield” asset location steps to take:
- If you are going to invest in muni bonds, do so in a taxable account. Their interest is federal and sometimes state tax-free.
- If you have an investment with a high expected return that is very tax-inefficient (hard money loan fund earning 11% for instance), this is likely worth moving into a tax-protected account—even if you end up paying some fees/costs/hassle to do so.
- Put your bonds in your tax-deferred accounts. Recognize this isn't a free lunch and it isn't necessarily the right thing to do at very low interest rates, but even when you're wrong, it won't matter much.
- If you have to invest in a taxable account, the types of assets you want there include equity real estate, municipal bonds, and total market stock index funds. If your taxable-to-tax-protected ratio gets so large that you have to find another asset class to move into taxable, congratulations, you're going to be very rich. Quit worrying about stuff like this.
- Max out your retirement accounts and consider Roth conversions.
- REITs and their mutual funds probably still belong in a tax-protected account even if they would qualify for the 199A deduction.
- Don't bother doing anything else. It's just as likely to be wrong as right, and even if you're right, it won't make much of a difference.
What do you think? What have you done to improve your asset location?
[This updated post was originally published in 2019.]
I am glad you clarified the bonds in taxable. If you actually read that post it makes a ton of sense but it seems to cause a lot of confusion when people skim it and do not understand the principle.
Great post!
This is actually the second clarifying post on that one, but it still gets all the traffic.
WCI,
One additional principal of asset location that may be worthy of consideration is which account to hold International equity mutual funds and ETFs (particularly, large cap blend and total stock market index funds).
If International is held in a tax free account, the foreign income taxes paid on dividends are completely lost.
If International is held in a tax deferred account, the foreign income taxes paid on dividends is partially recovered through lower future taxable distributions.
If International is held in taxable account,( then in theory), should get a $1 for $1 tax credit on Federal. Also, 6 states give a tax credit as well.
The problem is there is an offsetting factor- the yields on international stocks are higher. So it’s probably a wash when deciding whether to put TSM or TISM in taxable first.
Really appreciate nuts and bolts posts like this. I know the majority of your content is geared toward just getting docs to get their heads on straight in the first place (saving enough, not overspending, etc), but it’s nice to get pieces like this that cover more advanced topics without assuming a ton of knowledge of the reader.
Great article. I struggle with the question of Roth conversions. Is it worth it for me? I have yet to find a good calculator to answer this question.
Dunno. Why not lay out your details on the forum and see what people think?
Principle #5 is one of my favorites. I have not seen much written about that, except in your post about “my pet peeves about asset allocation.” This principle, is subtle, abstract, not widely emphasized, and esoteric. Do you know of anyone else that has described this concept? On the Roth conversions, the calculation should take into account the opportunity cost of the money lost to Uncle Sam in the years following the conversion. By way of example, if one of my fellow docs pays $10,000 to Uncle Sam for the Roth conversion, that $10,000 could have been in the WCI’s favorite mutual fund (and mine) growing a the market rate until age 70.5. I like the Lone Peak picture. I’ll look that up to—an added bonus!
It’s actually better to have that money in Roth than in taxable where it was before. Don’t think of it as “opportunity cost.” Think of it as moving after-tax money into a tax-free account.
An excellent article, especially for those new to or confused by the topic. It may be worth considering mutual funds vs. ETFs when considering asset location. Though much less of an issue if your mutual funds are tax efficient index funds, it may make sense to limit mutual funds to tax deferred and tax free accounts, while investing in ETFs in taxable accounts. This will allow you to control the timing of any capitol gains.
When considering ROTH conversions, especially in the case where distributions from a pre-tax account will not be spent, another consideration is the potential tax rate of your heirs. For example, your daughter, and only heir, is the CEO of a mid-size company. She is in the the 32% tax bracket and you are in the 22% bracket (for white-coats this might occur during the period after retirement, but before collecting Social Security). If you anticipate pre-tax, taxable and ROTH funds will be passed on to your daughter, doing ROTH conversions, in a manor that keeps the conversion tax rate below 32%, may increase the net legacy. In the reverse situation, conversion may be less appealing if your heir is in a very low marginal bracket.
In addition, when estimating future tax rates, it is worthwhile for married couples to consider the impact of mortality. It is likely that one will pass before the other and the remaining spouse will have several years of single filing status. Unless income declines commensurately, this would drive up marginal tax rates. This is especially significant if one spouse is materially healthier and/or younger.
For those who will likely pass away with pre-tax assets and have a charitable intent, naming charities as beneficiaries of those assets is tax efficient. Structuring your assets such that upon your death charities receive tax deferred assets and heirs receive tax free and step-up basis assets is an effective strategy. Of course you should be sure this does not adversely affect a spouse.
I would advise anyone considering a QCD, to compare this approach vs. donating significantly appreciated longterm cap gains assets. Depending on the taxpayers situation, the QCD may not be the best tax strategy. Michael Kitces has an excellent article on this topic, which can be found on his Nerd’s Eye View blog.
Thanks for your educational efforts.
The relative sizes of your accounts matter as well. If someone has 90% of the portfolio in tax protected accounts, tax efficiency isn’t much of a problem. 90% of the portfolio are protected no matter what you do. You can optimize the 10% but it won’t make much difference to the overall portfolio. If someone has 90% of the portfolio in taxable accounts, you can only protect 10% of the portfolio anyway. Again optimizing what you do to 10% of your portfolio won’t make much difference overall. So relax if your account sizes skew lopsided one way or the other; a naive mirror allocation will work just fine. Pay more attention when your account sizes are more or less equal between tax protected accounts and taxable accounts.
Fair point.
read james lange Retire Secure-loves Roth conversion
Especially ideal if leaving as a legacy
Beyond retirement, which accounts should I prepare for the trust? and which should I prepare for the beneficiaries directly?
?
Depends on what you wish for the heirs to get and when.
I’m still looking for a way to explain AFTER TAX equivalent asset location to folks. I can’t figure out a way to explain it any better than as you did in #5 and then wave my hands around a lot…
Maybe a graphic artist type could come up with a visual of the 4 different account types (brokerage, roth, and the two tax deferred — mine, and the IRS’s) and show how they flow from funding to distribution. Can’t really explain it in words…
Yes, it can be tough for people to grasp.
WCI
Thanks for a great article; the information is put in a simple and easy to understand way.
As I approach RMD I have a 50/50 stock/bond allocation and have 50% of my portfolio in taxable and 50% in 401K.
I’m concerned to put all equity in my 401K and when the market tanks I would be forced to take RMDs at a significant equity loss. Would a good strategy be to have something like 70/30 in the 401K and 30/70 in taxable to help mitigate taxes while at the same time hedge against market downturn. What are your thoughts for those approaching or in RMD phase of life for asset location?
This isn’t as big a deal as you think. Imagine your IRA/401(k) is all equity and your taxable account is all bonds and you have to take an RMD. But the market is currently down 50%. Sucks to have to sell low right? But why not rebalance the account at the same time. So you sell equity in your IRA, take your RMD and spend it. Meanwhile on the same day, you sell some bonds in taxable and buy stocks to rebalance. Boom, you didn’t sell low.
Thanks for the quick reply. Your suggestion makes a lot of sense. It’s easy sometimes to make things more complicated than necessary. I was also thinking it’s not a huge deal anyway because the starting RMD is less than 4% of the portfolio and hopefully the equity portion will have recovered within 2 to 3 years.
Dear WCI, thank you for your blog. I read the best place to place international stock like VTIAX is typically the taxable account (e.g. due to foreign tax credit, avoid double taxation). Currently I’m trying to maximize contribution into my traditional 401k and the After-Tax 401k (aka Mega Backdoor Roth IRA) since my company provides the latter, thus I don’t invest into taxable account for now. Could you please provide your insight on which is typically the next best available account to put in VTIAX (below is the list of what I have)?
1) Traditional 401k
2) Roth 401k
3) Mega Backdoor Roth IRA
4) Traditional IRA
5) Roth IRA
For future reference, would international stock (VTIAX) be better placed into a tax-deferred than tax-free account? Or does it not matter since we won’t receive foreign tax credit in both?
I would be grateful to hear your insight. Thank you!
It’s always better to put stuff in a Roth IRA whenever possible. BUT if you HAVE to put something in taxable, total international stock index is a pretty good first choice. Currently I have TSM, TISM, equity real estate, and a muni bond fund in taxable. Scratch that, just donated the muni bond fund to charity.
REIT question: I rolled my old SEP IRA into a decent 401K with low cost Vanguard Funds (total stock, total international stock, total bond) but no REIT funds. I have wanted to keep 8-10% of my portfolio in real estate and was focusing on REIT ETFs (specifically VNQ–Vanguard Domestic REIT, VNQI–Vanguard International REIT and SCHH–Domestic REIT). Options are taxable account and Roth IRA. Will be in 35% tax bracket this year and 32-35% tax brackets next few years. Based on the figure at the top of this article, you are suggesting that the Roth should be used.
1. Does the fact that these are ETFs change anything?
2. Does the mantra that investments poised for the most growth should go into the Roth affect this decision?
-Thank you
Our equity allocation consists of Vanguard TSM, S&P 500, small cap, and total international index funds. Is there an optimal location for these funds in tax-deferred vs. tax-free space?
Why do you own both TSM and 500 index? Both TSM and TISM are great taxable options if you have to have a taxable account, but that’s not your question. Your question is tax-deferred vs tax-free. That’s covered in # 5 above. But really, with those four funds it doesn’t matter. If there were some bonds there maybe it’s worth thinking about.
Thanks for the fast response WCI, and for all that you do! Your endeavors have seriously changed the trajectory of my life.
I suppose I was trying to ask is if there is a higher expected return for any of those funds, and therefore if one clearly belongs in tax-free space. Your response indicates that the crystal ball is cloudy, I was over thinking, and it doesn’t matter.
My 403b lacks a TSM fund but does have a 500 index and small cap fund, so I use those to approximate TSM. I use TSM in other accounts where it’s available. I *have* to use taxable because we max my 403b, his 401k (with after-tax to 57k), Roth IRA x2, HSA x2 and paused on my ng457b during COVID 😉
Is there a good rule of thumb for how to distribute my bond allocation between taxable and retirement accounts? I want 20% bonds across my portfolio. However, my taxable account value is 3x my retirement accounts (yes, I am maximizing) and will probably continue to contribute to the taxable account at roughly a 3x rate as well. Best to keep is simple and mirror the taxable and retirement accounts to my desired allocations? Thanks
No right answer. I’d probably have some of my bonds in tax protected such as taxable bonds or TIPS and the rest in muni bonds in taxable.
The tax-adjusted argument seems to ignore the fact that tax rates change over time, though. I can take gains which occured during high-bracket years and then realize them (convert or simply withdraw them) during low-bracket years. Need to do the math on converting now versus converting a larger amount at a lower rate, but lots of unknowns in that.
It’s all about the rate, not the amounts.
Where would something like the Wellington Fund go? Seems like it’s going to spit out alot of income and it’s a hybrid of equity and debt. Thanks.
That’s a holding I’d definitely try to have in a tax-protected account.
That’s a holding I’d definitely try to have in a tax-protected account.
The fact that it is both stocks and bonds, the fact that it’s actively managed (leads to higher turnover), the fact that it is higher income as a value stock/bond fund. Lots of reasons.
The Wellings* fund is very interesting to me. Mobile home/RV parks and storage access is difficult to find and they seem to have great returns on an individual basis.
It will def decrease my portfolio diversification but it seems like a great thing to get access to for the long run.
What questions would you recommend asking before investing with them? Any cautions with this fund in particular?
Thanks.
The usual kind of due diligence questions are appropriate. Our online course goes through that kind of stuff in detail.
I don’t know of any particular cautions I should warn you about with Wellings. There’s a lot more in the fund than just mobile homes and self storage though.
I am working towards a less aggressive portfolio. I want to have 25% in bonds and I currently only have 6% of bonds in my portfolio. I invest both in retirement and taxable accounts. I obviously max out my retirement accounts.
On my retirement accounts I hold a Fidelity index target date fund (FIOFX) and a Fidelity US bond index fund (FXNAX).
In my taxable account I hold a Fidelity total market index fund (FSKAX) and a Fidelity 500 index fund (FXAIX). I know these funds are similar, but I just recently realized that investing in a total market index fund is better, so I stopped funding my FXAIX fund.
If I only invest in bonds in my retirement account, it is going to take me a couple of years to reach my goal of 25 % in bonds (without putting any money into my target date fund). I would still be investing in stocks in my taxable account.
Should I sell some of my target date fund in order to buy into my bond fund in my 401K or should I just put new money into my bond fund for the next couple of years in order to reach my goal?
Should I invest in bonds in my taxable account? If yes, which fund would you recommend?
Another question I have is: should I start putting money into the Vanguard total stock market ETF (VTI) in my taxable account instead of my Fidelity total market index fund due to tax efficiency? I don’t know if it matters but I don’t do tax loss harvesting.
Please find below some of my information.
Age: 41 y/o
Desired Asset allocation: 75% stocks / 25% bonds
Taxable (about 500k)
43% Fidelity 500 Index Fund (FXAIX) (0.015%)
5.7% Fidelity total market index fund (FSKAX) (0.015%)
Retirement 401k and Roth IRA at Fidelity (about 500K)
50% Fidelity index target date fund 2045 (FIOFX) (0.12%)
1.3 % Fidelity US bond index fund (FXNAX) (0.025%)
Yes, if you want more in bonds just sell the TR fund and buy a bond fund.
At these interest rates, it probably makes sense to keep the bonds in the retirement account. More discussion here:
https://www.whitecoatinvestor.com/asset-location/
The bond funds I use in my taxable account are the Vanguard intermediate fund and the Vanguard muni bond index fund.
Either the Vanguard or the Fidelity TSM fund is fine. Frankly, the 500 index fund is fine. If I had to choose between the three, I’d choose VTI, but it’s only a slight preference.
https://www.whitecoatinvestor.com/my-favorite-mutual-fund/
If you did tax loss harvesting, you’d need two funds for each asset class in taxable anyway.
Thanks so much for your guidance. I really appreciate it.
I love your blog and your podcast- so helpful!
Out of curiosity, where would you hold an Avantis small cap tilt? There are various items that move the argument one way or the other. For instacnce, I am early career, have made a commitment to the small cap value tilt and want to use Avantis funds. If I maximize all of my retirement and tax protected accounts with target date funds, would doing Avantis funds (both domestic and international small cap value) in a taxable account be acceptable? Would this perform better in tax protected accounts?
Wrong question to ask. The question to ask is “I have to move something into taxable. Here’s everything I own. What should go in there first?” Everything that makes money is better in a tax protected account than in a taxable one, but some things are more tax-efficient than others. I’d put an avantis SC fund in taxable before a target retirement fund, but it’s unlikely I’d ever own both in the same portfolio.
As far as asset allocation, it’s pretty odd to choose a target date fund then try to tilt with it. Tilters tend to be big time optimizers. Those using target date funds tend to be satisficers.
I believe Roth 401k no longer has RMDs.
You’re right. Guess we missed that when updating this prior to republication.
@WCI,
Let me help by clarifying your opening statement: “Asset location is determining which of your assets to place into tax-free (Roth), triple tax-free (HSA), tax-deferred, and taxable accounts. ”
There are really only 3 types of accounts and not 4. In the order of most tax efficient to least:
1. 100% tax free — HSA, what some call triple tax-free, when used for health care
2. Partially tax free, to the same amount when Roth and tax-deferred exist under same tax bracket. Actually, either account can become a “type 1” given the right zero tax condition. Though tax-deferred can typically convert more 100% tax free than a Roth, so it should be preferred.
3. Taxable account. This can become very close to a type 2 Roth account under the right conditions, if you don’t need to spend the money.
This opening statement is very appropriate: “What most investors want is a prescribed list of what types of investments go into what type of account that they can simply plug and chug with, so they can move on with their lives. The Bogleheads and others have attempted to do this many times over the years. ”
The answer to this is quite simply it can’t be done, except in the case of some luck.
If anyone here, or any advisor knows which investments are going to have the higher returns or the best tax efficiency, they are truly in the wrong business.
@WCI,
“Place High-Expected-Return Assets into Tax-Free Accounts, But Recognize You Are Taking on More Risk”
I believe you are suggesting in point #5 that in comparing the Roth to TIRA, it somehow makes more sense to put your APPL stock in the Roth and the cash or bonds in the TIRA. I have pointed out it makes no difference and dispelled that myth many years ago:
https://seekingalpha.com/article/3979557?gt=75c4a291d3130604
Table 1 shows the math.
The point in this article and in many others is the same one you make. And nobody is advocating for individual stocks.
@WCI,
To be clear, my point had nothing to do with the stocks per see. If you like replace those with your 8% CAGR and 3% CAGR. Your math is flawed because you don’t compare Pretax earnings to spendable income. What you do inside the Roth or tax-deferred is irrelevant, as long as you treat both equally.
In this case it means, one investor puts 50% of earnings in 8% investment in Roth, and 50% earnings in 3% investment in tax deferred and the other does just the opposite (3% investment in Roth). They both have the same spendable income, which is not what you suggest. At least the way I read your #5.
I know you just read this, but I wrote it 6+ years ago so you’re going to have to be more specific about what you’re referring to exactly, then I’ll need to go back and read what I wrote, then I’ll have to decide if I still agree with what I wrote, then I can argue with you about it.
At this point, I’m not sure exactly what you’re referring to so if you really want to argue about this, let’s start by clarifying that.
@WCI,
Yes, I have learned over the years to read the “fine print” on your articles because they are not always current. I would suggest just as a helpful hint to put the original article published date up at the top of the article right next to the “republished date.” A person should not have to read down the whole article to find out this is something that is 6 years old. This has little to do with the conversation at hand, except that it is your duty to make sure what you publish is still relevant.
I don’t know what else I can say other than quote the exact section I am talking about which I have already done:
““Place High-Expected-Return Assets into Tax-Free Accounts, But Recognize You Are Taking on More Risk”
I believe you are suggesting in point #5 that in comparing the Roth to TIRA, it somehow makes more sense to put your APPL stock in the Roth and the cash or bonds in the TIRA.
[if you replace the word APPL above with 8% and “cash or bonds” with 3% then you should be able to see where your math goes wrong — if in fact you are even talking about Roth vs TIRA, which is not 100% clear to me, as you are talking about “taxable” in many of your points above, which is a whole conversation for another day.]
PRINCIPAL #5 is the relevant topic here.
If you don’t like re-runs, avoid Sunday articles. We didn’t use to publish Sundays. Then someone said, “Why don’t we just rerun the good old stuff that was published years ago since 90%+ of readers haven’t read them?” So we do, every other Sunday. I’m not the one updating and republishing them though. All that got hired out years ago. And no, we’re not going to put “re-run” at the top because fewer people would read it, be helped by it, click on ads etc. If you can’t figure out that you’ve already read it until you get to the end, then it must still be worth reading. I mean, you not only read it again but decided to argue about some point in it this time. It must be worthwhile. But no, I don’t have some “duty” to do anything here. If you want to only read blogs from people with some sort of duty to you, good luck. I don’t have a fiduciary duty or anything else to the readers in a legal or even a moral sense. You don’t get to decide how and when I work just like I don’t get to decide how and when you work. If you don’t think what is written here is relevant, it’s still a free country where one can read any blog they want or no blogs at all.
But at any rate, I guess you want to have an argument about it so let me go back and read at least the section you’re talking about. You’re referring to Section # 5. So I’ll re-read that.
Yup, I still agree with what I wrote there and I think the math is fine. And no, what you think I’m suggesting isn’t really what I’m suggesting as discussed under # 5 AND in this separate piece on the topic you may like more:
https://www.whitecoatinvestor.com/my-two-asset-location-pet-peeves/
I think you just don’t like how I phrased it. And it’s entirely possible I did a lousy job phrasing it. Let me try again.
Now if you disagree with that, I’ll argue with you. But I suspect you don’t.
It’s also worth a quick peek at one of my favorite cartoons about the internet:
https://xkcd.com/386/
@WCI,
The word argument sounds a little harsh. This is just about math and it’s not about your “Sunday” articles either. Yes, I think our discussion has to “sort out” what each is talking about.
Your link about your “pet peeves” seems to all include “taxable account” asset allocation. This discussion is not about that.
When I re-read your quote above it seems like what you are saying (avoiding all the “tax-speak”) is that simply:
Putting $10,000 into your Roth at 8% CAGR will likely result in more spendable income than putting $10,000 into your traditional IRA at the same 8%.
The clarification note, for those that don’t understand your “tax-speak” should be:
IF you live in a 25% tax world then what you said above is that the person who earns $13,333 and puts that ($10k) into a Roth will most likely be better off than the person who only earns $10,000 and puts that in their traditional IRA.
Yes, I can agree with that, but having tutored my granddaughter in her 5th grade math class, I know what she would say is “so what?” The lesson seems to be that earning $133 is better than earning $100. The lesson is NOT that Roth is better, nor is the lesson that paying that 25% tax on the front end somehow is better for you.
Yes, you need to work on your delivery, otherwise, the readers are taking away the wrong message, and I know that is not your goal.
Did I capture the essence of your math? I can work it out with different assets and different CAGRs, but as I think you imply putting the proper initial conditions on this 5th grade math word problem is all that is required for you to see Roth and traditional IRA are equal, if given equal treatment.
Dave, the piece I think you’re missing is that you’re talking about contributions while this article is talking about what to do with the money once it’s in. Assume that a person has *both* a Roth *and* a Traditional account of equal value, and they’re deciding what investments to make in each. Taxes at time of contribution are equal in both cases, because they pre-date the decision we’re examining. To put the higher-return asset in the Roth is to take on more risk on a tax-adjusted basis, with a commensurately higher potential return.
Mike,
Trust me I do get what you are saying, but your logic is flawed. You are merely saying $133 is worth more than $100. However, every dollar has to stand on its own.
Otherwise let’s say you put $100 in the Roth and it doubles to $200 and at the same time you put $100 in the TIRA and it doubles to $200. BOTH accounts NOW have $200, because if taxes didn’t matter on the front end of one account you CAN’T apply them to the other account.
In fact, I think WCI has agreed with me on this point that given no tax-differential the two accounts are equal.
I disagree that it’s flawed; it’s exactly the point. $100 in a Roth is worth more than $100 in Traditional. Thus, putting an equal amount of a given investment in the Roth is effectively holding more of it than holding the same investment in Traditional. If you put your higher-risk assets in the Roth, you’re assuming more risk than just looking at the balances would suggest.
Otherwise stated, your $100/$100 portfolio is not actually a 50% allocation to the risks of the two investments, it just looks like it.
If this still doesn’t compute, however, perhaps you should take it to the forums or some other venue than blog comments?
Mike,
Of course, the $100 in the Roth is worth more than $100 because it cost you more to earn it, but don’t fall into the trap that says the $100 in traditional is worth less, because that ship has not sailed until you spend it. However, in the case of the Roth the ship HAS sailed on your tax cost. I spent over $20k in 2025 from my traditional and paid not a single penny in tax on it.
If I can’t convince you, so be it. I have published over 50 articles, and covered this topic and a few others from many angles and more than 6,000 comments over 11 years. In all that time no one has shown that the simple properties of math can be violated, just by having more money in one account over the other. The math does not change for $1 or $1000.
One such article from 2016 linked above in the comment to WCI has over 319 comments, while a more recent one on the “Common Cents About Roth Conversions” has over 600 comments. All that should tell you this is a very complex subject, but what I always stress is if you don’t understand the very basic math, you are most likely destined to fall short in converting the most of your hard-earned dollars into spendable income.
I acknowledge it is possible that you could get all $100 out of the traditional IRA without paying any taxes on it. But that’s unlikely enough that it wouldn’t be wise to formulate advice or articles assuming that. But determining what % one should assume will go to taxes is challenging for sure.
I agree decisions around this are some of the most challenging in personal finance and investing.
It’s also worth noting that every piece we republish has been re-edited and updated to the current-day laws to the best of my abilities. If something slips through (like Roth 401(k)s no longer having RMDs), that’s on me. But we still get it right 99% of the time. It’s funny; since we started rerunning these classic pieces every other Sunday in May 2024, there’s been like three people who have complained about them. Congrats on being No. 4!
@WCI,
“I acknowledge it is possible that you could get all $100 out of the traditional IRA without paying any taxes on it. But that’s unlikely enough that it wouldn’t be wise to formulate advice or articles assuming that.”
I acknowledge this is a complex subject, but these are the basics. You can’t apply the tax math to the IRA without applying the tax math to the Roth. The principals in simple math demand it. I know you know this, so why are you fighting it?? You know quite well that once you have put money in the Roth that tax cost is paid and you cannot undo it, nor can you ignore it just because it makes the Roth look “better.”
By the way anyone over the age of 70.5 understands it is quite easy to get money out of the TIRA at no tax cost. Every year for the past 3 years I have made that decision a dozen times a year. Does it make sense to donate $1000 from my Roth or $1000 from my TIRA. I should not have to answer that question! Tell me how you do the same from the Roth? That tax cost has been paid up front. Ignoring it does not make it go away. In fact, that tax cost is compounding at the same rate as your Roth investments, you just don’t see it.
Don’t even focus on the fact that TIRA money is much more flexible as you haven’t “sunk” the tax cost yet, just focus on the math and applying it equally to both sides and not trying to ignore one side. That is all I am asking!
We clearly agree on the important issue here so I’m not going to waste any more time arguing about it. But one can’t “do the math” without an assumption of some kind on the tax rate on the withdrawal from an tax-deferred IRA. Reasonable people can disagree about what assumption to use, but the math itself is not complicated.
@WCI,
I must have missed where we agree because it sounds like you are still saying we need to assume some tax rate on the withdrawal from the TIRA, but you don’t seem to say the same applies to the Roth, as your “principal #5” suggests the Roth money comes to the account at no tax cost, or it doesn’t matter. If I have mis-characterized what was said in “#5” please let me know, as I only see tax costs applied to the tax-deferred.
If what I say is correct, then I can only find one example of the same logic, which occurred in my article on Roth conversions, that I referenced above where essentially this “advisor” and author came into a 600 comment thread and spent a year and a half trying to get “anyone” to agree with him that spending 40% tax on a Roth conversion was a good idea. His reasoning was much the same as the logic here and to avoid a big long story amounted to the following two points:
1. He was going to make the conversion on an extreme down market day and “grow out” of the problem with the tax-free growth of the Roth. [I think we both know that the variable time is not a factor in the baseline of equal tax treatment in and out]
2. This one is the kicker and IMHO what you are suggesting here. When asked where the Roth conversion tax came from he stated — “Oh I am just going to pay that out of my savings next April. It is money most people would just “blow” on things they don’t need, so it will not affect me at all.”
I agree the math is not complicated, but the above math only uses one half the Roth vs TIRA baseline equation. In no place can I find that you acknowledged the Roth tax cost, much like item 2 above, which I think many would find it hard to believe with all the knowledge that is available on this subject.
Finally, in the real world both ends of the equation matter, and it is rare that the tax-cost will be equal, so the result of this is you are either compounding your loss of spendable income, or you are compounding a gain to your spendable income. That is the only place the variable TIME comes in. You can NOT grow your way out of a bad decision, with your Roth funds.
I have no idea why I keep responding or why you think we disagree about anything here.
Why don’t you pose a question if you think I disagree with you about something and I’ll tell you my answer and then you can decide if we disagree?
Yes, if you’re trying to decide if making a Roth contribution instead of a tax-deferred contribution (or doing a Rth conversion) is the right move or not you need to look at all the taxes paid. That seems so obvious to me I don’t think it needs to be said. I don’t think I’ve argued otherwise anywhere that I know of.
WCI,
I will keep going as long as you are willing:
Here is the existing equations from your principal #5:
“Stocks in Roth Investor
=FV(8%,10,0,-100000)+((FV(3%,10,0,-100000))*0.63) = $300,559
Bonds in Roth Investor
=FV(3%,10,0,-100000)+((FV(8%,10,0,-100000))*0.63) = $270,404”
My English interpretation of the above is, at a 37% tax rate on TIRA:
case 1: $100k Roth at 8% return + $100k TIRA at 3% return =$215,892 + $84,667 =$300,559
case 2: $100k Roth at 3% return + $100k TIRA at 8% return = $134,392 + $136,012= $270,404
Question 1: Do you agree you cannot “grow” your way out of a bad decision that was made when you contributed the $100k to the above two Roths? You said as much previously by agreeing with me ??
If you agree that “yes” you cannot grow your way out of a bad decision, then something else is going on here, yes?
Let me magnify question #2 by asking why did you pick equal dollar amounts?
Let’s change up the problem with how I would express it, in order to find out whether you CAN really grow out of a bad decision by looking at the above from a different vantage point.
In this case I am going to put $158,730 in the TIRA and $100,000 in the Roth. By the way doing this makes just as much sense as an arbitrary equal dollar amount.
My English interpretation of the below is, at a 37% tax rate on TIRA:
case 1: $100k Roth at 8% return + $158.73k TIRA at 3% return =$215,892 + $134,392 =$350,284
case 2: $100k Roth at 3% return + $158.73k TIRA at 8% return = $134,392 + $215892= $350,284
Question 2: Why is the 2nd problem a more “holistic” view of what is going on here?
Question 3: Can you see why you cannot just choose some arbitrary dollar amounts for the Roth and TIRA balances, if your goal is to decide — “can I grow my way to more spendable income by just putting more risk in my Roth? [note: refer to your answer to question 1 above.]
I think your concern was addressed by somebody a few days ago. The question I am answering here is
If you currently have $100K in a Roth and $100K in a traditional IRA, where should you put the stocks and where should you put the bonds?
You don’t have to go back to the contribution decision to answer this question. So I didn’t. You seem to want to go back to the contribution decision for some reason I don’t understand and make the example far more confusing than it is intended to be. Nobody is talking about the initial contribution decision. That’s the subject of a different blog post somewhere. This example is purely to illustrate that you would need to tax adjust your asset allocation to make the proper decision and that just lazily putting the stocks into the Roth account is actually just taking on more risk, not getting a free lunch. That’s it. You’re reading too much into the example and trying to use it to discuss something which it is not intended to discuss. It’s not an example to help you discuss whether you can grow your way out of a bad contribution decision.
WCI,
Wow, you ask me to pose a question, then you tell me what questions you are going to answer. How do you expect to make progress doing that? Had you answered the questions posed you would see where I was going! Please go back and try and answer the questions as posed.
The key question is what happens when you express the problem correctly with a starting Roth balance of $100k and a TIRA balance of $158.73k. Putting your riskier assets in Roth makes absolutely NO difference to your after-tax spendable income. This is what I call the Roth / TIRA baseline from which all simple math is derived. The reason you can’t just drop into the middle of your “life” with an arbitrary equal dollar spreadsheet that ignores what has happened earlier is because as I mentioned elsewhere when you are on one side of the line you are compounding a “mistake” creating less spendable income in total by making your Roth larger, either thru growth or contributions, and on the other side of the line you are growing your spendable income, just like I grew it by having applied the correct TIRA number to get you to the baseline.
Think of it this way. The word problem we are solving here is to convert the most pre-tax income to after-tax spendable income. You have merely avoided seeing the most important part – which is, where is the equivalence. I found that for you by putting another $58,730 into your TIRA. You may not like it as it means higher RMDS, but that is a fact of life. At that point of equivalence there is absolutely no reason to put risker stocks in any specific place! So had you chosen those numbers your illustration falls apart.
The part you may be missing is you CAN figure out where your “riskier” stocks should go when you are either above the baseline or below, if you care to know, rather than just think you are doing yourself a favor by essentially putting more money in your Roth than your TIRA, because make no mistake, growing your Roth more via contributions or internal growth has the same result. Either you are compounding the wrong side of the equation to less spendable income or you are doing the opposite. On the baseline itself where taxes are equal in and out, it absolutely does NOT matter where you put your riskier investments between the two tax-advantaged accounts.
Finally, in your principal #5 you started to make the point that both the TIRA, and the Roth have a “tax-free” component, but it was missed by most, as you didn’t really follow through explaining the tax cost to the Roth and assumed it didn’t matter.
One of my “pet peeves” is the trap that many including myself fall into of calling Roth tax-free, rather than calling both Roth and TIRA tax-advantaged. It sells the wrong message in the same way as your principal #5 sells the wrong message. This is one reason I hope you will consider publishing what I submitted for next year, as there isn’t enough emphasis on the fact that Roth is not “tax-free.”
You’re right. I don’t think our interaction is benefitting either of us or anyone else so I’m going to stop.
I’m sure your guest post is somewhere in the editing process and will give you a chance to have your say on this topic and interact with any commenters about it to your heart’s delight.
My 3 fund portfolio has the same percentages in each of my main accounts, Taxable, Roth IRA, 401(k), and Variable Universal Life. Currently 35% bonds, 35% Total US, 30% Total International in each of them. (Municipal bond fund in taxable).
Reasons:
Simplicity. If I died, my wife could continue this pretty easily.
Ease of rebalancing. Money comes to the different accounts at different times of the year, and some accounts are much larger than others, so maintaining my overall ratio is easier.
All the accounts have access to low expense ratios.
I donate to charity from my low cost basis shares from the taxable account.
Cons: Might be something marginally better.
PS, I am 12 years into the VUL, so am keeping it. The investments have done as well as they could have.