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TAX EFFICIENT FUND placement is an often underrated topic. The goal of the tax efficient fund placement is to minimize taxes within your investments, and select the right account for those investments.
But how much does that actually matter?
Vanguard’s research finds that a thoughtful asset location strategy can add significantly more value than an equal location strategy. The value added typically ranges from 5 to 30 basis points of after-tax return, depending on circumstances (e.g., income, portfolio size).
Investors generally have access to different account types, including:
If you are an employee that may not have access to a retirement plan, you could perhaps consider a Solo 401(k) if you have “side hustle” business income.
Generally, if your investments are all in tax-deferred or tax-free accounts, fund placement will not make a huge difference for you. That is because these accounts already come with tax efficiency.
If that’s your case, two things become important though:
1. Consideration between pre-tax, like Traditional 401(k) or after-tax account, like Roth 401(k). Put simply, this decision generally comes down to your marginal tax rate now versus marginal tax rate in the future (which isn’t something easy to predict due to the ever-changing tax landscape).
2. Account allocation. It becomes equally important where exactly you are investing. Roth accounts grow tax-free and qualified withdrawals are tax-free. You likely don’t want to hinder that growth by choosing conservative assets (like fixed income, Money Market Funds, and so on).
Tax-efficient fund placement becomes extremely important when you also have a taxable brokerage account, along with tax-advantaged accounts. Many funds pay dividends and distribute capital gains if placed in your taxable brokerage account. At the end of the year, you receive a 1099 with that income and must pay taxes on the dividends and certain distributions.
One thing to call out from history is that you generally shouldn’t hold Target Date Retirement mutual funds (or any “proprietary” funds) in your brokerage account. This is because unexpected redemptions could cause a huge tax bill.
You may remember a Vanguard 2021 fiasco where Vanguard opened an institutional TDF to more investors (lowered the minimum investment from $100M to $5M), which caused smaller retirement plans to sell out of individual funds and move into the institutional fund. This triggered massive unexpected capital gains for anyone invested in the individual funds if held in a brokerage account.
All of those unnecessary taxes could’ve been avoided by:
Let me give you a simple example:
Let’s say you are in a 22% federal tax bracket and a 5% state tax bracket, and you have some money invested in a dividend fund like Schwab US Dividend Equity ETF (SCHD). SCHD dividends are generally qualified, which means that the dividends get preferential treatment at a 15% federal tax rate for this investor.
The dividend yield is 3.43%. Considering the tax rates, the tax drag is (15% + 5%) * 3.43% = 0.686%.
To put this in perspective, a $10,000 investment will yield ~$343 in annual dividends. The tax impact on that investment will be $60.86.
Of course, if that money was in a Roth IRA, you would pay $0 in taxes on dividend distributions. Alternatively, this is something you may need to decide whether a dividend-focused investing strategy is the right one for you. For example, a Total US Stock Market ETF could have almost 3x less tax drag, and potentially more growth.
As someone in their 20s (who is subject to the Net Investment Income Tax) my focus is 100% on a growth investment strategy, rather than income generation. For someone in their 60s, that strategy could be different (even though selling shares for capital gains is better from a tax timing point of view).
A few more important points:
REIT stocks/ETFs are the least tax-efficient asset class to hold in a brokerage account because their distributions aren’t qualified, so you pay more tax (even though it may qualify for a 199A deduction).
Stocks that don’t pay dividends are the most tax-efficient to hold within your taxable account (Adobe, Amazon, Netflix, and others). However, holding individual stocks may not be the best strategy from an investment and diversification standpoint.
A big benefit of a taxable account is that the money is always easily accessible (liquidity), and you can control your withdrawal timing. While there are strategies that allow you to withdraw from retirement accounts before age 59 (like Rule of 55, 72(t) SoSEPP, Roth conversions), a brokerage account is more flexible. Therefore, analyzing the contributions and investments that go into this account is crucial.
How do you maximize tax efficiency? Let us know in the comments! 
Bogdan Sheremeta is a licensed CPA based in Illinois with experience at Deloitte and a Fortune 200 multinational.
Buffer ETF’s may have some tax advantages as a Bond like alternative in a taxable account. For example PBAP resets every April and provides a 20% buffer to sp500 losses in the 12 month period. It does NOT pay a dividend, so if held over a yr the gains are 100% cap gains rate, unlike a bond fund.
I think of it as a stock/bond hybrid as far as return potential.
The editor in me suggests a typo correction:
“To put this in perspective, a $10,000 investment will yield ~$343 in annual dividends. The tax impact on that investment will be
$60.86.”$68.60Just let me say, the only important thing for most of us, is to have Retirement Accounts and Taxable accounts. Saving is the key for Retirement in an IRA or equivalent, and Roth if possible. Most of us do not have significant funds where these kinds of taxes make a lot of difference. However, the more you know the less taxes you can pay.
The obvious thing to do is to buy stocks, not funds, particularly in taxable accounts. Then you will know exactly what dividends you are getting, and you can take capital gains (or losses) when it suits your personal finances.
If you are going to buy individual stocks, then yes, placement in taxable accounts would be a way to go.
But as someone who does not buy individual stocks, and prefers to use highly diversified, low cost funds, I would have no issue having them in my taxable account as dividend yields can be low.
For instance the dividend yield for Vanguard Total Stock Market ETF (VTI) has fluctuated between 1.2% and 2.3%, with a long-term average centering around 1.8%, most of which are qualified dividends. I can handle that.
Thanks, Bogdan, for those tips.
As you allude to, it’s also important to begin, in mid- to late-career, thinking differently about tax efficiency with respect to tax-deferred accounts. For those fortunate to have significant assets, keeping the bulk of one’s fixed income in tax deferred accounts becomes increasingly favorable with age. That has to do with both the size of future RMDs and that fixed income interest is considered regular income. IRMAA considerations may also enter in.
Good tips. We keep these points in mind, as well. Our Roth accounts are all stock-index funds, with bonds kept in tax-deferred. Looking back, we might have been served better by putting a larger percentage of our savings in taxable accounts.
This is a good list, and we follow all the advice here.
Our taxable brokerage accounts hold a significant chunk of our investments. I’ve sometimes thought that perhaps I emphasized these perhaps more than I should have. I did so because of the flexibility mentioned.
Now they throw off a fair amount of dividend income, which is okay because we spend it. They also have a lot of embedded capital gains. I guess this is also okay as when we spend from principal, the capital gains will be taxed at a lower rate than distributions from an IRA or 401(k). The time to do this, and in a large chunk, may be coming soon, and I’ll appreciate it more.
The taxable accounts will also be easier to inherit from a tax standpoint, though this doesn’t matter much to us past each other.