Minimize your taxes through asset location
June 11, 2013
Rebecca Katz: Our next question is from Erica in San Marcos, California. Thanks, Erica. And she asks, "What types of investments—bonds, dividend-paying stocks, growth funds—should be held where, within an IRA, outside the IRA? Thanks for your help." So are there better places to hold different types of assets than others?
Maria Bruno: Of course there are, yes. Yes there are, and that's what we commonly refer to as "asset location," in terms of where do you place different types of investments in what type of accounts. The general rule of thumb is to place tax-inefficient investments, things that generate a lot of income that may be subject to taxes, within tax-advantaged accounts; and hold tax-efficient investments in taxable accounts. Things like broad-market index funds, for instance, or municipal bond funds—those that may be more tax-efficiently managed or are not subject to income taxation—in taxable accounts.
Rebecca Katz: Now, before we went on air we were having a little discussion about this, because I think sometimes we think about it as, you know, bond funds throw off a lot of income and so you should hold those in, say, an IRA where you won't get taxed on that.
Maria Bruno: Yes, that's an easy one. Right, yes.
Rebecca Katz: But Joel actually had a different perspective on this and I wondered if you'd share.
Joel Dickson: First, on asset location, I would just go back and say, as that first chart that we had up showed, the most bang for your tax buck, if you will, is by actually maximizing tax-deferred opportunities. So asset location is kind of like the frosting on the cake; it helps a little bit but it's not nearly as impactful as maximizing the tax-deferred opportunities. And where it matters most is the closer that you are to a 50-50 stock-bond split of your portfolio, and a 50-50 split between assets held in tax-deferred accounts and taxable accounts. That's where you maximize the benefits from asset location.
In the current environment, though, really the benefits from asset location come from deferring what would otherwise be a lot of taxable income, which is why you normally would have taxable bonds in tax-deferred accounts. In a low-interest-rate environment, though, where we have been recently and may continue to be going forward, you are actually not deferring that much in taxes because you have lower yields if, in fact, you are holding taxable bonds in tax-deferred accounts. So while asset location still matters—it's still helpful a little bit—its impact even right now in the current environment is less than what it normally would be.
Rebecca Katz: So as an investor is trying to figure out whether or not a fund is tax-efficient, what should they be looking at? Is there something on the web that they could look at to have some sense of that?
Joel Dickson: As much as I hate to say this: read the prospectus. And the reason that I say that is the prospectuses for many of Vanguard's actively managed funds, both stock and bond funds, actually say in [them] "this fund is generally not managed with regard to tax consequences." So even if it has been tax-efficient in the past, it's not because there was necessarily an eye towards that, whereas in the prospectus of—sometimes in index funds, certainly in the Vanguard Tax-Managed Funds prospectus—there's actually discussion of how the fund and tax considerations are taken into account in the portfolio management process. And while, again, [there is] no guarantee, that's the way that you want to think about "do I have some sense that the portfolio is being managed on an after-tax return basis." Because one of the big things about—let's take an actively managed fund for a moment—one risk even if it has been very tax-efficient in the past, if the manager changes and you have a new manager come in, even if that manager is going to be very tax-efficient in the future, they may have a different view of which securities they want in the portfolio, and you sell the old, buy the new, and any past tax-efficiency might be negated.
Rebecca Katz: I would also assume market environment can have an influence on that, if we've had a few bad years in the markets. I would assume a fund is a little bit more tax-efficient, isn't it?
Joel Dickson: It certainly can be and, in fact, through much of the 2000 period, relative especially to the 1990s, capital gain distributions from U.S. equity funds were a lot lower than in the 1990s on average. In part because with the 2000-to-2002 bear market, so many losses were built up and realized that it made future gains, that were realized as the market recovered, not necessarily have to be distributed because they were just offsetting these capital losses that had been realized in large scale in the downturn.
All investments are subject to risk, including the possible loss of the money you invest.
For more information about Vanguard funds, visit Funds, Stocks & ETFs or call 877-662-7447, to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.
When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.
Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
We recommend that you consult a financial or tax advisor about your individual situation.
© 2013 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor.
Vanguard leaders discuss where to invest your assets
It's not just how much you invest but where you invest it. Maria Bruno and Joel Dickson of Vanguard's Investment Strategy Group describe how a specific mix of funds layered in different accounts can help you create a tax-efficient portfolio.
Other excerpts from this webcast:
- All investments are subject to risk, including the possible loss of the money you invest.
- For more information about Vanguard funds, visit Funds, Stocks & ETFs or call 877-662-7447, to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.
- When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.
- Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
- We recommend that you consult a financial or tax advisor about your individual situation.