In a recent blog post (here), I gave the traditional explanation of why assets are located where they are.
But I don’t think of it exactly that way. Here is what I consider a better explanation (though you generally get to the same conclusion).
There is no difference between an IRA and a Roth if you consider (as I think you should) the government to merely be a partner in the IRA. In other words, suppose a taxpayer will forever be in the 30% marginal bracket. In that case he or she simply owns 70% of the IRA, but for that portion it is completely tax-free and looks exactly like a Roth (except it has RMDs).
So, what we are really doing in asset location is deciding what goes into a taxable account and what goes into a tax-free account. The key is to determine which investments get the smallest return haircut when located in a taxable account. (That last sentence is the key so make sure you grok that before reading on.)
For example, assume someone is in the marginal 40.8% tax bracket (37% + 3.8%) for ordinary income and 23.8% (20% + 3.8%) for capital gains and qualified dividends (and living in a state with no income taxes, such as Florida or Texas). Further, let’s assume the investments are tax-efficient ETFs (so no capital gains distributions), and they will be held until death (so no sales). We’ll relax that last assumption later.
In keeping with the simple example in the previous post, we’ll start with just two investments, VTI (stocks) and BND (bonds). According to Yahoo Finance, the yield on VTI is 1.11% and BND is 3.82%.
In a taxable account VTI will lose 1.11% * 23.8% = 26 bps, while BND will lose 3.82% * 40.8% = 156 bps. It is clearly much better to lose 26 bps rather than 156.
Let me add in VXUS so we have an international stock fund as well.
| ETF | Yield | Haircut |
| VTI | 1.11% | 0.26% |
| VXUS | 2.86% | 0.68% |
| BND | 3.82% | 1.56% |
In the above, I used the qualified dividend rate and ignored the foreign tax credit. If I adjust for both of those, the ranking now looks like this:
| ETF | Yield | Qualified Foreign Tax % of Dividends | Taxable Yield | Haircut |
| VTI | 1.11% | 0.00% | 1.11% | 0.26% |
| VXUS | 2.86% | 58.46% | 1.19% | 0.48% |
| BND | 3.82% | 0.00% | 3.82% | 1.56% |
I assumed the investments are held until a step-up at death. For bonds, I wouldn’t expect any capital gains, but for stocks, the higher the return and the shorter the time horizon until sale, the more tax inefficient the holding is. I made a quick table showing the annualized tax drag (the growth percentage is price only, not including the dividends since we took care of that above):
| Annualized Growth% | 5 | 10 | 15 | 20 | 25 | 30 |
| 0% | 0.00% | 0.00% | 0.00% | 0.00% | 0.00% | 0.00% |
| 1% | 0.23% | 0.23% | 0.23% | 0.22% | 0.22% | 0.21% |
| 2% | 0.46% | 0.44% | 0.43% | 0.41% | 0.40% | 0.38% |
| 3% | 0.68% | 0.65% | 0.61% | 0.58% | 0.55% | 0.52% |
| 4% | 0.90% | 0.83% | 0.77% | 0.72% | 0.67% | 0.62% |
| 5% | 1.10% | 1.01% | 0.92% | 0.84% | 0.77% | 0.70% |
| 6% | 1.31% | 1.17% | 1.05% | 0.94% | 0.85% | 0.77% |
| 7% | 1.50% | 1.32% | 1.17% | 1.03% | 0.92% | 0.82% |
| 8% | 1.69% | 1.47% | 1.27% | 1.11% | 0.98% | 0.86% |
| 9% | 1.88% | 1.60% | 1.37% | 1.18% | 1.03% | 0.90% |
| 10% | 2.06% | 1.73% | 1.45% | 1.24% | 1.07% | 0.93% |
| 11% | 2.24% | 1.84% | 1.53% | 1.29% | 1.10% | 0.95% |
| 12% | 2.41% | 1.95% | 1.60% | 1.34% | 1.13% | 0.97% |
| 13% | 2.57% | 2.06% | 1.67% | 1.38% | 1.16% | 0.99% |
| 14% | 2.74% | 2.16% | 1.73% | 1.41% | 1.18% | 1.01% |
| 15% | 2.89% | 2.25% | 1.78% | 1.45% | 1.20% | 1.02% |
Let me give an example to show how to interpret this. Assume you expect a 5% return (remember this is price-only, so the total return would be that plus the dividend yield) and a ten-year holding period. I have made that cell bold above. You will lose 101 bps annualized, so we add that to the haircut on the dividends as we determined previously. So, for VTI, that would be 26 bps (dividends) plus 101 bps (growth) for a total of 127 bps. Compare that to BND at 156 bps (no growth), and it’s a closer call, but you still want stocks in the taxable account.
Notice that the higher the return, the worse having stocks in the taxable account is. This means (obviously) the converse is true as well: the worse stocks do the more you want them in the taxable account. What we should generally be trying to do is reduce the variance in the outcomes, i.e., accept worse good outcomes if it improves the poor outcomes sufficiently. This is why we diversify portfolios, buy insurance, etc. Locating the stocks portion of the allocation in the taxable account helps more when returns are poor – which is exactly when we most want them improved. (I wrote about this concept here: “The goal is to maximize the sum of happiness across all potential futures, keeping in mind the declining marginal utility of wealth.”)
You may wonder if the calculations change at lower tax rates, and the answer is, not really, since the LTCG/Qualified Dividend rates are always lower than OI rates.
Finally, let me close the loop on this by going back to having three buckets (IRA, Roth, and Taxable). First, you put stock funds that you are unlikely to turn over frequently or that you expect to have lower expected returns in the taxable account (to the extent that you can). Then you put everything else in the IRA/Roth accounts, but you prioritize between those two based on expected returns. In other words, because IRAs have RMDs you want the lower-expected-return funds to be in the IRA and the higher-expected-return funds in the Roth (again, after prioritizing putting the tax-efficient stock funds in the taxable account). This keeps more assets in tax-advantaged accounts longer. (If there were RMDs on Roths, or no RMDs on anything, then you would be indifferent to which assets are in each of those accounts. Note that the client has more exposure to assets in the Roth than the IRA though because, as noted above, in reality the government owns part of the IRA. I discussed that here.)