Improving your Tax Efficiency

The following list by Taylor Larimore over at diehards.org is often cited on the internet as the rule for tax efficient fund placement. The basic idea is to shelter tax-inefficient funds in tax advantaged accounts. Tax in-efficient funds are those that distribute dividends and/or have a lot of portfolio turnover resulting in capital gains distributions.

4-Step Rule for Tax Efficient Fund Placement:

1. Put your most tax-inefficient funds in 401ks, 403bs, Traditional IRAs and similar retirement accounts. When full..

2. Put your next most tax-inefficient funds in your Roth(s). When your Roth(s) are full..

3. Put what's left into your taxable account.

4. Try to use only tax-efficient funds in taxable accounts.

Here is a list of securities in approximate order of their tax-efficiency. (Least tax efficient at the top.):

Hi-Yield Bonds
Taxable Bonds
TIPS
REIT Stocks
Stock trading accounts
Small-Value stocks
Small-Cap stocks
Large Value stocks
International stocks
Large Growth Stocks
Most stock index funds
Tax-Managed Funds
EE and I-Bonds
Tax-Exempt Bonds

The underlying issue here is the disparity in tax rates. The IRS taxes dividends from bonds at your income rate and that rate is typically higher than the capital gains rate. For example, if you receive the same amount in dollars in capital gains from an equity mutual fund as dividends from a bond fund you would still pay more tax on the bond dividends. Consequently, it is possible to significantly reduce a tax bill by sheltering bonds in tax advantaged accounts.

Given the current marginal tax system, the tax bill for a single taxpayer earning $60,000 in dividend income would look like this:

10%*7825
+ 15%*(31850-7825)
+ 25%(60000-31850)
-------------------------------
= $11,423

Compared to the tax bill for $60,000 on long term (held 1 year or more) capital gains

15%*60000
= $9,000

That’s a savings of over 21%

I currently have very few bond holdings. As I near retirement, my goal is to gradually increase my bond allocation. In light of this tax information, I plan to convert approximately 20% of the funds that I hold in my Roth IRA to a bond fund. In the next few months, as part of my 2008 financial resolution, I will be evaluating several different bond options, posting about each and eventually making an investment within my Roth.