Week 42 Day 4: Asset Location: Which Investments Go in Which Accounts

Bonds (taxable interest) go in your IRA (where interest is tax-deferred). VTI (tax-efficient, low dividends) goes in your taxable account (where gains are taxed at favorable capital gains rates). SCHD (higher dividends) can go in either but is slightly better in taxable (qualified dividends get favorable rates). Think of it as putting the noisiest instruments in the soundproofed room (IRA).

Asset location rules of thumb: TAX-ADVANTAGED (IRA, 401k, Roth): place tax-inefficient investments here. (a) Bonds (BND, VCIT, VTIP) -- interest is taxed as ordinary income (up to 37%). Shield it. (b) REITs (SCHH, VNQ) -- REIT dividends are taxed as ordinary income (not qualified dividend rates). Shield them. (c) High-turnover funds (actively managed funds that generate short-term capital gains). Shield them. TAXABLE ACCOUNTS: place tax-efficient investments here. (a) Total market index (VTI, VXUS) -- low turnover, low dividend yield, mostly qualified dividends. Tax-efficient. (b) Dividend stocks (SCHD) -- qualified dividends taxed at 0/15/20%. Better than ordinary income rates. (c) Individual stocks -- only taxed when sold, and at favorable long-term capital gains rates if held 12+ months. ROTH ACCOUNTS (best for highest-growth assets): (a) Small-cap stocks (VB) -- tax-free growth on the highest-expected-return asset. (b) Growth stocks (VUG) -- same logic. High expected growth, never taxed. (c) VTI -- fine in Roth for the same reason. Example: you have $300,000 total: $100,000 in 401(k), $50,000 in Roth IRA, $150,000 in taxable. Target allocation: 70% stocks / 20% bonds / 10% REITs. Optimal location: 401(k): $60,000 bonds (BND) + $30,000 REITs (SCHH) + $10,000 VTI. Roth: $50,000 VTI (or growth stocks). Taxable: $150,000 VTI. All bonds and REITs are shielded. All stocks are in tax-efficient locations. The OVERALL portfolio is 70/20/10 as desired.

Asset location optimization was quantified by Daryanani (2004) and Reichenstein (2006), who estimated the value at 0.20-0.75% per year in after-tax return improvement for typical multi-account households. The optimization depends on the tax characteristics of each asset (dividend yield, turnover, qualified vs. non-qualified income) and the tax treatment of each account (tax-deferred, tax-exempt, taxable). The general principle: assets that generate the HIGHEST tax drag belong in the accounts with the MOST tax protection. Tax drag by asset class (approximate annual): REIT funds: 1.5-2.5% (high ordinary income distributions). Bond funds: 1.0-2.0% (interest taxed at ordinary rates). High-dividend equity funds: 0.5-1.0% (qualified dividends, but frequent). Total market index funds (VTI): 0.2-0.3% (low yield, mostly qualified, minimal turnover). Growth index funds: 0.1-0.2% (very low yield, minimal turnover). The Roth account is particularly valuable for the HIGHEST-GROWTH assets because all growth is permanently tax-free. Horan (2005) showed that the present value of a dollar in a Roth IRA exceeds the present value of a dollar in a traditional IRA for high-growth investments, because the tax-free growth compounds more favorably. However, the asset location decision interacts with the rebalancing decision: if all bonds are in the 401(k) and all stocks are in the taxable account, rebalancing may require selling stocks in the taxable account (triggering capital gains). Maintaining some of each asset class in each account provides rebalancing flexibility without triggering taxes.