Asset Location – Bonds Go In Taxable!

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I’ve written about this subject before, but it has been over a year, and based on questions I’m seeing in the comments section and my email box, and recommendations I’m seeing in online forums, people aren’t getting it.  Many investing authorities over the years have recommended that if you have to use a taxable account, that you preferentially put very tax-efficient asset classes, such as stock index funds into it, while preferentially putting tax-inefficient asset classes, particularly bonds, into your tax-protected accounts, like 401Ks and Roth IRAs.  This seems like a nice simple way to conceptualize the subject of asset location.  However, as Einstein famously said, “Make things as simple as possible, but not simpler.”  It turns out that basing your decision simply on the tax-efficiency of the asset class is making things “simpler.”  You also have to take rate of return into consideration, and for bonds, that varies highly with changes in interest rates.

Remember The Value Of A Tax-Protected Account

To understand this, it is important to first be able to conceptualize the value of a tax-protected account.  The value of a Roth (AKA after-tax, AKA tax-free) account is simply the value of the tax-free growth, i.e. how much more money you’d have in the Roth account than you would have if you had put the investment into a taxable account.  Obviously, there are also some estate planning and asset protection benefits and perhaps some additional fees, but let’s ignore all that for the moment.  The value of a 401K (AKA tax-deferred) account is a little more complicated.  First, you recognize that the money in a 401K is only partly yours.  Part of it is the governments.  If your marginal tax rate at contribution is 33%, only 2/3 of the 401K is yours.  On that 2/3, the benefit is the same as the Roth.  There is also the possibility of a tax arbitrage.  If you contribute at a 33% marginal tax rate, but withdraw the money at a 17% effective tax rate, you get an additional significant benefit out of the 401K.  Obviously, the arbitrage CAN be negative, but that’s pretty unlikely for most doctors, even with a rise in marginal tax rates.   More details on calculating the benefit of retirement accounts can be found in my recent post on the value of a 401K.

The important concept to understand here, of course, is that assets grow faster in the retirement account due to the lack of tax drag.  So you will benefit from having a fast-growing asset (i.e. stocks) inside the retirement account.  It expands your tax-protected space, increasing your tax benefit, estate planning benefit, and asset protection benefit as the years go by.  You have to weigh that benefit against the additional tax drag of having a tax-inefficient asset class in the taxable account.  At our current low interest rates, the first benefit dramatically outweighs the second.  Let’s look at two examples to understand this.

Why Bonds Go In Taxable

Insuring-Income-250x250-banner[Update:  Post updated 2/11/2014 with some minor changes to the calculations to make them more accurate, based on criticism found in the comments section below. These changes made the numbers less impressive, but did not change the conclusions.]

Make a few reasonable assumptions, and it becomes easy to see why bonds belong in taxable. Let’s assume a $200K portfolio, split half into a Roth IRA and half into a taxable account.  Our physician investor has a 33% marginal tax rate, a 15% long-term capital gains/dividends rate, an 8% return for stocks of which 1.86% (the actual yield on the Vanguard Total Stock Market Fund on 2/11/2014) comes from qualified dividends/long-term capital gains, and a 2.16% return for municipal bonds and 2.69% for high quality taxable bonds (actual yields from appropriate Vanguard bond funds on 2/11/2014.) We’ll also assume no rebalancing to keep things simple, but that won’t distort the direction of results, only the magnitude.  (Run the examples using just 1 year if you’re not convinced of this.)  Note that this physician will use muni bonds when bonds are in taxable, and taxable bonds when bonds are in the Roth since 2.69*(1-33%) < 2.16%.

If you put the bonds in the Roth, you get this:

Roth IRA
$100K Bonds grows at 2.69% for 30 years to $221,740    =FV(2.69%,30,,-100000,1)=221,740

$100K Stocks grows at 8% -(15% * the 1.86% yield) = 7.72% to $930,873 over 30 years. =FV(7.72%,30,,-100000,1)

You don’t pay capital gains on the original $100K, nor on the $183,177 in dividends received.  So capital gains taxes on the $647,696 in gains are $97,154, leaving you with $930,873-$97,154 = $833,718.

Total = $1,055,459

Now, put the stocks in the Roth, and you’ll get this.

Roth IRA
$100K Stocks grows at 8% for 30 years to $1,006,266

$100K Municipal Bonds grows at 2.16% for 30 years to $189,857

Total = $1,196,123

You get $140,664 or 13% MORE by putting the stocks into the Roth.

Even Under Old Assumptions Bonds Should Be in Taxable

Now, what really surprised me, was when I ran the numbers using what someone could have assumed just a few years ago.  It used to be that you could expect a return of about 8% from stocks, about 5% from taxable bonds,  perhaps 4% from municipal bonds, and a 2% stock market yield.  Capital gains and qualified dividends were taxed at 15%.  Under those assumptions, you might think that it would be best to put taxable bonds into your retirement accounts, especially for a high earner with a 33% tax bracket. Surely at those higher bond rates of return and lower tax rate on stocks, we should put bonds into the Roth, no?  Let’s take a look.

First, bonds in the Roth

Roth IRA
$100K Taxable Bonds grows at 5% to $432,194 over 30 years

$100K Stocks grows at 8% -(15% * the 2% yield) = 7.7% to $925,702 over 30 years.  You then pay capital gains taxes on $629,367 ($94,405) and are left with a total of $831,297.

Total = $1,263,491

Then, we’ll try bonds in taxable, (and given the 33% bracket, we’ll use the muni bonds at 4%, although using taxable bonds with an after-tax return of 3.35% doesn’t change the direction of results, only the magnitude)

Roth IRA
$100K Stocks grows at 8% to $1,006,266 over 30 years

$100K Municipal Bonds grows at 4% to $324,340 over 30 years

Total = $1,330,606

Bonds in taxable STILL leaves you with $67,115, or 5% more.  Now, I’m sure if we try hard enough we can come up with a set of assumptions that will favor putting bonds in tax-protected (it will likely involve a great deal of tax-loss harvesting and donation of shares or getting the step-up in basis at death), but under any reasonable assumptions in our current environment, it’s pretty hard to justify that advice.

[Update 2/11/14: Using current yields, even if you assume that you DIE without ever selling any of the appreciated stock fund shares in the taxable account (meaning you get a complete step-up in basis at death), stocks in Roth still comes out ahead by $43,510 (4% more).  If you use the “old assumptions,” and have a complete step-up in basis at death, stocks in taxable finally wins, but only by $27,290, or 2%. This demonstrates the importance of running these numbers yourself using current yields and other assumptions specific to your situation when making asset location decisions, rather than blindly following a rule of thumb, unless having 13% more money to spend doesn’t matter to you.]

Keep in mind that this exercise is already slanted in favor of the bonds in the tax-protected account just by virtue of the fact that we’re assuming we’re pulling all that Roth money out exactly after we finish contributing it, when in reality, it will likely be withdrawn over the next 15-30 years by the retiree, and perhaps another 20 by the retiree’s heir.

Too many investors, including many very knowledgeable investors and advisors, have been giving portfolio construction advice that is too simple, and costing those taking it real money.  Even the Bogleheads just recently revised their Wiki on this subject to show that stocks in taxable isn’t always right.  Put your bonds in taxable and let proper asset location give your portfolio a boost.

What do you think?  How did the dogma of “stocks in taxable” get started and why does it persist?  Comment below!


Asset Location – Bonds Go In Taxable! — 73 Comments

  1. My favorite reasons for having stocks in taxable are things I have only discovered recently: Tax-Loss harvesting and charitable contribution of appreciated securities. Tax loss harvesting is most financialy and emotionally satisfying. If you plan on charitable giving every year,having stocks in taxable is a big winner as well. Combining these two approaches leads to some significant advantages. Neither of these stratigies are nearly as usful in tax deferred accounts.

    Basically it has functioned like this. Each year you buy say $10,000 total stock market and $10,000 total international in a taxable account. If these funds drop more than a preassigned cut off, I use $500-$1000 in losses, you sell and shift into a similar but not substantially identical fund. I use large cap index and ftse international with vanguard but lots of different funds are possible. You can get up to $3000 per year in tax deductions from selling these funds. The kicker is it is only a paper loss. When these funds go back up, if you have kept them one year or greater you can then donate them at their fair market value for a tax deductible charitable contribution. Then I rebuy in taxable each year what I donated. To me I get to play heads I win tails you lose with the IRS.

    Two kickers, one watch out for wash sales when tax loss harvesting. Two, you must hold a fund for at least one year to get fair market value for your charitable contribution. I am each year getting rid of the FTSE international and large cap index funsd that are my second choice funds in December without having to sell for capital gains and rebuying my first choice total international and total stock market index.

  2. These are great thoughts, but I think most people who have a taxable account and read about investing are going to utilize that account for TLH and charitable contributions. Could you show an example of how that would affect the numbers?

  3. i have to agree that for those of us reading your blog, tax loss harvesting, step up basis at death, and charitable contributions are real players.

    • It is very difficult to quantify the benefits of TLHs, a step-up in basis at death, and charitable contributions. But obviously if you never realize a capital gain on a stock (by either donating it or holding it to death) AND get some losses to use elsewhere on your taxes, that’s going to be pretty helpful. How helpful depends on how much money you lose temporarily. But you can easily make some assumptions and make a decision that’s right for you. The math isn’t complicated, although guessing the future can be.

  4. Useful post. This one took me a while to figure out myself as well. Once you realize it, it seems so obvious.

    I actually have a two question test for financial planners. I’m unlikely to ever hire one, but this just gives me something to talk about when approached and I feel like engaging them.

    1. Which is better: dollar cost averaging or lump sum (e.g. funding whole 401k at the beginning of the year or take an even amount out of every pay period of the year)?

    2. Where should I put my bond funds: in taxable or non-taxable account.

    Obviously there are some assumptions that need to be made when attempting to answer these questions and I furnish those as well.

    Of the 5 or so professionals I’ve asked, all 5 got the second one wrong (and 4 got the first one wrong).

    I think both are dogmatic bits of advice that many people in the financial planning profession memorize and then parrot back without really understanding the basic arithmetic underlying them. It’s really pretty sad. I’m sure they are not all that way. It’s possible that I’ve just run into a bad sample.

    I think non-professionals would not fare any better. So, it’s great for WCI to lay it out like this.

  5. Makes sense when comparing Roth vs. Taxable, but what about traditional IRA/401k vs. taxable? Especially since you’re then comparing LT cap gains on the taxable stocks vs. normal income bracket from tax-deffered.

    • It’s the same thing, just more complicated due to the additional arbitrage factor. For these purposes, just consider that a traditional IRA is 2/3 a Roth IRA that belongs to you and 1/3 a Roth IRA that belongs to the government.

      • This is a very useful and well-done post — thank you. I think it’s worth taking it a step further by running the math for tax-deferred accounts as well. When I modeled taxable vs. Roth scenarios, I reached the same conclusion as you. That is, under a surprisingly wide variety of return scenarios, folks in high tax brackets are better off locating equities in a Roth and bonds in a taxable account. But when I modeled taxable vs. tax-deferred scenarios (putting aside the arbitrage factor that you mentioned), the results were not what I expected. I actually found it near-impossible to find a plausible scenario (including the current low-rate scenario) where it would be optimal to put equities in the tax-deferred account. Therefore, I keep equities in my Roth, bonds in my 401k, and whatever is left in my taxable account.

        I’m guessing that the conventional wisdom about efficient asset location is based on a comparison of taxable and tax-deferred accounts, without separate consideration of Roth accounts. While I fully agree with your taxable vs. Roth calculations above, I think the math for tax-deferred accounts yields the opposite result. At any rate, I found it worthwhile to model both scenarios, rather than extending conclusions by analogy — as I originally did myself.

        Now, I am a lawyer and not a mathematician, so perhaps my math is flawed (wouldn’t be the first time). It would be really useful to know if you reach a different conclusion based on your own calculations.

        • In order to compare taxable to tax-deferred, you must first recognize that you do not own the entire tax-deferred account. If you don’t make that adjustment, you’ll arrive at the wrong conclusions. If you compare $100K in after-tax money in the taxable account to $100K in pre-tax money in the tax-deferred account, you’re not comparing apples to apples. Of course if you put the riskier asset into the taxable account you’ll end up with higher returns…BECAUSE YOU OWNED MORE OF THAT RISKY ASSET than if you put it into the tax-deferred account.

          • Many thanks for your reply — much appreciated. I’ve been thinking about your point since last night and have read through the various Bogleheads threads on this subject. I’ve concluded that you are correct and I was wrong. My calculations were based on a portfolio divided 50/50 between Roth and tax-deferred. My first scenario assumed all bonds in the Roth and all equities in the tax-deferred. My second scenario reversed the asset locations. A comparison between the scenarios indicated that holding bonds in the tax-deferred account was advantageous. But as you recognized, I was doing an apples-to-oranges comparison, since my two calculations did not control for asset allocation (as opposed to asset location). Holding bonds in the tax-deferred account appeared advantageous only because doing so effectively decreased my bond allocation on day one. When I modify the comparison to keep my asset allocation on day one constant across scenarios, the difference in results disappears.

            Having seen the error of my ways, I might be in a good position to respond to your question how the “stocks in taxable” dogma got started and persists. I think it’s a combination of three things. First, many people automatically analyze tax efficiency questions only in terms of rates and not absolute dollars. It’s important to recognize that paying high taxes on taxable bond coupons in a low rate environment doesn’t hurt nearly as much as it would in a high rate environment. An investor focused only on tax rates and not absolute dollars ignores this.

            Second, when attempting to analyze tax efficiency through scenario calculations, it’s ridiculously easy to make the methodology mistake of failing to keep asset allocation constant on day one — even for sophisticated investors who understand the concept of tax-adjusted asset allocation and therefore should know better. In fact, as you’re no doubt aware, Vanguard made this very mistake in its asset allocation white paper ( In the paper, Vanguard compares two scenarios: (1) $500k in bonds in a taxable account and $500k in equities in a tax-deferred account; and (2) vice versa. They completely miss the fact that these two scenarios represent different asset allocations (as opposed to asset locations) on day one. The day-one risk profiles of these two scenarios are not equivalent, so it’s no surprise that the results differ.

            Third, it’s very difficult to change people’s minds on this topic. The Bogleheads threads in this area are full of long and at times heated exchanges that never get resolved. Few people seem to be swayed by the arguments. This is due in part to the first two reasons above. And of course entrenched views are hard to move even if proven wrong. But people are especially unlikely to change their minds after being told they are wrong in a way that could possibly be perceived as condescending. Most of the time human nature seems to get in the way.

            Thanks again for the help.

  6. Question: Seems the examples use municipal bonds in the taxable account. I am a relatively new investor and like the simple portfolios that comprise of things like Vanguard total bond mkt funds or short term bond funds (like those outlined in the recent post on 150 portfolios…). Can municipal bond funds be considered equivalent? Can i rely on just these simple bond funds, or should I be looking at things like TIPS, I bonds etc…

    • Lots of questions, no right answers, especially without knowing more about you. But if you’re in a high tax bracket, and your bonds are in taxable, you generally want to use muni bonds or I bonds. TIPS aren’t so great in taxable. Although they are state tax free, you run into a phantom tax issue, where you have to pay tax on income you don’t actually receive. A taxable bond fund like TBM likely has a lower after-tax rate of return than a typical muni bond fund for a high tax bracket investor. Just multiply the yield of a high quality bond fund by (1- your marginal tax rate) and compare it to the high quality tax-free bond fund. For example, if your marginal rate was 28% + 5% = 33% total, and a taxable bond fund yielded 5% and a tax-free bond fund yielded 3.8%, then you would be better off with the tax-free fund (3.35% vs 3.8%). If your marginal rate was 15%, then you’d be better off with the taxable bond fund (4.25% vs 3.8%). Hope that helps.

  7. I agree that it’s not always simple. For us, taxable is mostly equities, but not for the traditional reasons.

    I have no Roth space available (have a large tIRA that my 401k plan won’t accept as a rollover). And we’re also usually in the 33% tax bracket, so I opt for maximum t401k contributions.

    So I treat my taxable account as a “Roth Substitute”, and invest mainly in stocks and ETFs that pay little to no dividends, but instead focus on increasing share price. Berkshire Hathaway would be a textbook example. And I am mostly a buy and hold type investor, so I do very little trading. Since the tax rate on unrealized capital gains is zero, I get essentially tax free compounding as well.

    It’s hard to find truly tax efficient funds that operate like this, so I’ve basically built my own fund of 30-40 individual stocks. I know, not recommended! But it’s worked well for me for 25+ years. I do pay a small amount annually in dividend and cap gain taxes, especially if I get hit with a buyout, which happens from time to time. But then, I’m only paying 15 or 20%, which is close to what I expect to eventually pay on my t401k withdraws. And, FWIW, my “expense ratio” is extremely low ( a few $7 trades each quarter).

    We’re planning on early retirement at age 52-55, and hope to live off the proceeds from the taxable account at that point. Assuming current cap gain rates hold, we’ll be in the 0% tax rate until $90k +/- annual income (married filing jointly). So again same as a Roth

    Another advantage with equities in taxable is what some folks call “tax gain harvesting” . That is essentially reestablishing basis by selling appreciated equities while you’re in the 0% cap gains rate bracket, and immediately rebuying them. My pay is heavily bonus based, and in a down year, I can sometimes capture that benefit.

    That being said, our 401k plan will be changing drastically in the next few months. I will now have an after tax 401k option available, and will hopefully now be able to roll my existing IRA into the 401k plan. So it’s back to the spreadsheets for me!

    • Not quite a Roth IRA substitute, but not a bad strategy. Far too many of your colleagues go buy whole life insurance instead of using a taxable account in a tax-efficient manner like you are doing. I would argue that you’re probably trying to be more tax-efficient than you need to be and giving up valuable diversification to do so, but it’s hard to argue it’s a BAD strategy. I’d probably just go with TSM/TISM/Muni bonds in taxable to keep it a bit simpler and more diversified.

  8. Vanguard has a position paper on asset allocation for taxable and I thought it recommended bonds in tax sheltered, maybe you should pull that and go through the examples to dispute. I think time horizon has to be considered, if you have 20+ years why hold anything heavy in bonds in taxable or protected I would think you want the growth exposure for a while.

    • Asset allocation is a separate decision from asset location. I agree that with long time horizons you want a portfolio more heavily weighted toward stocks. That isn’t what this post is about.

      I suspect this paper by Colleen Jaconetti, CPA, CFP is the one you’re talking about:

      Part of the issue with that paper is that it assumes a 35% effective tax rate on tax-deferred withdrawals which seems silly on such a small portfolio. More importantly, it muddies the water by using a tax-deferred account instead of a Roth account. In doing so, she doesn’t tax adjust the money. So her scenario of stocks in tax-deferred comes out behind because the after-tax asset allocation is less aggressive than when the stocks go into taxable. Her accounts ($500K in taxable and $500K in tax-deferred) and presumed tax rate on withdrawal (35%) indicate that the asset allocation is either 60/40 or 40/60, depending on what goes where. Of course you’re going to end up with something different when you’re using a different asset allocation. If she had tax-adjusted the asset allocation, then she would see that her tax location decision was wrong. If she had kept it simple, using a Roth account and a taxable account, it would have been easier to see what is going on with asset location. She also heads off into the weeds talking about an actively managed fund, which further obscures the more significant issue- rate of return and expansion of tax-protected space.

      I hate to say Colleen Jaconetti is wrong on this (she’s a very nice lady), but unfortunately, she is.

  9. Let’s take this a step further. I agree that right now bonds in taxable makes sense. But what if you have a mortgage in the scenario I’ve outlined below. Would you put money in a taxable bond or would you move it to prepaying your mortgage? I’ve seen numerous discussions about this lately, but no definitive strategy. I appreciate your thoughts.

    Bond portion of portfolio: Prefer an intermediate term bond. Per the argument in this post, it makes the most sense to hold Vanguard Intermediate Tax Exempt (VWITX) in a taxable account. After tax yield is 2.18%

    Mortgage: 10 year mortgage with an after tax interest rate of 2.30% because interest is deductible.

    Would you put new money into bonds in taxable, or would you prepay the mortgage? Using the “mortgage is a bond” argument, the mortgage has a similar duration to the tax exempt fund. One could “lock in” the 2.30% rate by prepaying the mortgage and beat the current yield on the fund. Would you do this? If not, how much would the mortgage rate have to exceed the bond yield before you would prepay? If it matters, assume that the person in this situation wants the option to stop working ~6-8 years. I appreciate your thoughts.

    • I think paying down a mortgage with an after-tax rate higher than the after-tax rate on your bonds in taxable is a smart move. This is one reason I don’t have much of a taxable account.

      One thing to keep in mind is that if you start adding in debt to your asset allocation it becomes tricky to rebalance and your non-mortgage portfolio has a more aggressive allocation you may not be able to tolerate.

      I prefer to look at this as a decision between paying down debt and investing vs an asset allocation decision.

  10. Dear White Coat Investor,

    Thank you for the thought-provoking article.

    Your analysis is severely flawed in two ways.

    First, when you put stocks in the taxable account, you are assuming that the dividends get re-invested. However, if the dividends do get reinvested, then the basis gets increased by the amount of those reinvested dividends. This makes a huge difference in the eventual capital gains tax. Rather than the basis on 900,260 being 100,000, the correct basis is 310,594.

    Second, you are implicitly assuming that all bonds are municipal bonds. While many people says that ordinary bonds should go in tax-protected accounts, no serious person says that *muni* bonds should.

    The first one is clearly wrong. The second one, perhaps you could argue that muni bonds are absolutely superior to corporate bonds and that this fact affects your location decision. That may be a reasonable argument (I don’t know), but you should make it explicitly if that is the argument you wish to make.


    • Thank you for your valuable criticism.

      You are correct on your first point. I don’t think it changes the conclusion, although it does make a stocks in taxable approach more favorable. I’ll rerun the numbers to make sure as soon as I get a chance and update the numbers.

      I am only assuming that bonds in the taxable account are muni bonds. However, muni bonds and taxable bonds of similar risk had very similar yields at the time the post was written, so I just used 2% both inside and outside the tax-protected account. When running your own numbers at any given time period, you need to take into account this spread. It might be interesting to use a 3% yield on taxable bonds in the retirement account to see if it changes the conclusions. Obviously, the higher the return on the bonds, the more likely it is for bonds in tax-protected to be the right option.

      • If the basis is changed to $310,594 for the bonds in the taxable account (I’ll trust you on your calculation as that seems about right), that would increase the amount with stocks in taxable to $963,463. This is still significantly less money than putting the bonds in taxable ($1,187,402) although it starts closing the gap.

        If you also used 3% for the taxable bond yield in the Roth IRA (leaving the muni yield at 2%), that would increase the stocks in taxable total to $1,025,053 but that is still 15% more than doing the reverse.

        Another reasonable criticism is that putting stocks in the Roth IRA is taking on more risk, since part of the money in the stocks in taxable really belongs to the government, but I think that is a poor criticism since it is possible to avoid those taxes altogether by donating shares to charity or dying and leaving it to heirs with the step-up in basis.

        In conclusion, you are correct that the calculation was slightly flawed, but under these assumptions and current interest rates, it only affects the magnitude rather than the direction of the conclusion.

        With higher expected returns on bonds, lower expected returns on stocks, lower tax rates on dividends/LTCGs, higher tax rates on bond yields or a higher spread between munis and taxable bonds, the conclusions can change. You need to run the numbers for yourself. But I keep seeing people bending over backwards to try to keep their bonds in their tax-protected accounts. Not only are they wasting time, but they’re probably actually hurting their overall financial picture by doing it. It isn’t just a decision you make based on relative tax-efficiency of asset classes, but also on the expected returns of asset classes.

  11. The following statement to be untrue…

    “The value of a 401K (AKA tax-deferred) account is a little more complicated. First, you recognize that the money in a 401K is only partly yours. Part of it is the governments. If your marginal tax rate at contribution is 33%, only 2/3 of the 401K is yours.”

    Due to progressive tax brackets of 10%, 15%, 25%, 28%, 33%, etc, the portion of the 401k that is yours depends on your effective tax rate and not your marginal rate.

  12. WCI,

    1) I always tell clients in a perfect world you want your Roth to be your biggest account, it may not work that way but that is pretty much what you are saying. This is a simple concept, I usually have stocks and growth stock in Roth unless the client is in the 15% tax bracket (non-physician retirees).

    2) Why the 20% tax on qualified dividends and capital gains? Depending on where in the 33% bracket this physician is in he/she will pay 15%, max of 18.8%.

    3)I understand that you are simplifying this for people to see what is pretty obvious (Big Roth good, small Roth bad) but very few MDs I work with are in such a simple account situation. A 40 year old doc in the 28-33% (most of my doc clients) typically has about 100 – 200k taxable account, 150-250k 401k, 25-75k traditional IRA, and about 30k in Roth if they were smart and contributed to Roth while in residency. My comment is just to show that while you knock those in financial planning positions for keeping things simple, you are doing it yourself. Simple is what people understand and like, showing somebody a way to pay more tax today is a losing proposition with many clients.

    4) I think someone else hit on this but if you switch the Roth out for a traditional then the step up in basis on growth stock (taxable account) surely impacts the transfer to heirs more than what you let on.

    5) Also, I know you like to keep it simple but your calculations are using the wrong tax rates on qualified dividends and capital gains for most MDs I know, add to that when we are talking about the majority or money being taxable, 401k, and traditional IRA, keeping growth stock (not an in-efficient index fund) in the taxable account keeps tax drag to a minimum.

    • 1) It is important not to mix this concept with tax-adjusted tax-deferred (traditional IRA and similar) and tax-free (Roth IRA and similar) accounts. Putting high return investments in the Roth and low return investments in the traditional does have higher expected returns, but only because you are taking on more risk. You must first tax-adjust the accounts.
      2) For some crazy reason, I thought the 20% LTCG rate applied to the 25%-39.6% bracket when in reality, it only applies to the 39.6% bracket. I was looking up a source to show you how wrong you were when I realized that I was the one who was wrong. Excellent criticism. For a few docs, it will be 0%. For many docs, that rate will be 15%. For some 18.8%, and for a few 23.8%. But it won’t be 20% for any of them. Of course, given current interest rates, it won’t change the outcome of the calculation, but it does make it so bonds in taxable is less advantageous. My point with the article is that you have to run the numbers for yourself. You can’t just go by a simple dogma like “tax-inefficient assets in tax-protected accounts.”
      3) I’m not suggesting anyone pay more tax today, at least in this post, since I used muni bonds in taxable. I’m keeping it simple (leaving out tax-deferred accounts) to emphasize the point. It certainly applies to tax-deferred accounts too, you just have to tax-adjust the account first.
      4) I believe the last paragraph of the original post addresses the step-up in basis issue quite well. The best account to inherit, however, is still a Roth IRA, not a taxable account, even with the step-up in basis at death.
      5) It isn’t about tax-drag. That’s the misconception I’m trying to dispel. You can’t just look at minimizing tax drag. You have to look at what ends up with more money. You have to consider BOTH the tax-efficiency of the assets, and their expected rates of return. As you say, Big Roth is better than Small Roth. Big 401K is also better than small 401K, all else being equal.

      I’ll redo the calculations here soon, since I need to make another correction anyway. But you’ll see that it only decreases the amount by which stocks in the Roth are better.

      • WCI,

        A real life scenario is adding a 401k/Traditional to the mix. Again, Big Roth good, is an extremely simple concept, so yes the growth stock goes in Roth. But I think where you may lead some people astray is putting bonds (corps or muni’s) in taxable when those maybe better suited for the 401k/ traditional IRA.

        Your case study boils down to this question, what would you rather have a larger taxable account or a larger Roth? The answer is simple.

        What would you rather have, a larger taxable account or a larger 401k/traditional IRA? This is where most people are, Roths are limited to $5500/6500 per year unless you convert, in which case you pay tax today. At some point ( not withstanding the back door Roth) somebody decided to pay tax earlier than later to have a Roth.

        My point that I was trying to get across is that you are (rightfully so) trying to conceptualize a somewhat complicated matter with a simple case study, one that doesn’t exist so often. Simple is what people understand and can tolerate. My meetings can’t last longer than an hour or my clients glaze over, I think this is how most whole life policies are sold. Wear them out and they will sign anything.

        I am looking at your proposal and not sure why the bonds (1st case) in the Roth are only growing at 2.69%? I have that growing at 5% for $432,194.

        Also, not sure that Muni’s are paying 4% yield, I haven’t seen the tax equivalent yield work in Muni’s favor recently.

        Errors withstanding, I agree with a lot of what you say and I am a financial planner and tax advisor, my wife is a doc. The docs I work with (not PHD’s) are not interested in learning all this. I think I am fair to them and they are loyal clients, unfortunately they are also loyal to the “advisors” who also rip them off. Usually those advisors work for the largest, most superior, greatest mutual life company in the history of the universe.

        • I think you’re missing a concept here. I purposely mostly left this concept out of this post because it is more complex. It helps if you look at a tax-deferred account as actually being two accounts. The first is a tax-free (Roth) account and the second is an account that doesn’t belong to you at all. So if your marginal tax rate upon contribution is 33%, and you contribute $10K, then $6,667 is in a tax-free account and $3,333 is in an account that belongs to Uncle Sam. Now, all the principles discussed in this post absolutely apply to the tax-free portion of that account. You want it to be as big as possible. Most investors will actually get an additional bonus from using a tax-deferred account, in that upon withdrawal they’ll also be able to score a certain portion of the Uncle Sam account too. This is the tax-rate arbitrage benefit of a 401K. However, it is possible in rare situations for this “bonus” to be negative.

          So now your question- would I rather have a larger taxable account or a larger tax-deferred account? I definitely want the tax-free portion of that tax-deferred account to be larger. So, if my choices are to have $10K in the taxable account and $20K in the tax-free portion of the tax-deferred account or $20K in the taxable account and $10K in the tax-free portion of the tax-deferred account, I’ll take the first option, especially if I can score a portion of an extra Uncle Sam account too. Does that help?

          Remember in the post there are two examples- one using current assumptions and yields and one using assumptions and yields one might have used 6 or 7 years ago. I think you might be mixing them up. The 2.69% is the current yields on intermediate term bond index fund. 5% is about what that yielded 6 years ago. Again, munis are paying 2.16% now, but were yielding perhaps 4% 6 years ago.

      • Also, to respond to your comment on inheriting Taxable vs Roth. I agree, I wasn’t saying that its better to inherit a taxable over a Roth, I was saying in a real life scenario where traditional IRA’s are involved, the taxable account is best to inherit. I am sure you would agree there too.

  13. Post updated today based on the criticisms from Jeff Janes and JT. I also added information to show that even a complete step-up in basis at death doesn’t reverse the conclusion at today’s yields.

    The conclusions are:
    1) Tax-efficiency of the asset classes matters
    2) Your personal tax rates matter
    3) The rate of return of the asset classes matters
    4) You have to run the numbers yourself to make a decision.
    5) Placing the higher returning asset class into the tax-protected accounts is often the right decision, even when this causes less tax-efficient assets to be placed in the taxable account.
    6) The consequences of having to change from bonds in taxable to stocks in taxable due to future changes in yields or your personal situation are less severe than vice versa because little to no capital gains taxes will be due on the sale of the bonds.
    7) Don’t worry if you have to put some bonds in taxable; it’s probably the right move, but even if it isn’t, the consequences of being wrong won’t be very large.

  14. My question is this. How do you get substantial assets into a Roth if you are a high income investor? Converting from a traditional to a Roth doesn’t work because of 1) terrible tax burden and 2) I have too much in a traditional so if I did a non- deductible IRA I couldn’t convert that to a Roth. I cannot contribute directly to a Roth because I exceed income limitations

    • There’s no magic bullet. You make Roth 401K contributions, Backdoor Roth IRA contributions, Roth conversions in lower income years, or you just don’t get Roth money. This is part of the reason I encourage residents to make Roth contributions.

  15. I think a better name for your post here would have been, “Stocks go in your ROTH!” or “Investments with most potential to appreciate go in your Roth”. This is how I have my docs invest their money. Stocks in Roth, bonds in 401, trad IRA, and then as the taxable will be a mix of different assets.

    The conclusions you are reaching are that the strategy that leaves you with the larger Roth account at retirement is the best strategy. Saying that bonds go in taxable may lead some of your followers to put bonds in their taxable accounts when they have traditional IRA or 401ks.

    • I agree that if there is a taxable account, bonds should go there first. I think you’re probably doing your clients a disservice putting their bonds in tax-deferred accounts and then putting stocks in their taxable account, but individual circumstances do vary and you might not be.

  16. Also, ROTH 401k contributions are forcing people to pay tax today in addition to putting bonds in the taxable account. It doesn’t matter how much sense your strategy makes, showing someone how to pay thousands more in taxes today is a difficult sale.

    To Steve, if you are working and like your 401k plan, you may be able to rollover your IRA money into your 401k plan and thus avoid the IRA aggregation rules. You have been keeping track of your basis in IRA’s right? its form 8606 on your tax return.

  17. How does VTIAX (Vanguard Total International Stock Index) factor into this thinking, if at all? I understood and followed conventional wisdom that it should be held in taxable, in part because of the foreign tax credit potential. From this article, it sounds like it may make more sense to hold it in Roth>401k space?

    Anything change here? I can move things around easy enough, either when I harvest of when I’d only have to pay a LTCG on it. I’m only 43 so still thinking for the longer haul.

    • It depends on what else you hold and how much of your space is taxable. Certainly VTIAX is a great taxable holding. But if I was choosing between putting it in taxable and putting some bonds in taxable, I’d buy some munis and put them in taxable. If I was choosing between VTIAX and REITs, TIPS (phantom taxes suck) or P2P Loans, I’d put the VTIAX in taxable. I’m lucky in that all my accounts are tax protected, so I’m not really faced with these decisions at all. Some people are essentially all in taxable, so they don’t have to make these decisions either.

      • Sounds good. I have enough space to move TISM into my ROTH, move some domestic from ROTH to my 401k (which only has an S&P index that is low-expense, everything else is 1.0% or higher, ugh) and buy munis in my taxable. I’ll wait a year to limit CGs, but it’s something to think about.

        I keep REITs in ROTH no matter what. They just feel too squirrely for me to hold them anywhere else. :)

    • Here’s his strategy for anyone interested:

      1. Continue to invest for the long run with the investment goal of retirement.
      2. Grow entire bond allocation into taxable account. I would use national AMT free munis or california AMT free munis.
      3. Increase bond allocation to 20%-30% until 200k is reached, then keep bond allocation fixed at 200k until it decreased to desired bond percentage based on age.
      4. When home buying opportunity presents itself, sell entire bond allocation and use it for downpayment.
      5. Convert the appropriate amount of equities in tax deferred accounts to bonds (likely vanguard TBM) to maintain the desired bond % based on age.

      I think the plan is fine. Munis are a reasonably safe way to save up a down payment to use in 5-10 years. There’s nothing wrong with looking at all your money as one big account, even though there are different goals. I tend to use one AA for each goal, but lots of people do it your way. Many roads to Dublin.

  18. Great post. Can you please explain how you calculated with Excel “the $183,177 in dividends received”?


  19. Ah, great post. I missed this one and commented on your 2012 one (awaiting moderation). But most of the questions are addressed here.

    I guess the underlying remaining one for those of us with the bulk in tax differed and after-tax, do we need to tax-adjust our asset allocation assessment? That seems really complicated nor rarely mentioned (though I will try the Boglehead link).

    • It is complicated. It is rarely mentioned. And it is seldom done. I confess I don’t bother because it just doesn’t matter that much. But if you really want to look at things accurately, you have to do it.

      • In looking at the bogleheads wiki on tax-adjusted asset allocation ( stock in a taxable account is generally worth about 15-20% less than a roth because of future taxes. Surely that amount is not insignificant? Essentially, the portfolio with stocks in roth is more risky because no taxes will be owed on the stock.

        Showing that even under the old assumptions stocks belong in tax-deferred seems like a warning about the analysis.

          • Agreed on the tax on gains.

            Tax-adjusting this “50/50” portfolio gives something more along the lines of 55/45 depending on tax rates. That means the “stocks in roth” portfolio is more like a 55% stock allocation, and thus riskier.

            There’s a complex formula on the spreadsheet linked from the bogleheads wiki ( that I don’t understand, and am not sure if it’s accurate as it doesn’t account for a starting basis. It attempts to calculate the effective tax rate for stocks including re-invested dividends. I did a few simulations of my own and suspect that for any time-frame of 10+ years, the effective tax rate will probably be somewhere around 15-20% depending on tax rates, duration, etc.

    • I think this is the most important paragraph from the paper:

      Based on the assumptions, Daryanani and Cordaro (2005) concluded that stocks should be located in taxable accounts and bonds in TDAs. However, the optimal asset location in this framework depends upon the specific assumptions. Daryanani and Cordaro noted that the opposite asset location is optimal if any one of the following change, everything else held constant: (1) the capital gain tax rate is 20 percent; (2) stocks earn 10 percent a year; (3) horizon is 40 years; or (4) the ordinary income tax rate is 25 percent. As they stated, “Clearly, the results are dependent on the input assumptions.” (p. 45)

      While everyone would like a cut-and-dried answer, there is none. It is a very personal thing and can change with time depending on what you plan to do with your taxable account, your particular tax rates, current yields on bonds etc.

  20. Thanks for the post. I am 30yo and right now all my bonds consist of high-yield bond funds. Since these supposedly are a “hybrid” between stocks and bonds, they act similarly to both and have returns closer to equities, should I put them in a Roth vs taxable? I believe the historical returns on HY bonds ~8%, almost that of equities, so the growthy will be more similar to equities than bonds (hopefully). Thanks!

    • High yield bonds are very tax-inefficient, so if the choices are roth vs taxable, then I’d choose Roth. However, I’m not a big fan of corporate junk bonds. Larry Swedroe hates them, suggesting that you should take your risk on the equity side (lots of SV) and keep the fixed side very safe (short, high quality bonds.)

      • Thanks! Yes I read the exchange between Larry and Rick Ferri regarding this. I do not know how long I’ll allocate toward HY bonds but figure perhaps at the age of 40 I’ll shift towards a more traditional, conservative profile. As it stands now I’ve got 5% HY bonds, 5% peer-to-peer lending, 10% REITs, 15% SMV, 32.5% US total market, 32.% international total market.

        So I’ll keep the HY bonds in the Roth and when I shift towards the total bond market ~10 years I’ll put it in the taxable account.

        Thanks again for all your help — Jason

  21. I just did a few simulations. My numbers agree, Bonds In Taxable! I even made a few favorable assumptions that should have slanted the numbers the other way. The only caveat is how difficult it is to quantify the tax-deferral advantage of tax-loss harvesting for stocks in a taxable account.

    I still see the old dogma being mentioned just about every day on the Bogleheads forum. For something that just comes down to simple mathematics, I don’t know why there is such a big controversy. It makes me question my own simulations.

  22. Hey WCI,

    What Vanguard bond fund do you recommend for a taxable account if I have a 30 year working horizon? I was thinking Vanguard intermediate tax-exempt but does the fact that the bonds are intermediate duration not make it ideal for someone with a longer investing period? Thanks.

    • As a general rule, you get paid to take term risk out to intermediate, but not necessarily long. Swedroe recommends you get 0.15% in yield for every additional year in duration (or perhaps maturity, I don’t recall) so you can use that to decide between intermediate and long. Be sure you actually benefit from the tax-exempt fund (do the math.)

  23. Leave all your Roth investments in stocks as you probably will touch them last or probably pass them down
    And open Roths for your kids to make them instant millionaires at retirement

    • Kind of defeats the purpose of tax diversification to never touch your Roths, no? Also, it’s possible your kids will be in a lower tax bracket than yours. Why not let them pay the tax on an tax-deferred inheritance? Don’t get me wrong, I’d rather inherit a Roth, but any inheritance is nice.

  24. Would the conclusion change if you controlled for “Asset Allocation Drift”?

    In your “Bonds in Roth” scenario, Bonds fall from 50% to 19% of the portfolio over the 30 years.

    But in your “Stocks in Roth” scenario, Bonds fall from 50% to 16% of the portfolio over the 30 years.

    We know that stocks beat bonds (given your assumptions), so it would follow that allocating more of the portfolio to stocks will win!

    To what extent is an “Asset Allocation Effect” crowding out (or masking or skewing) an “Asset Location Effect”?

      • I looked at the asset allocation drift in your numbers again, but this time after taxes. “Bonds in Roth” ends up with 21% in bonds, while “Stocks in Roth” ends up with only 16% in bonds. This is a 5% difference in asset allocation (higher than 3% but still not massive).

        Your overall point is excellent, which is that asset location is a function of BOTH expected returns and tax efficiency. That said, there may be bigger fish to fry in asset location than where to place bonds…

        One wrinkle I’ve been researching is the FTC (foreign tax credit) and whether it is large enough to prioritize placing international index funds in taxable…because if you leave them in tax deferred you never get the credit! Turns out Emerging Markets are an interesting case because they are tax inefficient BUT offer a large FTC (available only in taxable).

        For example, REIT’s are a total no brainer to go in tax deferred (high returns, low tax efficiency).

        The approach I’ve read and like is to START with your no brainer funds – locate them first where they should go, and then “fill in” with the rest.

  25. Based on this post and others, it seems like the outcome of fussing with asset location can be positive or negative, and depends a lot on assumptions about the future that are difficult or impossible to predict — future interest rates, future tax rates, future income, etc. Moreover, simple analyses can’t factor in possible mitigation strategies such as Roth conversion in a low-earning year and tax diversification in retirement. Trying to sort through the various scenarios makes my head hurt.

    Thus, as a young investor starting my professional life (along with my wife who’s a new minted EM attending), I feel like the best course of action may just be to maintain virtually equivalent asset allocations across tax-deferred, Roth, and taxable accounts, with the exception of using muni bonds instead of treasuries in taxable and carving out tax-advantaged space for the slices of extremely inefficient assets (e.g., REITs).

    This has the benefit of simplicity — especially in the accumulation phase where contributions are significant relative to total assets and the various accounts are growing at different rates — as well as flexibility in instances where alternative investment opportunities arise and there is a high premium on liquidity.

    Thanks for the great blog! Cheers.

    • I think your conclusion is excellent – simple and practical.

      Some of us are drawn to the asset location puzzle because we like puzzles, not because it ends up being a big driver of returns.

      Emerging Markets (Vanugaurd’s VWO) is an interesting “puzzle” case. It is pretty tax inefficient (so put it in tax deferred) but it offers a large foreign tax credit (which is only available in taxable). So round and round we could go debating this an other fine points of asset location.

      More broadly, if you are an index investor only, asset location is not a “big idea.” If you have a “vegas” account, on the other hand, obviously you would do that in tax deferred, and so on.

  26. For a taxable account, would it make more sense to use the Intermediate Term Tax Exempt Bond Fund (Expense ratio 0.20%) or the lower cost Total Bond Market Index Fund (Expense ratio 0.07%). Would the higher expense ratio of the tax exempt fund potentially outweigh any taxable advantage?

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