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What is the Optimal Asset Allocation Across Accounts?

One question that always seems to incite a sort of war amongst investors is how to allocate funds across accounts.  Do bonds go in tax-advantaged accounts versus taxable accounts?    Do stocks go in Pre-tax traditional or Roth?  With so many different perspectives it can be very confusing, so what should you do for asset allocation across accounts?

Tax Advantaged Accounts Come First

Well, let’s start with the obvious.  After adjusting for liquidity if you are not maxing out your tax-advantaged accounts that’s usually where you are best served to place funds.  Don’t let some hypothetical fear of not being able to get to the money in early retirement stop you from doing so.  There are plenty of exceptions that allow for tax-advantaged account withdrawal before 65.   I personally would not contribute to a taxable account over a tax-advantaged account for any funds not needed in 2-5 years or part of an emergency fund.

Optimal Fund Allocation Across Accounts

That out of the way we move on to the real question, what to do if you have funds beyond your tax-advantaged space, all upper 5 figures of it?  Well as the name implies the optimal way to allocate funds across accounts would relate to their taxation.  Particularly it relates to their tax efficiency.

Defining Tax Efficiency

What is tax efficiency?  Basically, certain investments are more optimally set-up for taxation than others.  Examples of tax efficiency include deferring, deducting, or reducing taxes.   Those investments that are more tax efficient should go in taxable accounts.  Meanwhile, those investments that are less efficient would find higher benefit from investing in a tax-advantaged account.  The tax advantage account might mitigate some of those inefficiencies.

Examples of Tax Inefficient Investments

So, for example, a bond fund may be considered inefficient for tax purposes.  If it’s not a tax-free municipal bond it’s encountering tax on interest every year.  That tax is not deferred since it’s a yearly coupon,  not reduced as it would be taxed as ordinary income, and not deductible, so it’s not tax efficient.  Meanwhile, a non-dividend paying stock might be considered fairly efficient.  Until you sell it there is no taxable event allowing deferment of taxes for potentially long periods of time.    Long term capital gains rates are also reduced to 15% from ordinary tax rates.

Tax Efficiency Is Relative To Your Situation  

That being said this last example starts to show cracks in hoping to make this piece one size fits all.  Deferring taxes is great, but only if your tax rate when you must pay taxes is lower than today.    While a general tax-advantaged account is helpful as it can allow you to control timing while also typically skipping certain types of taxes altogether (say on growth), the comparison between different asset classes may be negated by your personal situation or the individual investment.

Personal Impact on Asset Allocation Across Accounts

From an individual perspective, I mentioned it’s all about your tax rates and deferrals.  The impact of these benefits could be negated by a higher tax bracket at retirement versus now.  It could also be less beneficial for someone needing to duck under an Adjust Gross Income  (AGI) cutoff number.  (Many tax benefits have an AGI cutoff or phase out.  A non-exhaustive list of examples includes QBI Deduction, Roth IRA contributions, Traditional IRA contributions, and Health Care Subsidies. Not to mention something like Alternative minimum tax where a whole host of tax advantages disappear at a given income level.). 

The reality is a tax-advantaged account gives you more control over when you encounter the tax.  You want to tune that timing to optimally save on overall taxes.    Depending on if you are talking about a bracket or cut off your optimal timing may change.  IE there may be a tradeoff between losing an overall advantage based on a cutoff or being taxed on your particular asset at a slightly lower rate.    This whole area can be extremely complex.

Time In Investment and Asset Allocation Across Accounts

Your timing of needing the money or length of investment also might come into play.  If you were investing for less than a year in stock then you’d see more tax efficiency from a tax-advantaged account then if you invested for long term.  Why?  Short term stock holdings pay ordinary income tax rates while long term holdings usually pay the 15% capital gains rate.  That difference can skew the accounts viability for this asset class. 

Asset Allocation Across Accounts and Investment Options

Finally, the availability of an investment in your accounts may have an influence.  For example, an employer 401K might have funds of only certain classes with a low expense ratio (ER).   In my particular example, my employer has some excellent large-cap index fund choices with ERs in the .04 percent range.  But the small-cap or international funds in this account carry expense ratios in the .5-1% range.  Obviously I won’t be buying internationals or small caps in my employer 401k any time soon regardless of tax treatment.

Investment Impact on Asset Allocation Across Accounts

Also, in terms of what investments are tax-efficient things can get really complex.  Take a bond for example.  Some bonds are state or federal tax-free .  Their return is even reduced slightly compared to similar risk bonds to account for the tax efficiency.  Investing these in a tax-advantaged account over a stock would be a sub-optimal choice.  They are already tax-efficient, the account doesn’t make it more so.  So you’d want to prioritize tax-free bonds for taxable accounts, but maybe not all bonds.    

Taxable Bonds and Asset Allocation Across Accounts

But even taxable bonds might give you pause.  If a bond only returns 2% in interest a year how much is your tax-efficient play really saving?  Does the low return mean that other aspects of the account such as tax-free growth might now be more valuable?  What about stocks?  At what point does a stocks dividend rate tax inefficiency outweighs it’s capital gains efficiency?  These are all very situational dependent questions I can’t answer for you, making the answer here not one size fits all.

REITS, And Example of Changing Efficiency Choices

Another wrench in the equation is these situations might change over time for an asset class.  Take REITs for example.  REITs can be extremely tax inefficient as they actually have laws mandating 90% of returns are paid out to investors.  So historically it was a no brainer to place these in a tax efficient account.  Then along can the government and passed the 199 QBI business deduction.  Low and behold certain types of REITs, those that are direct REITs and not funds, can now qualify for a 20% reduction in tax bill.  That potentially makes them a better hold in a taxable account.

An Invesetment Class That Really Is A Bad Fit for Tax Free Accounts, or Is it?

On the extreme end of a class we probably don’t want in a tax-advantaged account we have international stocks.  When you own international stocks you can often take a credit for the foreign taxes paid on the instrument.  You can’t do that if they are in a tax efficient account.    So in some ways, the tax efficient account might make the stock more tax inefficient, not less.    But again there are situations where you can’t take the full foreign tax credit due to credit limits.  Then the foreign stock might be a good candidate for a tax-advantaged account.

Anyway, that’s enough examples.  By now you should get my point that your asset allocation by accounts is highly tuned personal question to you.  So how am I tuned?

Our Asset Allocation Across Accounts

Well, we have 3 types of tax-advantaged accounts today and a taxable account.  The tax-advantaged accounts are an HSA, Roth IRA, and 401K.  So one account that will never pay taxes so long as funds are used for health care in the HSA.  One Post-tax account where we already paid the tax and never will pay again in the Roth.  And finally one pretax account in the 401k.  

Our Taxable Accounts

Currently, I have my play money all in taxable accounts because of the short term nature of these funds.    I also have the bulk go my international stock holdings in taxable accounts to take advantage of deductions.   Finally, we have several individual stocks in our taxable account.  In all cases, these are the optimal tax placement for these assets for me.

 Our Roth Accounts

Our bonds are a bit of a mixed bag with about 50% being tax-free bonds in a taxable account and the bond funds sitting in our Roth.  All of my REITs meanwhile sit in our Roth.  We don’t have a viable 401K alternative for REITs at the moment.  Also, I tend to hold REIT funds instead of direct REIT’s so the QBI deduction does not apply.  As such it makes the most sense to part the REIT in our ROTH.  

Finally, our ROTH accounts also holds small-cap stocks and some international stock funds.  Our international stock funds would be more efficient in our taxable account, but the holdings are sizable enough to need to spread across multiple accounts.  Meanwhile, the small-cap index funds hold the most opportunity for long term upside.  Note, I may have a more sizable Roth then most my age thanks to rolling a pension there in 2008.

Our 401K Accounts

Finally, the bulk of our bonds as well as additional domestic stock funds sit in our 401k.    Part of this is because of the excellent large-cap options in my employer 401k.  As noted previously taxation shouldn’t wag the investment dog. In this case expense ratios also play a part.  Of course, tax efficiency still has a rol to play in the bond options utilized in this account.

In general, I’m happy with my asset allocation across accounts for tax purposes.    I have some opportunities but I generally follow the guidelines I mentioned above.  But I also realize even my own mapping changes over time.  How do you have your assets spread across accounts?


  1. Caroline at Costa Rica FIRE
    Caroline at Costa Rica FIRE February 14, 2019

    We prioritized our tax-advantaged accounts 1) b/c we live in a high tax state (NY); and 2) my husband’s employer offered generous tax-advantaged retirement plan contributions in lieu of immediate cash compensation. That said, I wish we had a better split of tax-advantaged to taxable (ours is currently two thirds v one third). We ended up hitting our FIRE number in our retirement accounts in our 40’s but these accounts are not available till 59+. It’s true there are some things you can use to avoid the penalty — 72t distributions, etc — and we’re doing that research now but there are some restrictions that wouldn’t exist had we saved in taxable accounts. We’re still happy we saved and invested as much, but it’s just a new problem I hadn’t anticipated.

    • FullTimeFinance
      FullTimeFinance February 14, 2019

      Hi Caroline, thanks for the thoughtful comment. There are actually a number of ways to get out of tax advantages without a penalty. Over the years I’ve researched 72t, retiring at 55, Roth conversions (with five year wait), or even contributions only from a Roth. The thing is for most people even getting hit with the ten percent penalty brings you out ahead of paying yearly taxable amounts. Ie you should do the math but you may still be ahead all else equal. Not necessarily much of a comfort when faced with the end tax bill, but something to keep in mind.

  2. Xrayvsn
    Xrayvsn February 14, 2019

    Great primer on where various asset classes should go.

    The most important part, which took me awhile to figure out, was to treat everything (non retirement and retirement accounts) as one single entity in terms of maintaining the asset allocation I wanted.

    This is a better method than trying to maintain that allocation treating each account individually.

    • FullTimeFinance
      FullTimeFinance February 14, 2019

      Absolutely agree. It’s a waste of time, effort, and tax advantages to try to balance each account by itself.

  3. Torch Red
    Torch Red February 20, 2019

    Nice summary. It took me years to figure this out and rarely saw articles that mentioned it, but I’m now very similar to your set up. Size of each account type has a big impact and is person-specific.
    For each asset class, here is where I put the money first (until that account type is filled):
    Cash/taxable bonds: traditional 401(k)
    REITS: Roth or HSA
    Small Cap / Mid Cap: Roth or HSA
    Foreign stock: Taxable account
    Large Cap Domestic index funds: goes wherever space is left, which is traditional 401(k), but it would also be fairly tax efficient for my taxable account
    Any individual stocks: taxable account

    • FullTimeFinance
      FullTimeFinance February 20, 2019

      Looks like a well thought out design. Thanks for sharing your setup.

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