In a follow-up to earlier research, our latest paper (PDF) dives deeper into the nuances of asset location with equity subasset classes. Investors can further maximize after-tax returns by considering equity characteristics such as geographic region, dividend yield, and management style, and strategically placing them across taxable and tax-advantaged accounts.
Taxes
Greater tax efficiency through equity asset location
4 minute read
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October 23, 2023
Taxes
Taxes on investments
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"Our earlier paper (PDF) showed how an investor could add up to 30 basis points (0.30 percentage point) of annualized after-tax returns through asset location by broad asset classes," said Sachin Padmawar, a co-author of both papers. "Compounded over years or decades, that is a lot of value added for investors. Our latest research shows some investors could add up to another 10 basis points of annual after-tax returns depending on where they place equity subclasses in their portfolio."
The new paper considers placement of stocks across account types based on three criteria:
- Geographic region, or U.S. versus non-U.S. ("ex-U.S.") stocks.
- Dividend yield, or value versus growth stocks.
- Management style, or actively managed versus index funds.
Why ex-U.S. stocks might be better off in taxable accounts
"Of all our findings, this one is the most interesting," said Daniel Jacobs, the other co-author of both papers. “For U.S. investors, U.S. stocks will have a greater percentage of qualified dividend income (QDI) than ex-U.S. stocks, and QDI is taxed at a lower rate than other income. So you would think it would make sense to keep U.S. stocks in taxable accounts and ex-U.S. stocks in tax-advantaged accounts.
"But our calculations show that most investors may be better off the other way around. Often the foreign tax credit the investor gets from ex-U.S. stocks more than offsets the advantage of the higher proportion of QDI from U.S. stocks. Some investors could gain up to another 10 basis points in after-tax returns just by keeping ex-U.S. stocks in taxable accounts."
The magnitude of the difference can vary widely, depending on the investor’s tax bracket, the overall allocation to equities in the portfolio (the glide path), the amount of foreign taxes withheld, and the proportion of QDI.
The charts below indicate which hypothetical portfolio—ex-U.S. equities in taxable accounts (signified by circles) versus U.S. equities in taxable accounts (signified by triangles)—provided higher after-tax returns across a variety of scenarios.
Holding ex-U.S. stocks in taxable accounts has the advantage in most scenarios
Notes: Added-value figures are relative to an asset-location-agnostic strategy. Circles indicate that ex-U.S. stocks are preferentially placed in taxable accounts. Triangles indicate that U.S. equities are preferentially placed in taxable accounts. The absence of a symbol indicates there is no difference between these two asset location strategies for that glide path at that tax bracket. Three hypothetical portfolios denote a range of equity allocations along a glide path, with “primarily equity” having the most allocation to stocks and “mix of bonds and stocks” having the least. The charts assume the following: a foreign tax withholding rate of 15%; the equity portion of the portfolio is allocated 60% U.S. stocks and 40% ex-U.S. stocks; the purchase order for the fixed income portion of the portfolio is traditional tax-deferred accounts, then Roth accounts, and then taxable accounts; the ex-U.S. stocks have a QDI rate of either 60% (left chart) or 80% (right chart). Portfolio return data and calculations are based on VCMM returns. Please see the paper for further details.
Source: Vanguard paper, Asset Location for Equity (PDF), October 2023.
Past performance is not a guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Higher-dividend stocks and active funds belong in tax-advantaged accounts
The paper's other two findings are more in line with conventional wisdom.
Investors are typically better off when stocks with higher dividends (“value” stocks) are in tax-advantaged accounts rather than growth stocks that have little or no dividends.
And actively managed funds—which typically have higher portfolio turnover (and therefore higher capital-gain distributions) than index funds—are generally better off in tax-advantaged accounts. Index funds typically have lower turnover and lower capital distributions, so they should be kept in taxable accounts.
That said, this isn't a hard-and-fast rule. Active funds that have low turnover and have high enough alpha to overcome the tax drag may be able to outperform index funds in a taxable account.
Who benefits most from this research
"Our findings are especially important to those investors who still have a moderate to substantial portion of their portfolio in stocks," Padmawar said. "Those who have a relatively small allocation to stocks are better off with the simpler guidelines from our original paper—which is to keep taxable fixed income in tax-advantaged accounts and equities in taxable accounts."
Those with higher allocations to stocks have more flexibility on where to place equity subclasses. Depending on their tax bracket and other factors, they have the most to gain by fine-tuning the asset location of their equities.
For more details on the findings, read on.
Related items
- Income-driven financial planning may help reduce taxes (article, issued August 2023)
- Negative convexity in municipal bonds (article, issued August 2023)
- HSAs: Tax-sheltered powerhouses (article, issued September 2023)
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