The tax-efficient guide to investing part 2

September 29, 2023

One of the most common investing mistakes I see is ignoring taxes.

If you’ve ever had a surprise tax bill from your investment accounts, you might be unknowingly giving up precious investment returns because your investments are tax-inefficient.

And sometimes you may not even be aware of the taxes you are paying (actively managed mutual funds).

Either way, you owe it to yourself and your financial freedom to pay attention to one of the only things in investing we have some control over:


Last time we covered Part 1 of tax-efficient investing.

Now that we understand how different investment types are inherently tax-efficient or tax-inefficient we need to place the investments.

Tax Efficient Investing Part 2

When I work with clients, we aim for 3 tax buckets:

  • Tax-Deferred: 401(k), 403(b), IRA, Solo 401(k), SEP
  • Tax-Free: Roth 401(k), Roth IRA, HSA
  • Taxable: Individual or joint brokerage accounts

Three different tax types create tax diversity.

And when you have tax diversity you have more control over your tax impact.

The recurring theme in how I approach financial planning is control: control over taxes, control over access to your money, and control over your options.

Now let’s assume you do have all three tax buckets.

You have a:

  • 401(k) (tax-deferred)
  • Roth IRA (tax-free)
  • Individual brokerage account (taxable)

Let’s also assume you hold:

  • Active stock mutual funds
  • Passive stock mutual funds
  • Municipal bonds
  • Bonds
  • REITs

Where should we place these investments in your portfolio?

The 401(k)

This account defers taxes until you take the money out later in retirement.

You could trade 100x per day and although your returns may suffer, you won’t have a tax impact from trading in this account.

Because of this tax advantage, it may make sense to place tax-inefficient investments here:

  • Active stock mutual funds
  • Bonds
  • REITs

The Roth IRA

This account avoids taxes while it grows and money comes out tax-free.

Just like the 401(k), you could trade all day without tax impact.

So, yes you can place tax-inefficient investments here just like the 401(k) but this account has something the 401(k) does not: tax-free growth.

So it may be the best idea to place investments here with the most growth potential.

This way your investments can create significant gains but you will avoid tax on those gains.

Your stocks have more growth potential than your bonds, so I usually heavily weight stocks here:

  • Active stock mutual funds
  • Passive stock mutual funds

The Brokerage Account

This account is taxed as you go.

If you trade 100x per day in this account, you might have a serious tax bill.

In this account, you are rewarded for holding your investments for the long term because long-term capital gains have a better tax rate than short-term capital gains.

And remember interest from bonds is taxed as ordinary income.

So passive stock funds (minimal trading) and qualified dividends (if the stocks do pay dividends) are best here.

You may also want to hold municipal bonds here because municipal bonds are exempt from federal tax and sometimes state tax (if purchased in home state).

Important note:

Asset allocation is more important than asset placement.

If you are decades from financial freedom, you may have a 100% stock portfolio and you may hold the same fund in each of your accounts.

That is fine.

It’s more important to stick to your asset allocation strategy than to try to include different investment types to optimize for tax.

And if you are in retirement and you have a large brokerage account that you are using for income, you may want to include bonds in the account (plus remember munis exist).

It should be asset allocation first and then determine asset placement.

Disclaimer: This is not financial or tax advice. Before implementing anything you read online, consult with a financial professional to see if it makes sense for your unique situation.