Asset location

Although there is no academic support, it is common (now declining) to hear that assets with the highest effective tax rates should be prioritized in tax-shelter accounts. This will have been broadly appropriate over the 30 years from the 1980s to the 2000s in North America, as interest rates declined and debt's total returns matched the returns of equity. The rule is dependent on the assumption that total returns from different asset-types are equal. When interest rates are low and expected to rise that assumption will not be valid.

Another common metric to decide which assets should be prioritized is tax-efficiency.[3] This equals the dollars of tax payable per principal invested - the multiple of the asset's rate of return by its effective tax rate. Another way to look at the same metric is as the difference between the asset's nominal rate of return and its after-tax rate of return.

This metric measures the tax-sheltering benefits of the first year only. Reed [4] finds that this metric fails over the life of the accounts. Given two assets with the same tax-efficiency, the asset with the larger rate of return will always create larger benefits in tax-exempt accounts. Even when a high-return asset has a lower tax-efficiency, given enough time it creates more benefits.

It is only when the effective tax rate is very low that its importance relative to the rate of return is equally strong or stronger.

Reed[5] calculates the cumulative tax savings over varying time spans from tax-free growth. For tax-deferred accounts there may be an additional bonus (or penalty) from a lower (or higher) tax rate on withdrawal vs. contribution. Assets with the largest benefits are given priority into tax shelters. He points out that re-balancing to some asset allocation will reduce the benefits from asset location.

He concludes that 'it all depends' and general rules of thumb are not valid. For example, given enough time high return assets create the largest benefits from tax-free growth, but there may not be enough time, or the high return asset may result in a portfolio large enough to create a penalty from higher withdrawal tax rates.

Common advice is to locate tax-inefficient assets (such as bonds and real estate investment trusts) in the tax-advantaged accounts.[6] This is to fully utilize any long-term capital gain, or capital gains allowances available in taxable accounts. Place income-generating investments into tax-deferred or non-taxable accounts, and place equity investments into taxable accounts. The deciding factor is apparently the effective tax rate on the asset's income.

For the same reason, tax-exempt bonds, national savings certificates and other similar tax-privileged securities are best located in fully taxable accounts.[7] Shoven and Sialm[8] provided an analysis of the decision point when income producing equities should be sheltered and optimal portfolio choice for each type of account. Individual stocks, passive index funds, or exchange-traded funds are generally regarded as tax-efficient and, consequently, better placed in taxable accounts, when more heavily taxed income generating assets, such as bonds, real estate investment trusts, and so on, are available for secretion in a tax sheltered location.

Actively managed mutual funds or unit trusts may also prove to be better located in tax-sheltered vehicles, because equities held through financial intermediaries tend to be taxed more, due to high turnover, than individual equities held by an investor for the long term, who has the opportunity to plan the realization of gains and offset losses. Siegel and Montgomery[9] demonstrate conclusively that taxes and inflation substantially dampen compound returns especially for equity investors.