Learn Tax Efficiency by Account Type | Practical Portfolio Management

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Understanding how to maximize your after-tax investment returns is a key part of practical portfolio management. The type of account you use—tax-advantaged or taxable—can make a major difference in how much you keep after taxes. Tax-advantaged accounts include traditional and Roth IRAs, 401(k)s, and HSAs, where investments can grow tax-deferred or even tax-free. Taxable accounts, on the other hand, require you to pay taxes on dividends, interest, and realized capital gains each year.

When thinking about where to put your assets, you want to place investments that generate a lot of taxable income—like bonds, REITs, or actively managed funds—into accounts that shield you from taxes as much as possible. Meanwhile, investments that are naturally tax-efficient—such as broad-market stock index funds or ETFs—can be held in taxable accounts without much penalty.

Note

Asset location, choosing which assets to hold in which account types, can significantly impact your after-tax returns, sometimes even more than asset allocation itself.

The formula for after-tax returns by account type helps you see this effect clearly. For a given asset, your after-tax return depends on both the asset’s pre-tax return and the tax treatment in the account type:

\text{After-tax return} = \begin{cases} r, & \text{if held in a Roth account} \\ r \times (1 - t), & \text{if held in a taxable account (t = tax rate)} \\ r \times (1 - t_{\text{withdrawal}}), & \text{if held in a traditional IRA/401(k) (t}_{\text{withdrawal}} = tax rate at withdrawal) \end{cases}

where r is the pre-tax return of the asset.

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Section 3. Chapter 10

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Section 3. Chapter 10