I like balanced funds and target retirement funds as much as the next guy. (Actually, I probably like them more, presuming we’re talking about low-cost ones.) But buying a balanced fund in a taxable account is generally not a good idea.
Why? Because they’re not very tax-efficient.
Taxable Bond Funds
The bond portion of a balanced fund’s portfolio is generally made up of taxable bonds (or, perhaps, taxable bond funds). Because income from bonds is taxed at a higher rate than income from stocks, you generally want to make every effort to shelter them from taxes (by putting them in an IRA, for instance).
Simplified Example: Imagine that you have $100,000 in a Roth IRA and $100,000 in a taxable account and you’ve decided that a 60/40 stock/bond allocation is appropriate for you.
One option would be to buy a 60/40 balanced fund in each account. That would be easy, and it would give you the desired allocation. Alternatively, you could achieve the same allocation, while simultaneously reducing your overall tax burden, by implementing the following asset location strategy:
- Roth IRA: $80,000 in bond funds and $20,000 in stock funds.
- Taxable account: $100,000 in stock funds.
This way, all $80,000 of bond funds would be sheltered from income taxes rather than just $40,000 of bond funds.
(Relatively) High Turnover
Because they rebalance so frequently, many–though not all–balanced funds have relatively high portfolio turnover. Higher turnover always leads to higher costs in terms of commissions and bid/ask spreads. And if you’re investing in a taxable account, higher turnover leads to higher taxes as well.
The reason that high portfolio turnover leads to higher taxes is that the fund’s capital gains distributions will be primarily short-term rather than long-term, and they will therefore be taxed at your ordinary income tax rate rather than the more favorable long-term capital gains tax rate. Higher turnover also minimizes the potential for delaying taxes on capital appreciation.
Foreign Tax Credit
Many balanced funds (and, as far as I know, all target retirement funds) are funds of funds. And as we discussed recently, funds of funds don’t qualify for the foreign tax credit. Granted, in comparison to the effect of poor asset location and high portfolio turnover, the foreign tax credit isn’t that big of a deal. It’s simply another strike against holding balanced funds in taxable accounts.
My Suggestion
As wonderfully convenient as balanced funds are, they just don’t make sense in taxable accounts. Unless we’re talking about very small sums of money, the tax-efficiency gained by taking asset allocation into your own hands (via separate stock funds and bond funds rather than a fund that combines the two) will be well worth the effort.
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{ 5 comments… read them below or add one }
Mike,
I know municipal bonds are tax efficient- are there any low cost municipal bond funds or ETFs that would work well outside an IRA?
-Rick
What is your opinion on “Placing cash needs in tax-exempt accounts”?
My understanding is it is best to use bond funds in Traditional IRA/401k accounts. Use the equity funds within the Roth portions so that if you do get a big return you will not owe taxes later. Then in taxable accounts use a combination of munis and tax-managed or index funds depending on your preference.
Rick: Vanguard’s muni funds all appear to look pretty good in terms of costs (0.20% seems to be the standard), but admittedly I haven’t done much comparison shopping, as I don’t have much use personally for muni funds at the moment.
Ziggy75: Depends upon the circumstances. Could you elaborate on the situation in question?
One thing you could do is create your own low-cost balanced fund by putting 60% into an index mutual fund such as Vanguard S&P 500 (VFINX) or an ETF (SPY) and 40% into a municipal bond fund or 40% into a taxable broad bond ETF such as AGG.