Once you are done setting your primary asset allocation you can now turn to selecting funds that flesh out your desired asset allocation and placing them in the most tax efficient manner. If you do not have taxable accounts, then tax efficiency isn’t a huge concern but it is still a factor that should be considered. It is usually best to consider all of your investments together. If you are married you should usually blend accounts held by both spouses into one unified portfolio.
The best place to start building a portfolio is by making a
list of all your current investment accounts and the investments in each
account. Then, start with the account types that offer the most limited
investment choices, which are usually 401k and 403b type plans. These plans
normally offer limited fund choices, so starting here and building around the
best fund choices is often the best idea. Look at all the funds available in
your 401k and list the ones with the lowest expense ratio from each category
(US equity, international equity, bonds, etc).
Finally, you must consider the tax consequences of
investing, especially in taxable accounts. Generally, the most tax efficient
way to use your different accounts is (our thanks to Taylor Larimore and David
Grabiner for this list):
1. Invest as much as possible in your tax-deferred and
tax-free accounts.
2. Put the most tax-inefficient funds in your tax-deferred
and tax-free accounts.
3. Use only tax-efficient funds in taxable accounts.
4. If all else is equal, put funds with higher expected
returns in tax-free (Roth) accounts in preference to tax-deferred (traditional
401(k), 403(b), traditional IRA) accounts.
Here is a list of securities in approximate order of their
tax-efficiency. (Least tax efficient at the top.):
Hi-Yield Bonds
Taxable Bonds
TIPS
REIT Stocks
Stock trading accounts
Balanced Funds
Small-Value stocks
Small-Cap stocks
Large Value stocks
International stocks
Large Growth Stocks
Most stock index funds
Tax-Managed Funds
EE and I-Bonds
Tax-Exempt Bonds
Investing Priority
The general rule of thumb for investing priority is:
1. 401k/403b
up to the company match
2. Max out Roth
3. Max out
401k/403b
4. Taxable
Investing
source: bogleheads.org
