I will have money left over after maxing my 401(k) and Roth IRA. I plan to open a taxable investment account to invest the remaining money, but I want to make sure I understand the basics of tax-efficient investing before I do.

I plan to invest exclusively in low-expense index funds, but I am open to investing in other vehicles (I bonds, municipal bonds, etc) if you think they would be appropriate.

It seems like stocks that pay dividends should go in a 401(k) or IRA, and so should most types of bonds, because dividends or coupons will be taxed on receipt. It seems like this holds true for bond and dividend-paying-stock indices as well.

On the other hand, it seems like stocks that generate returns primarily through capital gains should be kept in a taxable account. As I understand it, capital gains are taxed when the stock is sold; since I am planning to hold the stock until I retire, and since I will presumably have a lower income tax bracket when I am retired, selling these stocks to generate income will result in lower capital gains taxes.

With that said, I was thinking of the following portfolio:

401(k): domestic and foreign bond indices, and domestic and foreign REITs Indices

IRA: Same as 401(k)

Taxable: Total US Stock Market Index , Total Foreign Stock Market Index

If this looks tax efficient, my next question would be: is there any tax advantage to using mutual funds instead of ETFs that mirror those mutual funds?

Thanks in advance.

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Your tax efficient reasoning is solid for where you want to distribute your assets. ETFs are often more tax efficient than their equivalent mutual funds but the exact differences would depend on the comparison between the fund and ETF you were considering. The one exception to this rule is Vanguard funds and ETFs which have the exact same tax-efficiency because ETFs are a share class of the corresponding mutual fund.

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  • Thank you. I've tried to understand the relationship between Vanguard ETFs and Mutual funds for a while, but I'm not sure it's clicking. I get that a index mutual fund holds all of the shares of the companies included in its index, but are the shares represented by a Vanguard ETF distinct from the shares in its mutual fund counterpart? In other words, if the VTI ETF is consisted of 100 shares, are those shares the same as the shares in VTSMX or are they a small portion or what? It doesn't seem like it- it seems like there would be 200 shares total- 100 for the etf and 100 for the mutual fund. – AwfulPersimmon Jun 23 '16 at 2:27
  • @Harper: You have different elections for your mutual fund and ETF dividends. The former you apparently have set to mail you a check, the latter set to reinvest. It makes no difference in terms of tax efficiency. – Craig W Jun 23 '16 at 12:57
  • @CraigW Sorry you're right, my information was wrong, VTI doesn't put the dividends back into the ETF. So I guess you have to report that dividend income on taxes every year. (this, rather than lower taxes, was what I am most concerned with.) Are there any ETFs that work by refolding taxes into the ETF value, generating no taxable events except when you sell? – Harper - Reinstate Monica Jun 23 '16 at 22:08
  • @Harper: I don't think it's legally possible in the U.S. – Craig W Jun 23 '16 at 22:37

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