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$1.3 million of Household A’s $3 million sits in two 401(k)s and a rollover IRA, the accounts built to hold whatever gets taxed hardest. For the first three months of its scripted year, those accounts held the same mix as the taxable account next to them, because a target-date default had set the split, not a household decision. That is the setup most households start from, and it wastes the two accounts meant for exactly this problem.
Tax-deferred: $1.3M
Bonds and the tilt
- Bond interest is ordinary income wherever it is earned; held here it is untaxed until withdrawal, decades later.
- The value tilt turns over 20% of itself a year. Every one of those trades is free here; the same trade in taxable is taxed at 54.1%.
Taxable: $1.5M
The index sleeve, and the stock that cannot leave
- At 3% turnover the index sleeve already sits close to the 37.1% long-term rate, so sheltering it saves little.
- $400,000 of employer stock stays until sold, and selling it now would owe tax on its $150,000 gain.
Roth + HSA: $200K
Whatever compounds longest
- The smallest of the six accounts, and the only ones where growth is never taxed on the way out either.
- Room here goes to whichever holding is expected to grow the most, since none of that growth is ever taxed again.
Why do bonds and the tilt move, but not the index fund?
A dollar of bond interest is ordinary income wherever it is earned. Held in the taxable account, Household A’s top bracket taxes it at 54.1%, the combined federal, state, and net investment income rate; held in the 401(k) or IRA, that same dollar is untaxed until withdrawal, when it comes out at 50.3% instead, often twenty years later. Moving it costs nothing today and defers everything.
The value tilt behaves the same way for a different reason: turnover. Cap-weighted index exposure turns over about 3% of the portfolio a year; the household’s value tilt, run at a 2% tracking error against the French HML factor, turns over 20%. Nearly every one of those trades would realize a short-term gain in a taxable account, taxed at the same 54.1%. Inside the 401(k) the trades are free, which is exactly the reasoning in the household’s own record for month five: the tilt moved into the sheltered accounts because “its turnover is free” there.
The plain index sleeve is the opposite case. At 3% turnover, most of its return is unrealized appreciation that is never taxed until sold, and a sale still gets the 37.1% long-term rate rather than the 54.1% short-term one. Sheltering it saves little. The site’s own read on this point, turnover, not asset class, decides where a holding belongs, makes the same case: a patient index fund was already close to tax-free in taxable.
What about the employer stock already sitting there?
The $400,000 of employer stock is a different kind of problem. It sits in the taxable account with a $250,000 cost basis, and its $150,000 gain would owe tax the moment it moved anywhere else. Asset-location theory has nothing to say about a position that already exists; it only ever applies to money being placed for the first time, or to a household willing to pay the tax to move it. At $400,000 the position is 13% of the household’s $3 million in liquid wealth. The household’s own goal is to bring that under 5% within five years, a separate, slower decision than where new money goes. Fill the sheltered slots before adding taxable money covers where this year’s $60,000 of new taxable contributions belongs; none of it is this stock.
How much is getting this right worth?
Vanguard’s own estimate puts the value of correct asset location at up to 60 basis points of after-tax return a year, on top of whatever the mix and the strategy already earn. Dammon, Spatt, and Zhang’s 2004 model in the Journal of Finance reaches the same ordering from theory rather than simulation: an investor fills the tax-deferred account with bonds first and holds equity in the taxable account, because bonds carry the heavier tax burden of the two.
The arithmetic above runs on one synthetic household’s numbers, never a real one, and it says nothing about which mix or which strategy anyone else holds. It says only that once a mix and a strategy are chosen, which account holds which piece of them is worth up to 60 basis points a year, and the shelter is wasted on the piece that needed it least.