What some call “tax basketing” and others call “asset location” is becoming increasingly important, particularly for early retirees and those aspiring to be early retirees.
Tax basketing is not portfolio allocation. Tax basketing is the step after portfolio allocation. First the investor decides the assets he or she wants to invest in and in what proportion.
Once that decision is made, tax basketing starts. The idea is where to hold the desired assets within the available tax categories (Roth, Traditional, Taxable, HSA) that makes the most sense from a tax efficiency perspective and a tax planning perspective.
Early Retirees and Aspiring Early Retirees
To assess tax basketing for many early retirees, I will need to make a few assumptions. First, the aspiring early retiree and the early retiree (our avatars) want to hold three main assets: domestic equity index funds, international equity index funds, and domestic bond index funds. That is simply an assumption: it is not investment advice for you or anyone else.
Second, our avatars have at least 50 percent of their financial wealth in traditional retirement accounts. This assumption makes our avatars like most Americans when it comes to their financial assets, and, in my experience, most considering or in early retirement. Third, our avatars want to have less than 50 percent of their portfolio in domestic bond index funds (again, just an assumption, not investment advice).
Lastly, most of this analysis ignores HSAs unless specifically discussed, since the balances in them tend to be rather modest and most of the Roth analysis below applies equally to HSAs.
Let’s dive deep on where our avatars should hold their desired portfolio, considering that they are either striving for early retirement or in early retirement.
Asset Yield
Tax basketing should consider many things. Chief among them is annual asset yield. Financial assets such as stocks, bonds, mutual funds, and exchange traded funds (ETFs) typically kick off interest and/or dividend income annually (often referred to as “yield”).
The expected amount of that income and the nature of that income strongly inform where to best tax basket each type of asset.
Let’s explore the three assets our avatars want using Vanguard mutual funds as a reasonable proxy for their annual income (yield) profile (not presented as investment advice).
Fund | Annual Dividend Yield | Est. Qualified Dividend Income % |
VTSAX | 1.22% | 90.92% |
VTIAX | 3.22% | 61.16% |
VBTLX | 3.69% | 0% |
All numbers are as of this writing and subject to change. That said, they strongly inform where we might want to hold each of these types of assets.
Let’s start with VTSAX, our domestic equity index. Notice two things? First, it produces remarkably low yield. Say I owned $1M of VTSAX in a taxable account. How much taxable income does that produce for me? Just around $12,200 annually. Further, most of that is tax-preferred qualified dividend income!
People worry about tax drag when investing in taxable accounts. Tax basketing can solve for most tax drag! Why would you worry about tax drag when it takes $1M of VTSAX to wring out just $12,200 of mostly qualified dividend income on your tax return?
What about VTIAX? In today’s environment, it produces more than twice as much dividend income as VTSAX, and much more of that income will be ordinary income (since only about 61.16% qualifies as QDI).
Lastly, let’s think about VBTLX. Bonds typically produce the most income (bonds tend to pay more out than equities do as dividends) and bonds produce only ordinary income. You can see that from a tax basketing perspective, bonds in taxable accounts tend to be undesirable.
Tax Basketing Insights
Domestic Equity Funds
Domestic equity index funds do great inside a taxable account! They barely produce any income on the owner’s tax return. The small amount of income they produce mostly qualifies for the favored tax rates of 0%, 15%, 18.8%, and 23.8%.
Recall our avatar with $1M in VTSAX. He only gets $12,200 in taxable income from that holding. If that was his only income, he doesn’t have to file a tax return, as the standard deduction is large enough to cancel out that income.
An additional point: most early retirees and potential early retirees will probably have domestic equities in all three of the main baskets: Taxable, Traditional, and Roth. To my mind, that’s not a bad thing. Yes, inside a traditional retirement account, the qualified dividend income becomes tax deferred ordinary income, not a great outcome, but also not a horrible outcome.
The tax tail should not wag the investment dog. But it is logical for most early retirees and aspiring early retirees to only hold domestic equities in taxable accounts and then hold domestic equities in traditional and Roth accounts as needed for their overall asset allocation.
International Equity Funds
International equity funds sit well in retirement accounts, whether they are traditional, Roth, and/or HSAs. They are not awful in taxable accounts, but they are not great. Why do I say that? Compare the 3.22% yield on them to the 1.22% yield on domestic equity index funds. Wouldn’t you rather have the higher yielding asset’s income sheltered by the retirement account’s tax advantages and the lower yielding asset be the one subject to current income taxes?
What About the Foreign Tax Credit?
It is true that holding international equities in a retirement account sacrifices the foreign tax credit. In a world where yields were the same and future gains were the same, the foreign tax credit would be enough to favor holding international equities in a taxable account.
However, we don’t live in that world. Further, the foreign tax credit tends to be quite small. For example, the foreign taxes withheld by Japan when Japanese companies pay Americans a dividend is 10 percent. Not nothing, but considering that there is more than double the yield paid on international equities, not enough to make it highly desirable from a tax standpoint to have income in taxable accounts. Rates vary, but can be as low as zero. Consider that most dividends paid by United Kingdom companies to American shareholders attract no dividend withholding tax and thus create no foreign tax credit on federal income tax returns.
This video breaks down the math on the foreign tax credit.
Domestic Bond Funds
Domestic bonds and bond funds sit very well in traditional retirement accounts. Why waste the tax free growth of Roth accounts on bond funds? Bonds tend to have a lower expected return, making them great for traditional retirement accounts, not Roth accounts. Further, why put the highest yield assets with the worst type of income (none of it QDI) in taxable accounts? The stage is thus set: put all the bonds in traditional retirement accounts and don’t look back.
Two traditional accounts domestic bonds do particularly well in are inherited IRAs and 72(t) IRAs!
Tax-Exempt Bonds
High income people ask: should I hold tax-exempt bonds since I have such high income? In the early 1980s, it might have made sense to alter investment allocation for tax planning reasons and invest in lower yielding tax-exempt bonds instead of high yielding taxable bonds. Back then tax rates were higher and most affluent Americans had most of their money in taxable accounts and pensions. The era of the IRA and the 401(k) was in its infancy and few had large balances in tax deferred defined contribution accounts such as traditional IRAs and traditional 401(k)s.
The world of the mid-2020s is quite different. Many pensions are gone, and affluent early retirees and aspiring early retirees tend to have much of their financial wealth in traditional IRAs and traditional 401(k)s.
That sets the stage beautifully for holding bonds in traditional retirement accounts. Income generated by bonds is tax deferred inside the traditional retirement account. Further, there’s usually plenty of headroom in the traditional IRAs and 401(k)s to hold all of the investor’s desired bond allocation. So why not hold all of the desired bond allocation inside traditional retirement accounts?
This means that for most people, there’s little reason to adjust a desired asset allocation in order to hold tax-exempt bonds and thereby sacrifice yield. Tax-exempt bonds receive no preference over taxable bonds inside a traditional 401(k) or IRA.
Keeping Ordinary Income Low
Do you see what tax basketing can do for the early retiree? If the only thing he or she owns in taxable accounts are domestic equity index funds (perhaps with a small savings account), he or she will have low taxable income and almost no ordinary income.
That opens the door for some incredible tax planning. Perhaps it is Roth conversions against what would otherwise be an unused standard deduction. Those Roth conversions would occur at a 0% federal income tax rate. Who’s complaining about paying no tax?
Or perhaps it is the Hidden Roth IRA where a retirees uses the standard deduction to live off of traditional retirement accounts. It allows the early retiree to use the standard deduction to fund living expenses from a traditional IRA and pay no federal income tax. Again, who’s complaining about paying no income tax?
Lastly, tax basketing can keep those qualified dividends and long-term capital gains at a 0% long term capital gains rate. For married couples with $96,700 or less of taxable income, the federal income tax rate on all long term capital gains and qualified dividends is 0%. One way to help ensure that outcome is tax basketing. Ordinary income from higher yielding bond funds pushes qualified dividends and long term capital gains up (through income stacking) and can subject some of it to the 15% rate. Why not hide out that ordinary income in traditional retirement accounts and only hold low yielding domestic equities in taxable accounts?
Aspiring Early Retirees
For the still working aspiring early retiree, having taxable investments generate low yield and preferred yield (qualified dividend income) can help save taxes during peak earning years. The high earner would prefer to have less QDI (through dividends paid by domestic equities) rather than more ordinary income (through dividends of ordinary income paid by domestic bond funds) hit their annual income tax return. This keeps taxable income lower, keeps the tax rate better on the portfolio income, and reduces or potentially eliminates exposure to the Net Investment Income tax.
Premium Tax Credit Considerations
Recall Goldilocks looking for the right bowl of porridge. She can inform us about how tax basketing relates with the Premium Tax Credit in early retirement.
In theory, the early retiree can fund their living expenses in three extreme manners: all from traditional retirement accounts, all from Roth retirement accounts, or all from taxable accounts. Testing these three from a Premium Tax Credit perspective can inform us about which tax basket is the best to spend from first in early retirement.
If Goldilocks funds her early retirement first from traditional IRAs and 401(k)s, she will find it’s too hot from a PTC perspective. All her spending creates taxable income, which reduces her Premium Tax Credit.
If Goldilocks funds her early retirement from Roth IRAs, she will find it’s too cold from a PTC perspective. Her spending creates no taxable income in all likelihood. That’s a huge problem from a PTC perspective. If one’s income is too low, they will not qualify for any PTC, creating a big problem in early retirement.
If Goldilocks funds her early retirement from taxable accounts, she’s likely to find it just right from a PTC perspective. Say she has $60,000 of living expenses. Will that create $60,000 of “modified adjusted gross income”? Absolutely not. It will create $60,000 less her tax basis in the assets she sold in modified adjusted gross income. This gives her an outstanding chance of having a low enough income to qualify for a significant PTC. If her basis was too high and she did not create enough income to qualify for a PTC, she could, prior to year-end, execute some Roth conversions to get her income to the requisite level.
What Goldilocks’ example demonstrates is that it is a good thing to have amounts, perhaps significant amounts, in the taxable basket heading into early retirement. While there is absolutely hope for those with little in the taxable basket, it will require some additional planning in many cases.
RMD Mitigation
I’ve said it before: concerns about required minimum distributions tend to be overstated. That said, RMD mitigation is a legitimate concern.
You know what can help mitigate RMDs? Tax basketing!
By holding all of one’s domestic bond investments in traditional IRAs and traditional 401(k)s, retirees can keep the future growth inside traditional retirement accounts modest. When compared to equities, bonds have a lower expected return and thus a lower expected future value. This, in turn, reduces future traditional account balances, reducing future required minimum distributions. Recall that RMDs are computed using the account balance from the prior year as the numerator. Keeping that numerator more modest reduces future RMDs.
Sequence of Returns Risk and Tax Basketing
Some worry about sequence of returns (“SoR”) risk: what if I retire and the equity markets happen to have a year like 1987 or 2008 right as I’m retiring? At least in theory this is a risk of retiring at any time and the risk is magnified by an early retirement.
Say Maury, age 50, is about to retire and worried about SoR risk so he wants to have three years of cash going into retirement (again, not an investment recommendation, just a hypothetical). Cash generates interest income, which is bad from a tax efficiency perspective. Can Maury use tax basketing to manage for SoR risk and stay tax efficient? Sure!
Imagine Maury retires with $500K in a domestic equity index fund in a taxable brokerage, $240,000 of cash and/or money markets in a traditional IRA (3 years of expenses), $500K of domestic bonds in a traditional IRA, and about $1M in a combination of domestic and international equities in a traditional IRA.
Maury can live on the cash and only live on his taxable brokerage account. Wait, what? I thought the cash lives in the traditional IRA. It does.
But Maury can simply sell $80,000 of the domestic equity index fund annually and report mostly long term capital gains and (rather modest) qualified dividend income on his tax return. His income might be so low he wants or needs to do Roth conversions! Separately inside the traditional IRA he “spends down” the cash by annually buying $80,000 of any desired combination of domestic equities, international equities, and/or domestic bonds inside his traditional IRA.
Maury just used tax basketing to live off almost a quarter million of cash for three years without reporting a penny of interest income to the IRS!
Announcement
You have just read a sneak preview of part of the new book! Cody Garrett, CFP(R) and I are working on, tentatively titled Tax Planning To and Through Early Retirement. In 2025 the retirement tax planning landscape is changing, and Cody and I want to be on the cutting edge as retirement tax planning changes.
This post will, in modified form, constitute part of the book’s tax basketing (a/k/a asset location) chapter.
When will the book come out? Well, that’s a question better asked of elected officials in Washington DC than of your authors. 😉
What topics would you like us to cover in the book? Let us know in the comments below!
Stay tuned to me on X and LinkedIn and Cody on LinkedIn for updates on when the book will be available!
Conclusion
Tax basketing can be a great driver of success to and through early retirement. From a purely tax basketing perspective, domestic equity index funds tend to sit well in taxable accounts, international equity index funds tend to sit well in retirement accounts, and domestic bond index funds tend to sit well in traditional retirement accounts. Premium Tax Credit considerations tend to favor having some money in taxable accounts in early retirement. Good tax basketing can keep taxable income low and facilitate excellent early retirement tax planning.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
Follow me on X: @SeanMoneyandTax
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Great post! This is exactly the next level of thinking I need to be doing re: tax planning and early retirement.
One question: Why do we need to assume “at least 50 percent of their financial wealth is in traditional retirement accounts.” Maybe we are an outlier, but our brokerage account is the largest of all our accounts, and that’s after maxing out our 2 401(k)s, and doing 2 backdoor Roth conversions each year. Some of that reason is there was a period of several years where my wife (48) and I (47) did not have access to 401(k)s via our jobs and went heavy on the taxable account.
But does that really change the calculus here? Just curious.
As always, appreciate the blog!
Jason, thanks for reading and commenting. In this blog post, I’m writing based on the generalities I’ve seen over time. Most Americans have most of their financial wealth in traditional retirement accounts. That doesn’t mean all Americans have most of their financial wealth in traditional retirement accounts.
Fair enough! Just wanted to make sure there wasn’t something I was missing. Thanks!
Great post, Sean! I look forward to your book, and learning about the new tax law coming this year, so I can finalize my early retirement plans.
Topics I’d like to read about:
Balancing/optimizing ACA PTCs (“Obamacare subsidies”), Roth IRA conversions, and capital gains harvesting for early retirees whose annual spending is over 400% of the FPL and over the top of the 0% LTCG rate bracket.
Planning how much to withdraw from each account type, using marginal tax rates and factoring in ACA PTCs and any early-withdrawal penalties as taxes. In which cases might it be better to withdraw from Roth IRAs (contributions and conversions >5 years old) before Traditional IRAs or even fully depleting taxable brokerage accounts with high capital gains?
If retiring >5 years before 59.5 and >10 years before 65, i.e. with many years for Roth conversions (and potentially laddering), might it be optimal to use different strategies during different time periods? E.g. prioritize Roth conversions and spending from taxable accounts up to age 55 even if foregoing ACA PTCs, then reduce MAGI to get more ACA PTCs from ages 55-65 so spend the rest from Roth IRAs?
Finally, for DIY implementation, which software products are capable of evaluating these strategies and minimizing lifetime taxes including penalties & credits? Can consumers buy them or are they limited to advisors? Most consumer software I’ve seen allows only changing the withdrawal order of account types without limiting each account up to a MAGI limit or only from contributions and conversions >5 years old but not earnings.
Al, all great suggestions, many of which we’re currently writing about. Your last one is interesting to me. At this point I hadn’t considered an implementation chapter, but now that you suggest it I’m definitely going to discuss it with Cody.
I would second all of Al’s questions! Great to hear they are in consideration for the book. Can’t wait to read it once it’s out.
Excellent and thought provoking. Can’t wait for you and Cody to start tackling this! You asked for Q’s so here are a few, in no order.
1) What would the analysis have been in 2020-2022 when the yield on a 10 year treasury and/or MM Fund was < the yield on the S&P 500? Obviously VTI would still be QD but the absolute $ would have been higher. I kind of don’t see that happening again, but my crystal ball is still broken so I don’t know.
2) There is a conventional wisdom that taking as given one wants international equities that there some advantage tax wise to hold them in a taxable account. See the paper from Vanguard below. It may be a function of (a) which international fund you hold (ie generally developed markets have a higher % of QD than Emerging Markets, and European equities have a higher % of QD than Pacific Rim countries) and (b) your tax rate ie a retiree who is in the 22% bracket may have a lot more use for the FTC than a retiree in a 0 or 10% and/or one managing to ACA premium tax credits. I’m not saying your analysis above is wrong (and this may also be an area that many of us retirement analysis nerds overthink) but the ‘hold international in taxable for FTC’ seems a pretty common piece of conventional wisdom.
https://corporate.vanguard.com/content/corporatesite/us/en/corp/articles/greater-tax-efficiency-through-equity-asset-location.html
3) If one used US Government obligations AND was in a fairly high tax state (CA/NY/NJ) would that change the analysis? I realize there are 51 answers but for some % of people state taxes can matter and most of those higher tax states also don’t have favorable treatment for LTCG and Qualified Dividends.
4) I will add one other Q that isn’t related to this article if you don’t mind. A common questions that arises is ‘should I do LTCG gain harvesting to the top of the 0% bracket, or should I do Roth Conversions to the top of the 12% bracket (those two each are similar AGI). Assume the conversion makes sense (ie it will be 22% or higher in the future). I know of course the answer is ‘it depends’ but what factors would suggest one lean into LTCG harvesting and what factors would suggest one lean into Roth Conversions (and of course ‘do a bit of both’ is always a great option).
Thanks for the blog and videos they have been super helpful.
Scott, thanks for your comments and kind words. On the value of the foreign tax credit in a taxable account, I just did a video on the topic: https://www.youtube.com/watch?v=ZEM9yFi5Ico
Thank you for that it did help to articulate what I have been thinking which is $ do matter ie you eat $ not marginal tax rates though you do show the marginal tax rate is lower on an international index fund.
I’m going to have to navigate IRMAA (and the NJ Pension Exclusion) and my models say that is harder if I have a fund like a total international than a total us fund. so I continue to model it but I appreciate that thinking beyond marginal tax rates is helpful. Sometimes most papers focus just on marginal rates (which on some level makes sense) but there is more.
As always…it depends!
Thanks Sean for all you do to help the early retired like me! Looking forward to reading the book when it comes out.
Some things I would like to see covered:
1) Setting up 72t and circumstances when 72t makes sense and when it does not
2) Deciding on amount of Roth conversions to make
3) How the math changes when Taxable is depleted. HSA conversions+ paying tax with Roth basis.
4) How to avoid underpayment penalties on State +Federal taxes.
5) Exceptions to early withdrawal penalty
6) Order of operations for Roth basis
Oh please include case studies too. I really like seeing case studies for real life applications.
In the section titled “Sequence of Returns Risk and Tax”, It says, “Imagine Maury retires with $500M in a domestic equity index fund…” I $500M correct? Maybe $5M or $500K?
I love this thought provoking article and can’t wait for the book. Not sure that I will be an early retiree, since I’m turning 57 this month, but I am getting close to my FI number.
Typo! Thanks for noticing. $500K, not $500M. Maybe our next book will be for tycoons.