“Our earlier paper showed how an investor could add up to 30 basis points (0.30 percentage point) of annualized after-tax returns through asset location by broad asset classes,” said Sachin Padmawar, a co-author of both papers. “Compounded over years or decades, that is a lot of value added for investors. Our latest research shows some investors could add up to another 10 basis points of annual after-tax returns depending on where they place equity subclasses in their portfolio.”

The new paper considers placement of stocks across account types based on three criteria:

• Geographic region, or U.S. versus non-U.S. (“ex-U.S.”) stocks.
• Dividend yield, or value versus growth stocks.
• Management style, or actively managed versus index funds.

“Of all our findings, this one is the most interesting,” said Daniel Jacobs, the other co-author of both papers. “For U.S. investors, U.S. stocks will have a greater percentage of qualified dividend income (QDI) than ex-U.S. stocks, and QDI is taxed at a lower rate than other income. So you would think it would make sense to keep U.S. stocks in taxable accounts and ex-U.S. stocks in tax-advantaged accounts.

“But our calculations show that most investors may be better off the other way around. Often the foreign tax credit the investor gets from ex-U.S. stocks more than offsets the advantage of the higher proportion of QDI from U.S. stocks. Some investors could gain up to another 10 basis points in after-tax returns just by keeping ex-U.S. stocks in taxable accounts.”

The magnitude of the difference can vary widely, depending on the investor’s tax bracket, the overall allocation to equities in the portfolio (the glide path), the amount of foreign taxes withheld, and the proportion of QDI.

The charts below indicate which hypothetical portfolio—ex-U.S. equities in taxable accounts (signified by circles) versus U.S. equities in taxable accounts (signified by triangles)—provided higher after-tax returns across a variety of scenarios. 

The paper’s other two findings are more in line with conventional wisdom.

Investors are typically better off when stocks with higher dividends (“value” stocks) are in tax-advantaged accounts rather than growth stocks that have little or no dividends.

And actively managed funds—which typically have higher portfolio turnover (and therefore higher capital-gain distributions) than index funds—are generally better off in tax-advantaged accounts. Index funds typically have lower turnover and lower capital distributions, so they should be kept in taxable accounts.

That said, this isn’t a hard-and-fast rule. Active funds that have low turnover and have high enough alpha to overcome the tax drag may be able to outperform index funds in a taxable account.

“Our findings are especially important to those investors who still have a moderate to substantial portion of their portfolio in stocks,” Padmawar said. “Those who have a relatively small allocation to stocks are better off with the simpler guidelines from our original paper—which is to keep taxable fixed income in tax-advantaged accounts and equities in taxable accounts.”

Those with higher allocations to stocks have more flexibility on where to place equity subclasses. Depending on their tax bracket and other factors, they have the most to gain by fine-tuning the asset location of their equities.

For more details on the findings, see the paper.

• Income-driven financial planning may help reduce taxes (article, issued August 2023)
• Actively managing negative convexity in municipal bonds (article, issued September 2023)
• HSAs: Tax-sheltered powerhouses (article, issued September 2023)