You might be able to save yourself tens of thousands of dollars by reshuffling positions between taxable and tax-sheltered accounts.

By William Baldwin, Forbes Staff

First decision for investors: allocation. What percentages of your net worth do you want in stocks, bonds, cash, exotic things?

Second decision, following right behind: location. Where do you put this stuff? You have to determine which holdings go inside tax-sheltered accounts and which outside.

If all of your investment money is in one place or the other, of course, there’s nothing to decide. But most savers nearing or in retirement have assets divided between retirement accounts and taxable accounts.

Allan Roth is a Colorado Springs, Colorado financial planner whose clientele runs to very prosperous people who are accomplished in their careers but inattentive to their portfolios. They may show up holding municipal bonds in a taxable account while at the same time holding stocks in a tax-sheltered account. “That’s stupid,” he says. The cure is simple: sell the munis and invest the proceeds in a stock index fund. Sell a like amount of stocks in the IRA and invest in high-grade bonds.

What’s the point? The client will now be getting a higher and tax-sheltered return on the fixed income. Taxes will be due on the stock index fund but those taxes will be low.

Therein is the first and simplest rule of location: Bonds, which throw off high-taxed ordinary income, need shelter the most. Stocks, by and large, are taxed at very low rates, and should be last in line for the IRA. Note: “IRA” is intended as a catchall term for tax-favored retirement accounts, including 401(k)s and 403(b)s.

You may think of municipals as being tax-exempt, but they really aren’t. Their taxes are built into the coupons, in the form of lower yields than are paid on taxable bonds of similar credit quality. That’s why the muni-to-taxable-bond-to-stock switcheroo puts the client ahead.

Big money is at stake. A commentary at Vanguard posits a hypothetical investor who has $1 million, divided equally between an IRA and a taxable account, and who wants a 50/50 split between stocks and bonds. A naïve allocation has each account 50% in stocks and 50% in bonds. Rearranging to have all the bonds under the shelter delivers an expected $74,000 benefit over the course of 30 years.

The best kind of tax shelter to have is an aftertax IRA, also known as a Roth (after a U.S. senator who was no relation to the guy in Colorado). Withdrawals are tax-free. One Illinois CPA, who asks not to be named, says that among his clients is an agricultural professional who has a sideline trading cattle futures. This fellow has turned several hundred thousand Roth dollars into several million. All this moonlighting income is tax-exempt.

The graphic displays a hierarchy of investments, from those most in need of tax sheltering to those least appropriate for an IRA. Ideally, you fill up the retirement accounts by starting at the top and working down the list. But sometimes a legacy position gets in the way. Let’s say you have an actively traded stock fund acquired in a taxable account long ago. It is aching to be moved into an IRA, but you can’t get it there without selling appreciated fund shares and incurring a capital gain tax. So you let it sit.

Besides tax, there is a psychological component to the decision making. “Asset allocation is more art than science,” says Chris Benson, a Towson, Maryland planner with a master’s degree in taxation. He will leave some high-taxed but safe bonds in a taxable account for the client who may someday need to raise cash in a depressed stock market and would rather not be liquidating stocks expected to rebound. If all of the bonds are in the IRA, there’s no way to get at them without creating a taxable distribution from the account.

Another problem with an all-out location split, Benson says, is that it can get in the way of rebalancing. Suppose there’s a bull market, you want to shift some money from stocks to bonds, and all of your stocks are located outside the IRA. You can’t lighten up without incurring a capital gain tax.

Our ranking of shelter necessity makes no distinction between pretax IRAs and completely tax-free Roth IRAs. If you have both kinds, there’s something to be said for putting the assets with the highest expected returns in the Roth. But, for investors whose tax brackets are likely to stay put, the choice here is less compelling than it is often assumed to be.

Suppose you have $1 million in a pretax IRA, your marginal tax rate for ordinary income (state and federal combined) is 35%, and there is no reason to expect that your tax rate will change. Then you don’t really possess $1 million. What you have, in effect, is a $650,000 Roth IRA that belongs to you alongside a $350,000 trust fund that belongs to the tax collectors.

Now suppose this IRA is destined to triple before you spend the money. Meanwhile, a $650,000 chunk of your Roth is invested in something tamer that will only double. Left as is, the pretax pile yields an aftertax $1.95 million and the Roth an aftertax $1.3 million. Swap the holdings and the payouts become $1.3 million and $1.95 million. The sum is the same.

The Roth does have the advantage of not having mandatory distributions beginning at age 73. On the other hand, a pretax IRA is a great way to fund a bequest to a charity, since it will inherit not just your money but also the money that the tax collectors thought was theirs.

So, Roth accounts should get your high-powered assets? Sometimes.

Herewith, a ranking of assets on their benefit from sheltering.

1. K-1-free commodity fund

This popular vehicle for investing in futures (example: GraniteShares Bloomberg Commodity Broad Strategy No K-1) is toxic in a taxable account. The peculiar Cayman Islands holding company structure means that the fund may have to dish out highly taxed ordinary income at a time when it is losing money. Hold this hot asset in an IRA or don’t hold it at all.

2. Junk

A fund holding high-yield corporate bonds is likely to throw off coupon income of 7.5%, taxable as ordinary income, offset by capital losses of 1.5%. Capital losses are worth less than ordinary losses and, if you have too many of them, worth nothing. You’re earning only 6% but paying taxes on more than that. Bad combination. Junk is IRA-only material.

3. Income stocks

Some preferreds, many real estate investment trusts and all business development companies pay fat dividends that don’t qualify for the favorable capital gain tax rates. Example: Ares Capital Corporation. Shelter if possible.

Preferred-stock funds are a mixed bag. If yours has a low percentage of dividends qualifying for the low rates, it’s about as bad as one of those BDCs. But the GlobalX U.S. Preferred ETF, with 71% of dividends last year qualifying, is perhaps tolerable in a taxable account.

4. High-grade bonds

Same tax treatment as junk bonds, but the default losses are smaller and the coupon less painful at tax time. That is, the whipsaw of highly-taxed income offset by not very useful losses is not nearly as severe as in #2 junk. Still, most people will want these in a tax-sheltered account.

5. CD ladders

A series of bank certificates of deposit with staggered maturities is similar, and inferior, to a collection of Treasury notes. At tax time, CDs display their inferiority by getting hit with state income tax. They probably should be in your IRA.

6. U.S. Treasuries

You’ll usually want to keep these in the IRA. But outside they don’t fare too badly. Interest is exempt from state tax.

7. Growth REITs

Digital Realty Trust has delivered most of its terrific return over the past decade in the form of share appreciation, which doesn’t get taxed outside an IRA if you’re a buy and hold investor. Its dividend last year consisted almost entirely of low-taxed capital gains and so-called “pass through” income. On the other hand you can’t count on future appreciation and the pass-through dodge is going away in 2026.

8. Actively managed mutual fund

This costly object will disgorge taxable gains. It’s a foolish thing to own, but if you must have it, put it in your retirement account.

9. K-1 commodity fund

This older style of futures pool (example: Invesco DB Commodity Tracking) is taxed as a partnership, with most profits getting 60/40 treatment (meaning, they are presumed to consist of 60% long-term gains taxed at the favorable rates).

10. High-dividend stocks

We’re talking about the ones that (unlike those in #3 above) pay dividends qualifying for the low cap gain rates. Examples: Verizon, Altria.

11. Foreign stocks

Inside an IRA the dividend yield on these things, higher on average than on the U.S. market, incurs foreign income tax, typically at a 15% rate. Outside, the dividends incur U.S. income tax, most of the time at favorable cap-gain rates. Outside you owe the same 15% foreign withholding tax but you get back some (in rare cases, all) of this as a credit against your U.S. tax bill. There’s no way to get a credit for foreign tax collected from the IRA.

12. Stock index fund

The annual tax damage from the dividends on a total U.S. market ETF will be something like 0.3%. You have a capital gain problem only if you sell the thing.

13. Low-dividend stocks

Here is the sweet spot for taxable investors. The dividends incur federal income tax at low rates (usually between 15% and 23.8%). The appreciation is never taxed if you behave yourself. Capture capital losses on the stocks that go down and let the winners ride. If you have stocked up on loss carryforwards then you can cash in a few winners without paying tax. As for the rest of the stocks that went up: Duck capital gain tax by giving shares to charity, giving them to zero-bracket relatives or holding them until you’re gone.

If most of your money is in a retirement account (not uncommon for youngsters), you’ll have some stock market exposure there. For that account, disregard the instructions about loss harvesting. Don’t own individual stocks. Own a cheap exchange-traded fund.

14. Master limited partnerships

These collections of oil pipelines (example: Enterprise Products Partners LP) deliver fat dividends that go largely untaxed in the early years of your holding period. They don’t work inside an IRA because there they create “unrelated business taxable income” headaches.

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