Asset Location for Retirement Savers

This paper uses data on actual returns on taxable bonds, tax-exempt bonds, and a small sample of equity mutual funds over the 1962-1998 period to compare two asset location strategies for retirement savers who invest in equities through equity mutual funds. The first strategy, ‘defer stocks first,’ gives priority to holding equity mutual funds in a saver’s tax-deferred account, while the second strategy, ‘defer bonds first,’ gives priority to holding fixed-income investments in the tax-deferred account. We consider high-income taxable individual investors who saved in each year and invested in one of the actively-managed funds in our sample. Over the thirtyseven year span that we consider, such investors would have accumulated a larger stock of wealth if they had held their actively-managed equity mutual fund in their tax-deferred account than if they had held the fund in a conventional taxable form. The explanation for this apparent contradiction of the often-stated ‘bonds in the tax-deferred account’ prescription has two parts. First, many equity mutual funds impose substantial tax burdens on their investors. This raises the effective tax rate on investing in equities through mutual funds rather than in a buy-and-hold personal portfolio. Second, taxable investors who wish to hold fixed income assets can do so either by holding tax-exempt bonds or by holding taxable bonds. The interest rate differential between taxable and tax-exempt bonds suggests that the effective tax rate on fixed income investments may be lower than the statutory tax rate for high-income investors. We thank Olivia Lau and Svetla Tzenova for assistance with data collection, William Gale, Davide Lombardo, Sita Nataraj, and Paul Samuelson for helpful comments on an earlier draft, and the National Science Foundation (Poterba) for research support.