asset location decision of equities vs. bonds

The following text is from CFA Curriculum:

Some jurisdictions exempt municipal bond interest or other types of interest from taxes. In this case, it could conceivably make sense to place tax-free munic- ipal bonds in a taxable account and more heavily taxed stock in the TDA. The yield on tax-free bonds, however, is generally much lower than those on taxable bonds so that in a well functioning market their after-tax returns are approxi- mately equal. This yield concession is a significant disadvantage to placing low yielding tax-free bonds in a taxable account and equity in a TDA. In most instances the yield concession more than offsets the value of sheltering equity returns from taxes. As a result, it is generally better to follow the general strategy of locating bonds in TDAs and equity in taxable accounts.

(Level III 2012 Volume 2 Behavioral Finance, Individual Investors, and Institutional Investors, 5th Edition. Pearson Learning Solutions p. 261). My question – since equities have higher expected returns shouldn’t equities be placed in TDA’s rather than bonds? Does the decision of whether to place equities or bonds in the TDA turn primarily on the fact that coupons are generally taxed higher than capital gains?

Usually income taxes are more than capital gains tax, so to safeguard the income generating out of Coupon bonds, it’s better to “locate” them in TDA

The curric doesn’t do justice to the subject. But even in a situation where taxes on capital gains and interest are the same, the text will bias equities to the taxable account simply because capital gains are taxed later (in most cases).

In real life, the problems are much more complicated. One real issue is rebalancing. Rebalancing appreciated equities blows some of the tax deferral if those securities are located in a taxable account.

For the test, just know that equities are (in most cases) better off in a taxable account.

I think there are few points:

  • There is a limit of locating you assets in tax deffered , taxable & tax exempt accounts. Meaning you can not put all the eggs in one busket.
  • Suppose bonds are heavily taxed than equity (means int rate taxes are higher than dividend & capital gain taxes), in this case you would like to hold Bonds in either TDA or TEA but not in taxable account. Within bonds some are tax free (like MUNI bonds) & some are taxable.
  • Yield on tax free bond is much lower than the taxable bonds. If Post tax yield on taxable bonds is still > yield on low yielding bond, you would still like to hold these bonds in taxable account or eiher of these accounts.
  • Now comes question of equity location. Equity could either be placed in TDA or Taxable account. TDA has front end benefits. If you choose TDA account for Equity they are mainly two or three disadvantages : 1) You can not utilize tax loss harvesting every year if any (coz gain or losses are deffered) 2) If you choose to withdraw some portion of equity say due to liquidity needs you would generally be charged a penalty for early withdrawals from TDAs. 3) If you put equity here, you lower the limit of putting bonds in TDAs. Bonds are income generating which is more than the annual dividends generated by equity. So you would put equity in taxable account & bonds in TDA.
  • Mainly bonds are income generating (coupon) & equities are more of capital appreciation (offcourse dividends can be annual income here). Most country charge Capital gain tax on equity when they are sold (meaning only on realized gains & not on unrealized gains). Also long term capital gain are lower than tax on interest rate.

So this reflects GENERAL strategy of keeping Bonds in TDAs & Equity in taxable accounts

Above post is based on understanding. I would like other AFers to add/modify my thoughts so we all stay in one platform of understanding for the exams.


Good and thorough discussion, thanks. Add my two cents. It may assume the TDA and taxable accounts have similar size. The investor chooses a buy and hold strategy. So it’s better keep the bonds in TDA to avoid annual interst income tax. To keep equitiesin taxable account to diversify. In other words, allocating equities in TDA can benefit the investor too.