Visualizing the 3-Fund Portfolio in Different Accounts
Folks like the simplicity of a 3-fund portfolio. US and International equity funds, and a bond fund all wrapped up in a pre-determined asset allocation. When you have different account types with different tax treatment, however, you add a layer of complexity.
How can we simply visualize the 3-fund portfolio across the different account types?
When we add in tax-optimization, that is asset location, you need to consider in which accounts you place your three different investments. Where are the most tax-efficient places for equity and bond funds to land?
What is the Three Fund Portfolio?
Bogleheads popularized the 3-fund portfolio, which is a simple mix of total US and total International equity ETFs, as well as some fixed income (usually a total bond ETF). These three funds comprise your overall asset allocation (equities + bonds=100%).
Once you know which ETFs you want to own, where do you own them?
What are the Three Taxable Account Types?
Tax diversification is the reason why you want to own different ETFs in different account types. If you have tax diversification, you can Use Your Tax Planning Window to Control Your Income during retirement.
As different types of investments are taxed differently, and account types vary in their tax treatment, it pays to pay attention.
As seen above in figure 1, there are many different types of assets or accounts. These are taxed differently.
To simplify, there are really only 3 important account types to consider when thinking about tax diversification.
Lower income folks can often Contribute to a Roth IRA and get some retirement money in the TAX-FREE bucket. Tax-Free means you paid taxes once (now), and all future growth and withdrawals are tax-free. Roth money is precious; gather it whenever you can.
Often called a taxable investment account, a brokerage account invests after-tax money.
Worry about TAX-DRAG with these accounts. Tax drag happens when you pay capital gains tax on dividends and ordinary income on interest from investments in these accounts. You can avoid tax-drag using non-deductible IRAs or using a 529 as a Bonus Retirement Account. Neither are great ideas, though.
If you are well to do and want to retire at some point, you will need to have some after-tax money invested in a brokerage account. Just do so efficiently: a major subject below.
Pre-tax accounts are often called retirement accounts. You get a tax break when you put money in pre-tax accounts. Growth is tax-deferred. Eventually, when you withdrawal from these accounts, ordinary taxes are due.
The government wants its taxes paid!
Tax Arbitrage (deferring income tax during peak income years and recognizing it later when you have low income) is an important concept to understand.
So, there are the three main account types: Roth, Brokerage accounts, and Pre-tax accounts. Let’s visualize how a 3-fund portfolio fits into them.
Visualize the 3-Fund Portfolio Across the different Account Types
Here is my grade 3 drawing of how a 3-fund portfolio sits on top of your different accounts.
Above in figure 2, you can see the three account types: Pre-tax, Taxable, and Roth. Note that there is 50% of the portfolio in Pre-tax, and 50% in Taxable (40) and Roth (10). This distribution is a pretty typical for high income folks who sock away lots of money pre-tax and who have little opportunity to fund Roths.
On the left are the three funds: US Equity, International Equity, and Bonds.
In the Pre-tax account, you have 60% invested in US and 40% in Bonds. The little numbers in parentheses are the percentage times the 50% (which is size of your pre-tax compared to your whole portfolio).
In taxable, you are 50/50 US and international (which, in parentheses, is 20% of your total each).
Finally, in the Roth, you have 100% in US (which is 10% of your portfolio).
Add them up on the right and you have 60% in US (which a part of all three account types), 20% in international (which is just in your brokerage account to take advantage of the foreign tax credit), and 20% in bonds (held only in pre-tax in order to be tax-efficient).
Ta-Dah! You now see an example of the three-fund portfolio visualized across the three account types!
Why did I slice and dice the accounts that way? First, understand what the overall asset allocation is.
Asset Allocation Visualized in the 3-Fund Portfolio.
So, what is your asset allocation? You are 80/20! US (60) plus International (20) equals 80%, and the rest are bonds. 80/20.
Asset allocation is the second most important decision you make (the first is deciding to invest). Asset allocation has to do with risk tolerance. It is a bit more complicated than that, but that’s why it is the second most important question!
Now, what about asset location?
Asset Location Visualized in the 3-Fund Portfolio
Note: you want your assets with the highest expected returns in your Roth. That’s because you have already paid taxes on investments in this account. Any future growth is tax free!
Understand, however, you are taking more risk (in terms of market volatility) in order to get higher expected returns.
If you wanted to tilt or juice your portfolio (which isn’t the point of a 3-fund portfolio!), a Roth is where you put REITs, Small Cap Value, Emerging Markets, or other asset classes with higher future expected returns (and more volatility).
And in your pre-tax account, think about this for a second, you actually don’t own the whole thing. The government owns part of the account. You (or your heirs) will pay taxes on the income when recognized. That is, you owe ordinary income taxes on any withdrawals from pre-tax accounts. So, if you take a lot of risk in your pre-tax accounts, the government takes that risk with you.
But the point of pre-tax accounts: put your tax-inefficient funds in there so you don’t suffer from tax drag. Equities have dividends which, when qualified, are taxed at the Capital Gains Rate. Bonds (and cash), on the other hand, pay interest which is taxed at ordinary rates. Thus, having bonds in your pre-tax account means that you don’t owe ordinary income taxes on the interest. Sweet!
Finally, in your brokerage account, place the most tax-efficient funds. This includes US equities that don’t pay out large dividends (and don’t churn or turn over), and international equities where you get a tax-break due to the foreign tax credit. Ideally in the 3-fund portfolio, international should be held in the taxable.
I cover everything I know about asset location in Tax-Efficient Investing and Portfolio Optimization.
Conclusion: Visualize the 3-Fund Portfolio Across the different Account Types
There you have it. You have an asset allocation efficiently located among the different accounts.
Believe it or not, that is 90% of what you need to know to invest. It is highly likely if you can visualize the 3-fund portfolio across the account types you will beat 99% of the investors in the world.
Do you believe that?