Why is it better to put taxable bonds in tax-exempt accounts?

Question

Resources like this one suggest putting taxable bonds in tax-exempt accounts and equity index funds in taxable accounts. But the expected return of taxable bonds is much lower than that of equity funds, so isn't it better to do the opposite? For example, VTABX has a difference in average annual returns of 1.46% (4.46-3.00) between "returns before taxes" and "returns after taxes on distributions and sales of fund shares" over the last 5 years; VTSAX has a difference in average annual returns of 3.13% (15.42-12.29) between returns before and after taxes over the same time period.
What am I missing? Wouldn't I rather save the 3.13% difference and put the equity fund in my tax-exempt account?

gaefan · Accepted Answer

It is common advice to put bonds in tax-exempt account and stocks in taxable accounts.  The reason is that:

bond dividends are taxed as income (37% for rich folks)
stocks can be taxed as long term capital gains (15-20% for rich folks)

I believe that this advice was formed and started propagating when bonds had much higher returns than they do today.  You are correct that this advice does seem incorrect with recent stock and bond performance.
This blogger ran some numbers to confirm you are better off putting stocks in non-taxable accounts (too complicated to copy a summary here).
That blogger ultimately determined, however, that the benefits of optimizing taxes in this way were small enough that is wasn't even worth it for him to do it.  He'd rather have the same asset allocation in each account to make rebalancing easier.
In summary, reducing taxes through strategic asset allocation across accounts is mostly a wash.

Why is it better to put taxable bonds in tax-exempt accounts?

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