Active Funds in IRA, Passive in Taxable: The “Turnover” Rule
Active Funds in IRA, Passive in Taxable: The “Turnover” Rule
EXECUTIVE SUMMARY
- The Metric: “Turnover Rate” measures how frequently a fund buys and sells stocks. An S&P 500 Index Fund has ~3% turnover. An Active Growth Fund might have 100% turnover (replacing the entire portfolio every year).
- The Tax Impact: High turnover generates “Capital Gains Distributions.” Even if you didn’t sell a single share, the fund passes its internal trading profits to you. In a Taxable Account, this creates an unexpected tax bill.
- The Rule: Put high-turnover Active Funds in your IRA/401(k) (where trading is tax-free). Put low-turnover Index Funds in your Taxable Account (to control the timing of taxes).
You receive a 1099-DIV form and see a huge tax bill, even though you didn’t sell anything. Why? Because your mutual fund manager sold stocks inside the fund. This is “Tax Inefficiency.” Active managers don’t care about your taxes; they care about their alpha. According to Team BMT Analysis, locating high-turnover funds in a Taxable Account is the most common unforced error in portfolio construction. Source: Morningstar Research / Vanguard Whitepaper
Scenario: You own $100k of “Aggressive Growth Fund” (Turnover 80%).
- Taxable Account (Pain):
The fund sells Tesla to buy NVIDIA. Realizes a $20k gain.
The fund must distribute that $20k gain to you by Dec 31.
Result: You owe tax on $20k (~$5,000) this year, reducing your compounding power. - IRA Account (Shield):
The fund distributes $20k gain.
It stays inside the IRA wrapper.
Result: $0 Tax Due. The full amount reinvests.
BMT Verdict: This is not an opinion or a preference. It is a structural rule driven by turnover mechanics and the tax code. If a fund trades frequently, the IRS demands a cut. Locating that fund in an IRA is the only mathematical way to stop the leak.
Tax Drag Comparison (10 Years)
| Fund Type in Taxable Account | Annual Tax Drag (Lost Return) |
|---|---|
| Passive ETF (VTI) | 0.3 |
| Active Mutual Fund | 1.5 |
*Chart Note: Active funds lose ~1.5% of their return annually to taxes if held in the wrong account. This “Tax Alpha” is often larger than the manager’s actual outperformance.
Yes, some newer Active ETFs are more tax-efficient than old Mutual Funds due to the creation/redemption mechanism. That does not break the ruleโit proves it. The mechanism exists specifically to dodge the tax drag that otherwise kills active strategies. Unless you are certain your fund has this shield, assume the rule applies.
CRITICAL SCENARIO: The “ETF vs. Mutual Fund” Nuance
Structure matters.
| Vehicle | Tax Efficiency | Best Location |
|---|---|---|
| ETF (Exchange Traded Fund) | High. “In-Kind Creation/Redemption” mechanism washes away most capital gains. | Taxable Account (or IRA). |
| Mutual Fund | Low. Must sell stocks to meet redemptions, triggering taxes for everyone. | IRA / 401(k) Only. |
Execution Protocol
Go to Morningstar or your broker. Look up the fund’s quote. Find “Turnover Ratio.”
< 10%: Safe for Taxable. (Index Funds).
> 30%: Danger zone. Move to IRA.
Funds like Small Cap Value (AVUV) or Momentum (MTUM) have higher turnover by design (rebalancing to capture the factor). These belong in your Roth IRA because they combine High Growth + High Turnover.
Keep your Taxable Account simple: VTI (US) and VXUS (Int’l). Why? Because passive ETFs allow you to use Tax-Loss Harvesting (#450) effectively. You can’t harvest losses easily if an active manager is generating offsetting gains.
If you only hold index funds in tax-advantaged accounts, this turnover rule is irrelevant to you. This is a precision tool for taxable investors.
WEALTH STRATEGY DIRECTIVE
- Do This: If you want to “play the market” or use active managers (Ark Invest, Fidelity Contrafund), do it exclusively in your IRA. Let the manager trade tax-free.
- Avoid This: Holding a “Multi-Asset” fund (like a Balanced Fund 60/40) in a Taxable Account. The bond interest and rebalancing gains will create a tax nightmare every year.
Frequently Asked Questions
What about Vanguard funds?
Vanguard has a unique patent (expired 2023 but still effective) that makes some of their mutual funds as tax-efficient as ETFs. They are the exception. Most other mutual funds are tax traps.
Is high turnover always bad?
Not if the strategy works (e.g., Renaissance Medallion). But it creates a tax drag. In an IRA, turnover is irrelevant to taxes, so you can focus purely on the return.
Can I convert?
If you have an active fund in a taxable account with a huge gain, you are stuck. Selling triggers tax. Stop reinvesting dividends (take cash) and use new money to buy ETFs instead. This is “shutting off the tap.”