Tax efficiency of asset allocation ETFs

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danielc
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Tax efficiency of asset allocation ETFs

Post by danielc »

Hi everyone.

Nearly all of our savings are in 401k's and IRAs, but we do have an extra bit of money every month that we want to save for shorter term / non-retirement goals. I'm looking at iShares' asset allocation ETFs.
  • AOK - 30% Stock / 70% Bond.
  • AOM - 40% Stock / 60% Bond.
  • AOR - 60% Stock / 40% Bond.
  • AOA - 80% Stock / 20% Bond.
I quite like the 1-fund solution. For a taxable account, I don't want the effort or tax cost of rebalancing, and psychologically I find it easier to not mess with it.

What I'm wondering is whether these asset allocation ETFs are themselves tax inefficient. All of them work by buying other ETFs from iShares that individually invest in US stocks, US bonds, etc. So they have to rebalance and there must be some tax penalty for that. Also, any bond ETF must be tax inefficient already because that's just how bonds work. But then again, I don't see how a DIY approach would be any better. So I'm trying to figure out how big of an issue this is and whether this is the best that I can do if I want a relatively conservative portfolio in a taxable account.

Thanks for the help!
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Re: Tax efficiency of asset allocation ETFs

Post by ruralavalon »

That's an interesting question, but I don't know the answer.

You didn't state your tax bracket and the links do not give any information on the amounts of the distributions, and what percentage of dividends might be qualified dividends.
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Re: Tax efficiency of asset allocation ETFs

Post by retired@50 »

danielc wrote: Thu Sep 16, 2021 5:44 pm What I'm wondering is whether these asset allocation ETFs are themselves tax inefficient.
I think the answer to this question is yes.

One way to attack this issue is to look at the difference between returns "before taxes" and "after taxes on distributions". The wider the margin, the worse the tax efficiency is.

Similar funds, like the Vanguard LifeStrategy series have the same issue.

AOK: https://www.ishares.com/us/products/239 ... tion-etf#/

VSCGX: https://investor.vanguard.com/mutual-fu ... ance/vscgx

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Re: Tax efficiency of asset allocation ETFs

Post by danielc »

ruralavalon wrote: Thu Sep 16, 2021 6:00 pm That's an interesting question, but I don't know the answer.

You didn't state your tax bracket and the links do not give any information on the amounts of the distributions, and what percentage of dividends might be qualified dividends.
We're in the 22% marginal tax rate. The dividends should all be qualified because iShares is really good at making that happen. I'm more concerned about the fact that asset allocation ETFs have to rebalance too and I can't see how they can avoid taxes there; oh, and that bonds are very tax-inefficient.

I need to think about this more. I'm tempted to make a 2-fund portfolio (one stock ETF, one bond ETF) and intentionally *not* rebalance other than by purchasing new ETFs. In other words, I could allow the asset allocation to slide and that way avoid selling and incurring capital gains.
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Re: Tax efficiency of asset allocation ETFs

Post by anon_investor »

danielc wrote: Thu Sep 16, 2021 7:05 pm
ruralavalon wrote: Thu Sep 16, 2021 6:00 pm That's an interesting question, but I don't know the answer.

You didn't state your tax bracket and the links do not give any information on the amounts of the distributions, and what percentage of dividends might be qualified dividends.
We're in the 22% marginal tax rate. The dividends should all be qualified because iShares is really good at making that happen. I'm more concerned about the fact that asset allocation ETFs have to rebalance too and I can't see how they can avoid taxes there; oh, and that bonds are very tax-inefficient.

I need to think about this more. I'm tempted to make a 2-fund portfolio (one stock ETF, one bond ETF) and intentionally *not* rebalance other than by purchasing new ETFs. In other words, I could allow the asset allocation to slide and that way avoid selling and incurring capital gains.
Why not just buy equity ETFs, and do all rebalancing in your tax advantaged accounts?
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Re: Tax efficiency of asset allocation ETFs

Post by retiredjg »

Bond dividends are never qualified and always taxed at your marginal tax rate. Those ETFs contain bonds. And strangely, the 20% bond ETF tax-efficiency is not much different from the 70% bond ETF. Not sure what that is about. :?

Look under performance. Subtract "after-tax pre-liq" from "Total return'. If the numbers consistently come out in different time periods at .5% or thereabouts, that is pretty tax efficient. If they come out .8% or .9%...not so much.

If you just want one fund in taxable, it should be an equity ETF for the most tax-efficiency. Add a little more bonds in one of the other accounts.

Or do what you have in mind. If the taxable account is small enough, in the 22% tax bracket it will not hurt you too much. Or the two ETF solution you mention which will be easier to unravel down the road.
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Re: Tax efficiency of asset allocation ETFs

Post by danielc »

anon_investor wrote: Thu Sep 16, 2021 7:18 pm Why not just buy equity ETFs, and do all rebalancing in your tax advantaged accounts?
So far I've done that, but the funds in the taxable account would be intended for shorter term / non-retirement goals. My tax advantaged accounts are all for retirement. I know that money is fungible and in this forum there is often some admonition against creating mental buckets, but psychology aside, at the end of the day, I cannot move money back and forth between taxable and tax-advantaged. If I buy a new car, that money is coming from taxable.
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Re: Tax efficiency of asset allocation ETFs

Post by anon_investor »

danielc wrote: Thu Sep 16, 2021 7:57 pm
anon_investor wrote: Thu Sep 16, 2021 7:18 pm Why not just buy equity ETFs, and do all rebalancing in your tax advantaged accounts?
So far I've done that, but the funds in the taxable account would be intended for shorter term / non-retirement goals. My tax advantaged accounts are all for retirement. I know that money is fungible and in this forum there is often some admonition against creating mental buckets, but psychology aside, at the end of the day, I cannot move money back and forth between taxable and tax-advantaged. If I buy a new car, that money is coming from taxable.
Oh but you can:
https://www.bogleheads.org/wiki/Placing ... ed_account
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Re: Tax efficiency of asset allocation ETFs

Post by danielc »

retiredjg wrote: Thu Sep 16, 2021 7:25 pm Bond dividends are never qualified and always taxed at your marginal tax rate. Those ETFs contain bonds.
I should have been clearer. When I say dividend, that would be stock dividends. The thing we get from stocks are coupons and I realize that those are fully taxed at my marginal tax rate.
retiredjg wrote: Thu Sep 16, 2021 7:25 pm And strangely, the 20% bond ETF tax-efficiency is not much different from the 70% bond ETF. Not sure what that is about. :?

Look under performance. Subtract "after-tax pre-liq" from "Total return'. If the numbers consistently come out in different time periods at .5% or thereabouts, that is pretty tax efficient. If they come out .8% or .9%...not so much.
Thanks! That's very useful. So, for example, AOK comes to 0.8% so it's not very good.

retiredjg wrote: Thu Sep 16, 2021 7:25 pm If you just want one fund in taxable, it should be an equity ETF for the most tax-efficiency. Add a little more bonds in one of the other accounts.

Or do what you have in mind. If the taxable account is small enough, in the 22% tax bracket it will not hurt you too much. Or the two ETF solution you mention which will be easier to unravel down the road.
I will try to keep the bonds in taxable to a minimum (I haven't bought any yet). But I also can't easily get around the fact that near-future purchases need to come from taxable. I think I'm leaning toward the two-fund solution for the reason that you gave. Using your guideline for tax efficiency, I see that AGG comes to 1.24% (!!!!!!) while ITOT comes to 0.41%.

Man... I wonder how other people deal with this. Bonds obviously belong in a tax advantaged account, but you can't save for houses, cars, vacations, etc with a 100% stock allocation. If you don't mind me asking, how do you save for short-term goals?

On the other hand, current yields are so low I wonder why I even bother. It seems like I might as well stash the "bond" portion in a savings account.
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Re: Tax efficiency of asset allocation ETFs

Post by lazyinvestor30 »

The way to deal with this is let’s say your retirement allocation is 90/10 and your taxable for short term needs to be 50/50

Then your retirement balance is 200k that means 180 k in stocks and 20 k in bonds. Assume this is in 401k

Then if you are saving 100k for down payment then 50 k in stocks and 50 k in bonds.

So you need a total of 70 k in bonds. You put all of them in 401k and 100k in taxable as stocks.

Then when you withdraw the entire 100k for down payment then you buy stocks in 401k to go back to your 90/10 location. Hopefully that makes sense.
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Re: Tax efficiency of asset allocation ETFs

Post by danielc »

anon_investor wrote: Thu Sep 16, 2021 8:02 pm
danielc wrote: Thu Sep 16, 2021 7:57 pm
anon_investor wrote: Thu Sep 16, 2021 7:18 pm Why not just buy equity ETFs, and do all rebalancing in your tax advantaged accounts?
So far I've done that, but the funds in the taxable account would be intended for shorter term / non-retirement goals. My tax advantaged accounts are all for retirement. I know that money is fungible and in this forum there is often some admonition against creating mental buckets, but psychology aside, at the end of the day, I cannot move money back and forth between taxable and tax-advantaged. If I buy a new car, that money is coming from taxable.
Oh but you can:
https://www.bogleheads.org/wiki/Placing ... ed_account
Hmm... Thanks! Right now my taxable account is way too small to implement this solution (the page suggests that the taxable account be 2x the cash needs). But I can set this as a goal and work toward it. So what I'll do is I'm going to start with the two-fund solution (1 stock, 1 bond) and grow that until the account reaches the target size. Then I can gradually sell off the bond portion and "move it" to the retirement account using the 2:1 ratio suggested in the Wiki.

Thanks again. Now I have a plan.
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Re: Tax efficiency of asset allocation ETFs

Post by AlohaJoe »

danielc wrote: Thu Sep 16, 2021 5:44 pm What I'm wondering is whether these asset allocation ETFs are themselves tax inefficient.
viewtopic.php?p=4541604#p4541604

See this previous thread on the subject
VOO has taxes of $45 per $10,000 invested. AOR has taxes of $67 (and an $8 foreign tax credit) per $10,000.

So if you had $500,000 invested, it would result in an extra $700 of taxes. If you had $1,000,000 it would result in an extra $1,400 of taxes.
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Re: Tax efficiency of asset allocation ETFs

Post by danielc »

AlohaJoe wrote: Thu Sep 16, 2021 9:11 pm
danielc wrote: Thu Sep 16, 2021 5:44 pm What I'm wondering is whether these asset allocation ETFs are themselves tax inefficient.
viewtopic.php?p=4541604#p4541604

See this previous thread on the subject
VOO has taxes of $45 per $10,000 invested. AOR has taxes of $67 (and an $8 foreign tax credit) per $10,000.

So if you had $500,000 invested, it would result in an extra $700 of taxes. If you had $1,000,000 it would result in an extra $1,400 of taxes.
Thanks for the link, and the dose of perspective. As you said in that post, the price difference is well within the range of what one might pay for lifestyle simplification. I'm going to think about that.
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Re: Tax efficiency of asset allocation ETFs

Post by ClaycordJCA »

As an alternative one fund solution, you might consider Vanguard’s Tax Managed Balanced Fund (VTMFX). Not an ETF and a roughly 50/50 asset allocation, so it might not be an option in your specific situation.
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Re: Tax efficiency of asset allocation ETFs

Post by danielc »

ClaycordJCA wrote: Thu Sep 16, 2021 10:32 pm As an alternative one fund solution, you might consider Vanguard’s Tax Managed Balanced Fund (VTMFX). Not an ETF and a roughly 50/50 asset allocation, so it might not be an option in your specific situation.
Thanks for the suggestion. As far as I can tell, those products use munis for the bond component. Unfortunately my income is not high enough to put me on the tax bracket that makes munis a good buy.
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Re: Tax efficiency of asset allocation ETFs

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danielc wrote: Thu Sep 16, 2021 8:15 pm
retiredjg wrote: Thu Sep 16, 2021 7:25 pm Bond dividends are never qualified and always taxed at your marginal tax rate. Those ETFs contain bonds.
I should have been clearer. When I say dividend, that would be stock dividends. The thing we get from stocks are coupons and I realize that those are fully taxed at my marginal tax rate.
retiredjg wrote: Thu Sep 16, 2021 7:25 pm And strangely, the 20% bond ETF tax-efficiency is not much different from the 70% bond ETF. Not sure what that is about. :?

Look under performance. Subtract "after-tax pre-liq" from "Total return'. If the numbers consistently come out in different time periods at .5% or thereabouts, that is pretty tax efficient. If they come out .8% or .9%...not so much.
Thanks! That's very useful. So, for example, AOK comes to 0.8% so it's not very good.

retiredjg wrote: Thu Sep 16, 2021 7:25 pm If you just want one fund in taxable, it should be an equity ETF for the most tax-efficiency. Add a little more bonds in one of the other accounts.

Or do what you have in mind. If the taxable account is small enough, in the 22% tax bracket it will not hurt you too much. Or the two ETF solution you mention which will be easier to unravel down the road.
I will try to keep the bonds in taxable to a minimum (I haven't bought any yet). But I also can't easily get around the fact that near-future purchases need to come from taxable. I think I'm leaning toward the two-fund solution for the reason that you gave. Using your guideline for tax efficiency, I see that AGG comes to 1.24% (!!!!!!) while ITOT comes to 0.41%.

Man... I wonder how other people deal with this. Bonds obviously belong in a tax advantaged account, but you can't save for houses, cars, vacations, etc with a 100% stock allocation. If you don't mind me asking, how do you save for short-term goals?

On the other hand, current yields are so low I wonder why I even bother. It seems like I might as well stash the "bond" portion in a savings account.
If you wouldn't worry about a savings account paying you 2%, you shouldn't worry about a bond doing so either.
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Re: Tax efficiency of asset allocation ETFs

Post by retiredjg »

danielc wrote: Thu Sep 16, 2021 8:15 pm Man... I wonder how other people deal with this. Bonds obviously belong in a tax advantaged account, but you can't save for houses, cars, vacations, etc with a 100% stock allocation. If you don't mind me asking, how do you save for short-term goals?

On the other hand, current yields are so low I wonder why I even bother. It seems like I might as well stash the "bond" portion in a savings account.
You have to keep in mind that saving and investing for retirement are not the same thing.

When saving for a shorter term goal, it may not be possible to be particularly tax-efficient (unless you can use the "cash in tax-advantaged strategy).

Also, when saving for something, stocks are usually not a good choice unless you have several years of flexibility in when the goal is reached. If you need the money at a certain time, little to none of it should be invested in stocks.
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Re: Tax efficiency of asset allocation ETFs

Post by Horton »

Why not consider LifeStrategy funds? They are lower cost. I don’t think the ETF construct of the iShares funds makes them superior.

Look at the performance data for AOR and VSMGX:

Image

https://www.ishares.com/us/products/239 ... cation-etf

Image

https://investor.vanguard.com/mutual-fu ... ance/vsmgx

For the last 10 years as of 6/30, the Vanguard fund outperforms the iShares fund on both a pre-tax and after-tax basis. Coincidentally, the performance difference is about the same as the expense ratio difference.
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Re: Tax efficiency of asset allocation ETFs

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Horton wrote: Sun Sep 19, 2021 6:35 pm Why not consider LifeStrategy funds? They are lower cost. I don’t think the ETF construct of the iShares funds makes them superior.

. . . . .

For the last 10 years as of 6/30, the Vanguard fund outperforms the iShares fund on both a pre-tax and after-tax basis. Coincidentally, the performance difference is about the same as the expense ratio difference.
Thank you, that is very informative and interesting.
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Re: Tax efficiency of asset allocation ETFs

Post by Vegomatic »

And of course, can use NTSX + 'Cash' (short term taxable or muni ETF) to get an efficient 60/40. (Rebalancing issues, though.)

Scroll down in link below to see income of each portfolio. Combos that use NTSX have 1/3 the income [fwiw] than the Vanguard Balanced Index Fund, with otherwise remarkably similar (past) performance.

https://www.portfoliovisualizer.com/bac ... on5_3=33.4
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