Talk:Tax-efficient fund placement/Archive 2

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Proposed improvements

A general suggestion: Make a revised version of this discussion [[Strategies for Tax-Efficient Fund Placement]] (removed link to non-existent page, --LadyGeek 19:00, 16 May 2011 (EDT)) as a separate page, and leave the "Principles" page mostly as is. This will allow one page to discuss the procedure, and another to discuss the more complicated details such as the reason that an emerging markets index is less tax-efficient than a developed markets index. (The corrections below, with my comments, can be made to both pages.)Grabiner 00:46, 23 April 2011 (EDT)

Grabiner and LadyGeek - You folks are terrific! And fast. I'll move over to that other page to reply to your comments. I hope to reply this evening but I am not fast yet.--Stickman 23:28, 24 April 2011 (EDT)

Friends, I love the wiki and use it often. I want to suggest improvements to this page...as a super-neophite wiki editor. Here are the reasons I am proposing changes, followed by my specific suggestions:

  1. We need to explain what "tax efficient" means at the beginning.
  2. The Chart can be simplified to be more useable
    1. Add balanced funds. These are commonly held and cannot be found on chart.
    2. Eliminate the distinction between mutual funds and ETFs. This distinction clouds the main point, and the words "or index fund with ETF class" just raise unanswered questions.
    3. Re-order the TIPS from ambiguous to inefficient. These were previously considered less efficient than REITS but somehow moved to the moderate category. I think it was correct in a previous version of this chart given the liability on phantom income (the inflation component).
    4. Flip axis. Intuitively graphs go from low to high (least to most) as you go up the y-axis.
  3. Change the general strategy and instructions to be more informative
    1. Add the placement of international funds
    2. Differentiate the treatment of tax-free vs tax-deferred accounts

Here are the specific changes I propose to replace all content up to the section called "Explanation for the estimated order". Please leave me a note if you'd like me to modify any of the pictures.

  1. I agree; this definition is useful.
  2. I agree with two simplifications.
    1. The problem with classifying balanced funds is that the tax efficiency depends on what they hold and how they are managed. However, as a single category, they would be between large-cap active funds and bond funds, since they are usually a combination of both.
    2. The distinction between mutual funds and ETFs is now less important than it used to be; I will still leave the category for non-ETF indexes, because some of them do exist, but remove it elsewhere.
    3. TIPS have the same efficiency as other Treasury bonds. All the gain from either TIPS or Treasuries is taxed when earned; the tax on phantom income just means that you do not get to defer the gain from the increased principal value of TIPS. (For example, if you have a bond worth $10,000 yielding 5% and a TIPS worth $10,000 yielding 2% with 3% inflation, both will become worth $10,500 pre-tax and $10,375 after-tax in a 25% tax bracket.) REITs are probably less tax-efficient than non-junk bonds in the long run; most of their yield is taxable and non-qualified, and they are expected to grow faster than bonds, increasing the amount of taxable income in the future. (There is a similar explanation in the table of estimated costs.)
    4. Flipping is fine, with the text reversed; we can also reverse the table.
  3. Some of your general strategy comments seem to be based on an old version of the list
    1. International funds are already included, and they are slightly more tax-efficient than similar domestic funds because of the foreign tax credit
    2. Tax efficiency is irrelevant in the decision whether to place a fund in tax-deferred or tax-free accounts, which is why they are lumped together in the current list (but weren't in the old list). If you have a stock index fund and an active stock fund, it doesn't matter which one goes in your 401(k) and which one goes in your Roth IRA. (The difference in risk and returns may be relevant; see Tax-Adjusted Asset Allocation for the discussion of that issue.)

Grabiner 00:33, 23 April 2011 (EDT)

I flipped the Y-axis by reversing the text order. The arrow color should stay the same. By convention, "bad" things are red, "good" things are green (or a less bright color). Note the <onlyinclude> tag in the wikitext. This table is included on other pages; modifications should be made with this in mind.

Stickman - The "Sig" toolbar button (4th from right) inserts your signature. Select "Sig", then "Show preview" to see the effect. FYI - Wikipedia convention is to insert your signature when discussing topics for ease of identifying the editor. (This is a minor administrative detail, but discussions are easier to follow.)
--LadyGeek 09:33, 23 April 2011 (EDT)

(introduction from the top of page)

Not all investment income is taxed the same. If you have both taxable and tax-advantaged accounts, you generally want to hold bonds in a retirement account and stocks in a taxable account. The advantages for holding stocks in a taxable account include

  • lower tax rates for qualified dividends and long-term capital gains
  • opportunity for tax-loss harvesting
  • stepped-up cost basis upon death
  • gifting appreciated assets

This article introduces the concept of tax efficiency so that investments that generate high levels of income that is taxed at ordinary income rates are held (when possible) in tax-advantaged accounts. In practice, the size of the tax-advantaged accounts often prevents the ideal strategy from being realized. But these steps will lead you to your most tax-efficient fund placement, which can generate a dramatic return after many years of compounding.

General strategy

Step 0: Asset allocation without regard to taxes

Consider your portfolio as a whole (include spouse) and determine your risk level (% stocks / %bonds) and desired asset allocation before considering taxes.

Step 1: Determine Tax Efficiency

Understand the tax consequences of holding each of your chosen investment assets. For example, bonds returns are generally taxed at ordinary income rates. Most stock dividends are "qualified dividends" with a lower tax rate, but REIT funds distributions are an exception. REIT distributions are taxed like ordinary income. Holding TIPS in a taxable account generates a tax liability on "phantom income" (the inflation component) that the owner does not receive until that bond is sold. Note also that tax exempt municipal bonds and savings bonds (series EE and series I) can only be held in taxable accounts.

Step1.jpg

Step 2: Place Least Efficient Funds

Fill your tax-deferred accounts with your least efficient funds first. If this fills up, then put the funds in your tax-free accounts (e.g. Roth IRA). Exhaust both of these before putting these funds into your taxable account, and only after you have considered whether there might be some more tax-efficient alternatives. This is illustrated with an example portfolio with three asset classes.

Slide2.JPG

Step 3: Place International Stock Funds

It is sometimes possible to get tax credit for foreign taxes paid from international stock funds, but this opportunity is lost in tax-advantaged accounts. It is worth doing this, although it is not a large amount. Even when held in a taxable account, some funds do not qualify for this foreign tax credit if they are a "fund of funds".

Slide3.JPG

This is really part of the previous step; the foreign tax credit is part of the tax efficiency, and should be explained there.Grabiner 00:37, 23 April 2011 (EDT)

Step 4: Place high growth stock funds

Since a Roth IRA is forever tax-free, this space is most valuable for your fund that has the highest expected growth.

Slide4.JPG

This may be correct, but the reason has nothing to do with the principles of tax-efficient fund placement, and is too complicated to explain here. Putting the fund with the highest expected growth in your Roth IRA increases both the risk and return of your portfolio, so it isn't necessarily better. (You can eliminate the difference with Tax-Adjusted Asset Allocation so that you value $10,000 in a traditional IRA which you will withdraw in a 25% tax bracket as equal to $7500 in a Roth.)

If all else is equal (and it often isn't, because you have different options in your 401(k) and your Roth IRA), it is slightly better to have the fund with the highest expected return in your Roth, because the Roth is free from RMDs and probably is less subject to the risk of changing tax rates. Grabiner 00:42, 23 April 2011 (EDT)

Step 5: Efficient funds are fine anywhere

Tax-efficient funds are fine in any account. Regular rebalancing of your stock/bond ratio is particularly easy if you have enough room in your tax-deferred account to hold some of your tax-efficient stock fund because the stocks and bonds can be exchanged without tax consequence.

Slide5.JPG

Explanation for the estimated order

no changes to current version from here on

Further Discussion (after major update)

In Comparison of hypothetical tax costs, first paragraph, I changed "guess" to "estimate" as shown below - it sounded better. However, the implementation is unclear in Table 1. This statement is confusing. How are future capital gains used in Table 1?

Future capital gains are estimates, not necessarily based on recent values; it is not necessarily reasonable to assume that a small-cap ETF which has never distributed a capital gain will continue to do that forever.

--LadyGeek 09:15, 1 May 2011 (EDT)

  • Capital gains on funds which you still hold are included in Table 1 (the gains that VSS has distributed and that other small-cap ETFs might distribute). Capital gains on sales are included in Table 2, and those calculations involve assumptions which are already in the table; if the stock market returns 8% and your stock fund pays 2% qualified dividends taxed at 15%, then Table 2 shows the annualized cost.
  • However, I did mean "guesses" when I wrote that paragraph; I do not have a good basis for estimation of the distributions on ETFs because ETFs have not been around long enough. In contrast, there is a good basis for estimating the relative yield of US and foreign stock funds, because there is years of data, and only in the last few years have foreign yields been higher.

Grabiner 20:38, 1 May 2011 (EDT)

I'm still confused on the wording. Are you saying that ETFs are based on guesses, but the other fund classes are as stated? Perhaps reversing the wording order would make this clear:

From (reverted "estimates" back to "guesses"):

Table 1 assumptions use historical data available from Vanguard's index funds in the Vanguard fund distributions tables; which is used as a guide for qualified dividends, and the relative yields of value, small-cap, and tax-managed funds. Future capital gains are guesses, not necessarily based on recent values; it is not necessarily reasonable to assume that a small-cap ETF which has never distributed a capital gain will continue to do that forever. Interest for bond funds is based on historical rates, not current rates, because the numbers are easy to measure; a bond which has a 6% yield loses 1.5% to taxes in a 25% tax bracket whether that is the current yield on a short-term bond or a long-term bond.

To:

Capital gains on funds which you still hold are included in Table 1. Capital gains on funds sold are included in Table 2, and those calculations involve assumptions which are already in the table. For example, if the stock market returns 8% and your stock fund pays 2% qualified dividends taxed at 15%, then Table 2 shows the annualized cost.

Table 1 assumptions: Qualified dividends and relative yields for value, small-cap, and tax-managed funds use historical data from Vanguard's index funds in the Vanguard fund distributions tables as a guide. ETFs do not have a good basis of estimation due to a relatively short period of historical performance (add a table note indicating what was used - this needs to be quantified since there is no spreadsheet posted). Interest for bond funds is based on historical rates, not current rates, because the numbers are easy to measure; for example, a bond which has a 6% yield loses 1.5% to taxes in a 25% tax bracket whether that is the current yield on a short-term bond or a long-term bond.

"...it is not necessarily reasonable to assume that a small-cap ETF which has never distributed a capital gain will continue to do that forever." - I'm probably missing the point why this is stated.

If you would like to post the spreadsheet itself, and need assistance, send me the file. I'll upload it to Google Docs.

--LadyGeek 23:16, 1 May 2011 (EDT)

  • The distinction I am making is between numbers which are based on historical data (75% qualified dividends for most international funds has been consistent for several years), and numbers which must be guessed because there is inadequate data (whether small-cap ETFs will distribute capital gains, and whether VSS will distribute less in gains than it has over the last two years). I would like the wording to reflect the difference in reliability.
  • I have no spreadsheet to post; Table 1 was based on computations made by hand, and Table 2 was calculated from a spreadsheet (which I didn't save) but copied into the article by hand because the numbers are not dynamic. I could make Table 2 into a spreadsheet later.

Grabiner 20:28, 2 May 2011 (EDT)

Request for correction to Slide2

I corrected the introduction to Slide2 (in Step 2) to explain that tax-inefficient assets should be in either the tax-deferred or tax-free account, with no preference; therefore, I would like to see a revised Slide2 with arrows from bonds to both accounts. Step 4 then determines where the bonds should actually go, but includes the caveat "all else being equal". (Many investors have an S&P 500 index as the only good 401(k) option and therefore should hold their US stocks in a 401(k).) Grabiner 23:21, 4 May 2011 (EDT)

Thanks for your comments and this suggestion. I have modified the picture. Please review and approve.--Stickman 11:08, 5 May 2011 (EDT)
Excellent; this makes the point exactly as I wanted it made.Grabiner 21:49, 5 May 2011 (EDT)