Tilting in taxable - seeking advice

[StophJS]

I've been researching and preparing to invest a fairly large sum of money for several weeks now, and have recently become stuck on the question of whether or not to slice and dice in a taxable account with regards to tax implications. I'm drawn to the idea of trying to tilt toward value and small cap based on the writings of William Bernstein. I realize this has probably been discussed to death, but I haven't been able to find peace of mind with a decision in any of the information I've previously found. Without going into too much detail again, this account will be treated as a stand-alone portfolio. I intend to hold these investments for 25 years or more.

The portfolio I have come up with is:

30% Vanguard Total Stock
10% Vanguard Large Cap Value
10% Vanguard Small Cap Value
25% Vanguard Total International
25% Vanguard Total Bond

Recently I have been having doubts about including the less tax efficient funds, simply because I don't feel I fully understand the tax implications.

Many bogleheads seem to be vehemently anti tax-inefficient in taxable under any circumstances. My understanding though is that I should still be able to earn a better after-tax yield on these funds so long as the value funds do in fact outperform the total market over the long haul, which seems likely, historically speaking. The only other considerations I see are the potential for tracking error and increased risk, and the additional effort for rebalancing and taxes. If I'm not mistaken, shouldn't these additional funds actually serve as a means of increasing returns when rebalancing since there are additional funds to become overweighted and sold at a profit? Also, although small caps in and of themselves tend to be more volatile, couldn't they reduce overall portfolio volatility since they don't always track the broader market to the tee?

I may be way off base with some of these observations. I'm far from an investing expert. Any and all thoughts and suggestions are welcome.

[Joe S.]

Why don't you tilt heavily in your tax advantaged accounts, and don't tilt at all in your taxed accounts. That's what most tilters do. You insist this is a stand-alone portfolio, but you provide no evidence why this portfolio should stand alone.

I'm far from an investing expert

Then maybe your reasons why this is a stand-alone portfolio are wrong. Let's discuss this.

[livesoft]

I am not sure what the problem is. If you use Total US Stock Market Index and Total Int'l Stock Market index, what did these funds pay in dividends this year? That is, what is their yield? That gives you a measure of the best tax-efficiency that a non-tilter can achieve. Hint: They did not pay 0% yield.

The non-TotalIndex funds also paid dividends and their dividends were not 100% qualified (but qualified probably won't matter much going forward). Were they really that much less tax-efficient than the total index funds? Maybe you can provide 2012 numbers in a follow-on post, since I don't want to look them up myself. Thanks.

Normally, we wouldn't want to see BND in a taxable account, but it's yield may be lower than those stock index funds (I didn't check).

A comment: Did you want to tilt to international small-cap, too? If so, you are missing VSS/VFSVX.

[StophJS]

Why don't you tilt heavily in your tax advantaged accounts, and don't tilt at all in your taxed accounts. That's what most tilters do. You insist this is a stand-alone portfolio, but you provide no evidence why this portfolio should stand alone.

I'm far from an investing expert

Then maybe your reasons why this is a stand-alone portfolio are wrong. Let's discuss this.

Essentially it boils down to that this is a brokerage account set up by a parent to one day be inherited by my siblings and I, and despite my advising otherwise, the parent isn't interested in changing their sheltered allocation in order to effectively incorporate this account into their entire portfolio. I am the one who will decide on a portfolio and rebalance annually. The inclusion of BND, although tax-inefficient, is my safeguard against excessive volatility in the unlikely event the parent needs to tap the funds.

I am not sure what the problem is. If you use Total US Stock Market Index and Total Int'l Stock Market index, what did these funds pay in dividends this year? That is, what is their yield? That gives you a measure of the best tax-efficiency that a non-tilter can achieve. Hint: They did not pay 0% yield.

The non-TotalIndex funds also paid dividends and their dividends were not 100% qualified (but qualified probably won't matter much going forward). Were they really that much less tax-efficient than the total index funds? Maybe you can provide 2012 numbers in a follow-on post, since I don't want to look them up myself. Thanks.

Normally, we wouldn't want to see BND in a taxable account, but it's yield may be lower than those stock index funds (I didn't check).

A comment: Did you want to tilt to international small-cap, too? If so, you are missing VSS/VFSVX.

Assuming I'm calculating right, yields for 2012 are as follows:

VVIAX: 2.7%
VSIAX: 2.6%
VTSAX: 2.1%
VTIAX: 2.9%
VBTLX: 2.3%

So definitely not a whole heck of a lot of difference at all as far as I can tell. I'm thinking I'll just go ahead and tilt it. As far as international small cap, I excluded it because there is no admiral shares fund and I wanted to keep out the ETF for the sake of easy rebalancing and simplicity. That's one area where I was just going to opt to be lazy.

[Joe S.]

Your portfolio seems reasonable for someone who wants to tilt toward small stocks and value stocks. I don't know your parent's income tax bracket, so I don't know if municipal bonds would be a better choice. Not knowing your parent's tax bracket also makes it harder to estimate how much of a tax hit they will take.

[JimInIllinois]

Your suggested portfolio looks great. My one concern is if you will actually be able to implement your rebalancing plan, since selling overweighted assets will generate taxable gains for your parent and they may not want to pay additional taxes to buy an out-of-favor asset class. You may be better off picking an all-in-one fund that will handle the rebalancing internally and only exhibit the fluctuations of the total portfolio.

[Noobvestor]

30% Vanguard Total Stock
10% Vanguard Large Cap Value
10% Vanguard Small Cap Value
25% Vanguard Total International
25% Vanguard Total Bond

If this is 100% taxable, here is what I would do: get rid of large-cap value - your small cap value gives you small + value, and you can eliminate the large value which only gives you value + more taxation. I would then consider muni bonds instead of total bond. Results could look something like this:

30% Vanguard Total Stock
15% Vanguard Small Cap Value
30% Vanguard Total International
25% Vanguard Intermediate-Term Municipal Bond Fund

[and/or I Bonds added to the limit each year if you're OK with less rebalancing opportunities using existing funds]

[grabiner]

If this is 100% taxable, here is what I would do: get rid of large-cap value - your small cap value gives you small + value, and you can eliminate the large value which only gives you value + more taxation. I would then consider muni bonds instead of total bond. Results could look something like this:

30% Vanguard Total Stock
15% Vanguard Small Cap Value
30% Vanguard Total International
25% Vanguard Intermediate-Term Municipal Bond Fund

[and/or I Bonds added to the limit each year if you're OK with less rebalancing opportunities using existing funds]

And you can also add FTSE All-World Ex-US Small-Cap if you want to overweight international small-cap as well as domestic and are willing to use the ETF. (The mutual fund is significantly more expensive than this ETF.)

[StophJS]

Thanks everyone for the additional input. As far as the municipal bonds, my parents are actually in the 25% tax bracket so in my understanding municipal bonds aren't really ideal. My parents aren't huge earners, but they received a significant windfall through inheritance and that's where this money is coming from.

As far as rebalancing, my parents would certainly defer to me on the decision of whether or not to do it, so there isn't really a question of whether I could adhere to the plan or not. This raises another question for me though, and that's whether I should adhere to a strict annual rebalancing at all. I always took it for granted that it was a good idea, but perhaps in a taxable account, and with relatively volatile funds, this wouldn't be the case. I've never seen any data or researching indicating one or the other. Of course a strategy of tax loss harvesting and possibly just rebalancing based on threshholds could be employed here, but this is a bit beyond the scope of what I feel fully confident in my knowledge of.

If anyone has any insights into specific TLH or rebalancing strategies for taxable I'd love to hear them. In the meantime I'll try to dig up my own information.

[2beachcombers]

Thanks everyone for the additional input. As far as the municipal bonds, my parents are actually in the 25% tax bracket so in my understanding municipal bonds aren't really ideal. My parents aren't huge earners, but they received a significant windfall through inheritance and that's where this money is coming from.

As far as rebalancing, my parents would certainly defer to me on the decision of whether or not to do it, so there isn't really a question of whether I could adhere to the plan or not. This raises another question for me though, and that's whether I should adhere to a strict annual rebalancing at all. I always took it for granted that it was a good idea, but perhaps in a taxable account, and with relatively volatile funds, this wouldn't be the case. I've never seen any data or researching indicating one or the other. Of course a strategy of tax loss harvesting and possibly just rebalancing based on threshholds could be employed here, but this is a bit beyond the scope of what I feel fully confident in my knowledge of.

If anyone has any insights into specific TLH or rebalancing strategies for taxable I'd love to hear them. In the meantime I'll try to dig up my own information.

http://www.bogleheads.org/wiki/Tax_Loss_Harvesting

[Noobvestor]

Thanks everyone for the additional input. As far as the municipal bonds, my parents are actually in the 25% tax bracket so in my understanding municipal bonds aren't really ideal. My parents aren't huge earners, but they received a significant windfall through inheritance and that's where this money is coming from.

I think munis are actually quite ideal. For someone in the 25% bracket, Vanguard's intermediate muni fund right now has a tax-equivalent yield of 2.08%. Vanguard Total Bond has a yield of 1.59%. Their non-tax-adjusted yields are similar, but the 'bonus' of the tax-exempt status boosts the one's yield .5% over the other (which is a lot when we're talking about 1.5%-2%). Anyway, FWIW, my tax bracket fluctuates, but I keep munis whether or not I'm at, above or below the 25% threshold.

As far as rebalancing, my parents would certainly defer to me on the decision of whether or not to do it, so there isn't really a question of whether I could adhere to the plan or not. This raises another question for me though, and that's whether I should adhere to a strict annual rebalancing at all. I always took it for granted that it was a good idea, but perhaps in a taxable account, and with relatively volatile funds, this wouldn't be the case. I've never seen any data or researching indicating one or the other. Of course a strategy of tax loss harvesting and possibly just rebalancing based on threshholds could be employed here, but this is a bit beyond the scope of what I feel fully confident in my knowledge of.

If anyone has any insights into specific TLH or rebalancing strategies for taxable I'd love to hear them. In the meantime I'll try to dig up my own information.

One way is to simpy rebalance with new funds, or dump dividends out into a money market, then periodically use those funds to rebalance (the latter strategy has the slight disadvantage of having some money out of investments at pretty much all times, but can make things easier and more tax-friendly).

[StophJS]

Thanks everyone for the additional input. As far as the municipal bonds, my parents are actually in the 25% tax bracket so in my understanding municipal bonds aren't really ideal. My parents aren't huge earners, but they received a significant windfall through inheritance and that's where this money is coming from.

I think munis are actually quite ideal. For someone in the 25% bracket, Vanguard's intermediate muni fund right now has a tax-equivalent yield of 2.08%. Vanguard Total Bond has a yield of 1.59%. Their non-tax-adjusted yields are similar, but the 'bonus' of the tax-exempt status boosts the one's yield .5% over the other (which is a lot when we're talking about 1.5%-2%). Anyway, FWIW, my tax bracket fluctuates, but I keep munis whether or not I'm at, above or below the 25% threshold.

As far as rebalancing, my parents would certainly defer to me on the decision of whether or not to do it, so there isn't really a question of whether I could adhere to the plan or not. This raises another question for me though, and that's whether I should adhere to a strict annual rebalancing at all. I always took it for granted that it was a good idea, but perhaps in a taxable account, and with relatively volatile funds, this wouldn't be the case. I've never seen any data or researching indicating one or the other. Of course a strategy of tax loss harvesting and possibly just rebalancing based on threshholds could be employed here, but this is a bit beyond the scope of what I feel fully confident in my knowledge of.

If anyone has any insights into specific TLH or rebalancing strategies for taxable I'd love to hear them. In the meantime I'll try to dig up my own information.

One way is to simpy rebalance with new funds, or dump dividends out into a money market, then periodically use those funds to rebalance (the latter strategy has the slight disadvantage of having some money out of investments at pretty much all times, but can make things easier and more tax-friendly).

Oh wow, you learn something new every day. I suppose I should check out the munis after all. I think in order to rebalance I'll just direct my distributions into my MMA and direct them to the lower performing funds. The opportunity cost shouldn't be a factor. I don't really mind the extra effort of reinvesting the dividends as they come in a few times a year.

[Noobvestor]

Thanks everyone for the additional input. As far as the municipal bonds, my parents are actually in the 25% tax bracket so in my understanding municipal bonds aren't really ideal. My parents aren't huge earners, but they received a significant windfall through inheritance and that's where this money is coming from.

I think munis are actually quite ideal. For someone in the 25% bracket, Vanguard's intermediate muni fund right now has a tax-equivalent yield of 2.08%. Vanguard Total Bond has a yield of 1.59%. Their non-tax-adjusted yields are similar, but the 'bonus' of the tax-exempt status boosts the one's yield .5% over the other (which is a lot when we're talking about 1.5%-2%). Anyway, FWIW, my tax bracket fluctuates, but I keep munis whether or not I'm at, above or below the 25% threshold.

As far as rebalancing, my parents would certainly defer to me on the decision of whether or not to do it, so there isn't really a question of whether I could adhere to the plan or not. This raises another question for me though, and that's whether I should adhere to a strict annual rebalancing at all. I always took it for granted that it was a good idea, but perhaps in a taxable account, and with relatively volatile funds, this wouldn't be the case. I've never seen any data or researching indicating one or the other. Of course a strategy of tax loss harvesting and possibly just rebalancing based on threshholds could be employed here, but this is a bit beyond the scope of what I feel fully confident in my knowledge of.

If anyone has any insights into specific TLH or rebalancing strategies for taxable I'd love to hear them. In the meantime I'll try to dig up my own information.

One way is to simpy rebalance with new funds, or dump dividends out into a money market, then periodically use those funds to rebalance (the latter strategy has the slight disadvantage of having some money out of investments at pretty much all times, but can make things easier and more tax-friendly).

Oh wow, you learn something new every day. I suppose I should check out the munis after all. I think in order to rebalance I'll just direct my distributions into my MMA and direct them to the lower performing funds. The opportunity cost shouldn't be a factor. I don't really mind the extra effort of reinvesting the dividends as they come in a few times a year.

That's what I do - I have all muni and stock distributions pile up in Prime Money Market (could use the Muni Money Market one, alternatively) and redistribute from there. If there's a huge market swing, you just have to decide (ideally ahead of time) if you're going to sell whatever is up or let it ride, rebalancing as far as the distributions available will let you. I mentally treat my small percentage that's in Prime at any given time as just part of my bond allocation (but generally it doesn't get up above a few percent, anyway, even if I let it go for a while).

Oh, I forgot to link you to this - very handy tool for comparing different types of bond funds, taxation-wise: https://personal.vanguard.com/us/FundsTaxEquivForYield - you can run the numbers on your options. Personally, I see munis as being worthwhile in taxable for most brackets, but to each their own!

[StophJS]

Oh, I forgot to link you to this - very handy tool for comparing different types of bond funds, taxation-wise: https://personal.vanguard.com/us/FundsTaxEquivForYield - you can run the numbers on your options. Personally, I see munis as being worthwhile in taxable for most brackets, but to each their own!

Was just browsing for a tool like that. Thanks so much