imgritz wrote:Today I received short-term capital gain, a long-term capital gain and dividends. After I looked at the post-value of all of my fund’s contributions I realized I am not wealthier than I was before; I simply have more shares of the fund and an impending tax bill.
The capital gains are a consequence of what has happened to the bond market, not a problem with the fund. Suppose that a ten-year bond which was bought for $1000 and which pays $40 per year is worth $1100 five years from maturity. If the fund keeps the bond, it will pay $40 every year in income, all taxable, and the bond will be worth $1000 when it matures, for a total taxable income of $200. If the fund sells the bond and buys a new bond worth $1100 paying $20 per year, you will pay tax on the $100 capital gain but only receive $100 in income over the next five years, still for a total taxable income of $200, and you are probably better off because the capital gain is taxed at a lower rate. Either way, you will pay tax on $200 despite only earning $100 from this bond. But this is a temporary effect; over the life of the bond, the total return and total taxable income were both $400.
You do want to avoid capital gains in your stock
funds, because stock funds can avoid realizing them; stocks don't mature, and an index fund can hold stocks forever.
So…what is the best way to invest an inheritance for the long-term with fear of losing my parent’s wealth? I’m ok with the 20/80 allocation and I am wondering if I am doing it the correct way.
Are you still working? If you are, then every year, you can max out your 401(k) and IRA, moving money from the taxable investment to make the contributions. This will eliminate the tax consequence, as you don't pay taxes at all if you use a Roth IRA and Roth 401(k), and you pay taxes only corresponding to the tax subsidy you got in contributions if you use a Traditional IRA and Traditional 401(k).
If you are already retired (or already maxing out retirement plans) and you want 20/80 in your taxable account, then LifeStrategy Income is OK if you are in a low tax bracket. In a higher tax bracket, using a municipal-bond fund rather than the Total Bond Market in the LifeStrategy funds will give you a higher after-tax return for the same risk level. (The current yields are 1.56% on Admiral shares of Intermediate-Term Tax-Exempt, and 1.59% on Admiral shares of Total Bond Market Index, but Total Bond Market is slightly less risky because it has a lot of Treasury bonds.)