How to Use Tax-Advantages in Investing

[TVKNSC]

I currently have about 30% of my assets in a taxable retirement account, while I have about 55% in tax deferred accounts (ROTH TSP/IRA). I go with ROTH IRA because I dont like playing that "what tax bracket will I be in" game. Plus I would rather the savings grow in a tax-free account until retirement. The rest is in emergency fund and savings account, but I normally put money into my VG Wellington each month as it accrues in savings.

Given I am in my mid-thirties, are their any rules of thumb to follow with looking at taxes in investments? I know this can get confusing, but anything in layman's terms? For example, selling and transferring investments at a certain time of year or age to get a tax advantage? I am getting a much better grasp of investing using the Bogelhead philosophy, but learning the tax portion of it seems cumbersome. I think I will be a much better investor if I knew the tax consequences better.

I appreciate all your input.

[Craig25]

If you have already allocated you assets into appropriate taxable accounts, you have a good start. Generally speaking, you want to sell your losing assets prior to year end in order to lighten your tax load. Assets that have appreciated in value typically should be sold at the beginning of a new term so as to give more time to defer capital gains taxes; these are a couple of your most basic tax deferral strategies.

[grabiner]

Since you work for the government, you have another tax-deferred savings option; consider using a high-deductible health plan for your insurance and adding a Health Savings Account to your investments. (This is particularly attractive for government employees because of the subsidy on health plans.)

Also, since you have the TSP, you want most of your bonds in the G fund; this is a risk issue rather than a tax issue, as the G fund has no risk while bonds in other funds do have risk.

Wellington should be in your IRA, not your taxable account; the taxable account should hold stock index funds, which lose less to taxes. Wiki article link: Principles of Tax-Efficient Fund Placement If you have Wellington in taxable, I would recommend selling it, taking the tax hit on the capital gains, replacing it with a stock index fund in taxable, and moving some of your TSP from a stock fund into the G fund to keep the same stock allocation.

[TVKNSC]

Grabiner,
Great response! I am curious how a stock index fund loses less to taxes? It is probably a simple answer, but one I cant figure out. Any recommendations on a reliable VG Stock Index Fund?

[camaro327]

Most tax efficient is probably Vanguard Total Stock Market Index. Although if you want a large cap index, both 500 and Large Cap would work and still be very tax efficient.

Stock funds are better in taxable due to the preferential tax rates for capital gains and dividends. (max 0%, 15%, or 20% depending on your marginal tax rate). Bond funds are taxed at your marginal rate which is higher.

[TVKNSC]

Thanks for the response. Does it matter that I employ the "buy-and-hold" strategy? I really have no plans to touch the capital gains/ dividends for at least 12 months, probably more like 30 years!! If that's the case, wouldn't I only pay the %15 on the Wellington if I choose to sell it in, say, 18 months? Would I get 2 separate tax rates, 1 for the stocks portion (15%)/ 1 for the bonds portion (25%) if I sold the Wellington and went all into the total stock market index?

[nydad]

You pay taxes in the year you incur the income. I'm not sure how wellington works, but for a regular stock fund that has dividend payments, you would pay 0/15/20% tax on those. On bond income however you would pay your marginal rate. (eg 25, 33, etc).

I believe that if you *sell* shares of your wellington, then you're talking about capital gains - which are either long term or short term- long term are taxed lower, while short term are taxed at your marginal rate. So if you've held shares of wellington more than a year you will have long term gains.

Asset allocation and low cost is the most important thing - then come tax considerations. I sometimes get the feelings certain people on this board would rather pay no tax on $10 in gains than $20 tax on $100 in gains...

The biggest thing you can do to save money on taxes in your taxable account is to buy and hold for the long term. Selling will trigger capital gains, so try to rebalance with new money. You'll always have to pay taxes on dividends, even if you buy and hold.

Tax loss harvesting as mentioned below is another strategy, but spend some time reading about it, you need to be careful and avoid wash sales for example.

[Taylor Larimore]

Great response! I am curious how a stock index fund loses less to taxes? It is probably a simple answer, but one I cant figure out. Any recommendations on a reliable VG Stock Index Fund?

TVKNSC:

A stock index fund loses less to taxes in several ways:

* Less turnover (especially total market index funds). Every time a fund manager sells a profitable security the fund must pay a tax or pass the tax on to the shareholder to pay.

* More "qualified" securities whose dividends are eligible for a lower tax rate. All the stocks in Total Stock Market Index Fund are "qualified."

* Less higher-taxed short-term gains.

* Less reason for the shareholder to sell (no manager change, style drift, under-performance, etc.) which triggers capital-gains.

Morningstar assigns a Tax Cost Ratio for most funds. It shows a rough percentage of return lost to taxes. Type in a fund name or ticker symbol in the "Quote" box and then hit the "Tax" link in the task bar.

Total Stock Market and Total International Funds are two very tax-efficient funds often recommended for taxable accounts. They are used in The Three Fund Portfolio.

Best wishes.
Taylor

[TVKNSC]

I will tell you, this site has had quite an impact on me..All good, of course. Anyway, I feel I have a better grasp of the tax-efficiency that goes along with investing. I guess my concern with the total market index is the level of aggression. I max out my VG Roth each year, but I have thought about eventually exchanging for the LifeStrategy Growth as my Roth IRA. I would rather risk more growth with LIfeStrategy than be forced to become more conservative over time with 2040. Like i've said, I am a "stay the course" and "buy and hold" investor, so I really dont like moving much around once I get it set. To be honest, I am in the process of getting set since I joined this site. My knowledge is growing by the day!

I have the following in tax-deferred accounts:

Roth TSP 2040 (do not max out each year) = $5,500 in account
Roth IRA- VG 2040 (investor) max out each year = $40,000 in account

I have the following in taxable account:

Wellington (admiral) = $60,000 in account

I take it that I should exchange the Wellington for the total stock market index for better tax efficiency in this taxable account? What about the LifeStrategy Growth as my taxable account? I realize it's 80/20, but it seems less volatile than total stock market. Is 20% bonds in a taxable account that big of deal? It is currently 40%, which seems to be a definite issue that needs to be addressed. Keep in mind, I will be putting money each month into this taxable account, so I want to make sure I get it right. I really just want a simple portfolio with right asset allocation, low cost, and tax efficiency. I am on the right path, but I could use some fine-tuning.

[letsgobobby]

It is a mistake to invest in a taxable account before maxing out your Roth TSP. It may also be a mistake to invest in a Roth TSP over a TSP, but at least you have articulated your rationale for doing so. The first mistake has no rationale.

[TVKNSC]

I hear you, letsgo. Like I said, although I have always been frugile with my money, I am just recently getting into the "weeds" with investing. I actually may increase my monthly allotment so I hit that TSP max-out amount each year. The traditional IRA was attractive to me because it may have gotten me into a lower tax bracket, but roth was better because I could access what I put into it and the money will already be taxed when I start withdrawals.