How to invest taxable account?

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cantchooseaname8
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Joined: Sat May 04, 2013 6:16 pm

How to invest taxable account?

Post by cantchooseaname8 »

A good friend on mine is coming into a substantial inheritance soon and ask for my suggestions on investing it. I told him I would get some feedback from all of you. He will be receiving about $3 million. He is 25 years old and has no other investments or retirement accounts of any substantial size. My suggestion was to invest the equity portion the same as he would in a retirement account using index funds primarily from Vanguard. However, I'm unsure about the bond portion. In taxable accounts, muni bonds such a VWIUX (national muni-bond fund) will be the most tax efficient. This brings me to my questions:

1) Since his entire investment portfolio will be made up of taxable investments, does it make sense to use only muni bonds? I can't help but feel that he should have more diversification.

2) He lives in CA. Would you suggest splitting the bonds between a national muni bond fund and one made up of solely CA bonds? The issue with the national muni bond fund is that even the interest derived from CA bonds will still be taxable. CA has this weird tax law where the interest can only be received tax-free if at least 50% of the fund's assets contain CA bonds. This is why I ask whether or not it would be wise to split a portion into a fund consisting of solely CA bonds in order to receive that portion tax free at the state level.

Any suggestions?
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saltycaper
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Re: How to invest taxable account?

Post by saltycaper »

Nowhere near as big as my portfolio :happy but I would definitely split any muni bond fund allocation between state and national. Having it all invested in your own state is too risky IMO.

There is no reason to only use munis just because of taxes. Don't let the tax tail wag the asset allocation dog, as they say (or something like that). Diversification is too important.

Stock funds like Total US and even Total International are quite tax efficient. Long-term capital gains and qualified dividends are taxed at much lower rates than ordinary income.

There are also some tax-managed funds to consider, but I do not have any experience with them so will defer to others.
Quod vitae sectabor iter?
JDDS
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Re: How to invest taxable account?

Post by JDDS »

I would avoid putting all of the bond portion into a CA fund, though putting some in there certainly sounds reasonable. I'm guessing he won't want/need to be aggressive with his asset allocation.

Does your friend have other ordinary income?
Lafder
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Re: How to invest taxable account?

Post by Lafder »

Suggest your friend contact Vanguard's concierge service. They will be glad to walk through opening accounts and making a financial plan. The 0.3 % management feeis not necessary. With that level of assets, there will be plenty of free assistance. You or your friend can come back and post Vanguard's suggestions for more discussion.
Best wishes,
lafder
Topic Author
cantchooseaname8
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Joined: Sat May 04, 2013 6:16 pm

Re: How to invest taxable account?

Post by cantchooseaname8 »

saltycaper wrote:Nowhere near as big as my portfolio :happy but I would definitely split any muni bond fund allocation between state and national. Having it all invested in your own state is too risky IMO.

There is no reason to only use munis just because of taxes. Don't let the tax tail wag the asset allocation dog, as they say (or something like that). Diversification is too important.

Stock funds like Total US and even Total International are quite tax efficient. Long-term capital gains and qualified dividends are taxed at much lower rates than ordinary income.

There are also some tax-managed funds to consider, but I do not have any experience with them so will defer to others.
If we don't use just munis, what would you suggest. Would something like total bond make sense for a small portion since it is comprised of about 40% treasury bonds which are exempt from state taxes (I think, right?)?

And thanks to everyone for the replies. I will definitely suggest splitting the muni allocation. Maybe 50/50 (CA/national) or something more conservative like 30/70. To answer JDDD, he does have some ordinary income. About $80k from work would be my guess.
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saltycaper
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Re: How to invest taxable account?

Post by saltycaper »

cantchooseaname8 wrote:If we don't use just munis, what would you suggest. Would something like total bond make sense for a small portion since it is comprised of about 40% treasury bonds which are exempt from state taxes (I think, right?)?
Yes - treasuries are exempt from state (and local) taxes. It's not all about saving money on taxes though...

The tax advantage of municipal bonds is reflected in their lower yield. The 25% federal tax bracket is commonly used as a rough "breakeven" point. If your friend is in a tax bracket lower than 25%, the tax savings aren't usually enough to warrant the lower yields. Higher than the 25% bracket, it's usually worth it. 25% can go either way.

Consider that a corporate bond fund like Vanguard Intermediate-Term Corporate Bond Index Fund (VICSX) currently has an SEC yield of 2.9% and that Vanguard Intermediate-Term Tax-Exempt Fund (VWIUX) currently has an SEC yield of 1.53%. Now, credit risk and interest rate risk are not the same for these two funds, so this isn't a 1:1 comparison, but even paying taxes on the corp bond fund at the 35% rate, you would still come out ahead.

Here is a very simple calculator from Vanguard to compare taxable vs. non-taxable yields: https://personal.vanguard.com/us/funds/ ... alentyield

The general point is that it's your after-tax return that matters. Whether that's because you had a higher return to start with and paid taxes on it or if you had a lower return but paid no taxes doesn't really matter.

I would include munis if I was in a higher than 25% tax bracket, but I would also use treasuries and corporates. I like VBILX (mixed treasuries/corporates) if going with one fund; VICSX paired with VFITX or VSIGX if separating them. These are all intermediates. Lots of people just use total bond.

I agree with the above comment to hear what Vanguard has to say before making a decision.
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bdpb
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Re: How to invest taxable account?

Post by bdpb »

cantchooseaname8 wrote: If we don't use just munis, what would you suggest. Would something like total bond make sense for a small portion since it is comprised of about 40% treasury bonds which are exempt from state taxes (I think, right?)?
Why not all treasuries for anything not in munis? There is little need for anything else from total bond market. The extra stuff in total bond makes total bond be diversified, but the treasuries are what makes the portfolio diversified. Why waste expensive bond space on gnma or corporates?
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