Allocating tax-advantaged: fast growing or least efficient?

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johnanglemen
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Allocating tax-advantaged: fast growing or least efficient?

Post by johnanglemen »

Which is better to store in tax-advantaged space for a young person with a long investment horizon who wants to take risk?

a) Fast-growing but tax efficient assets, such as Total US Stock Market Equity
b) Slower growing but tax inefficient assets, such as Total Bond Market

I have a tension between these two in my mind that I've never quite been able to reconcile. Thank you.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by livesoft »

Since I don't put fixed income in taxable, I say put some of both in tax-advantaged.

That way, you can rebalance or market time to your heart's content.

Roth IRAs are special to me. They are future tax-free money, so you don't want to blow it on something that is not only fast growing but fast dropping. There is no tax-loss harvesting in a Roth account, so you really don't want to lose money in it.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by Taylor Larimore »

johnanglemen wrote:Which is better to store in tax-advantaged space for a young person with a long investment horizon who wants to take risk?

a) Fast(er)-growing but tax efficient assets, such as Total US Stock Market Equity
b) Slower growing but tax inefficient assets, such as Total Bond Market

I have a tension between these two in my mind that I've never quite been able to reconcile. Thank you.
Hi John:

Our Boglehead wiki offers valuable advice about fund placement:

http://www.bogleheads.org/wiki/Principl ... _Placement

Best wishes.
Taylor
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by STC »

I am 33. So a longer horizon like you have. I do the following:

US Equity, Int Equity, REIT, Bonds in Tax Advantaged
Max out my iBonds and my wife's iBonds to increase aggregate Tax Advantaged space
US Equity, Int Equity, small and value tilts, emerging markets (higher volatility to provoke TLH) in Taxable

iBonds and Taxable work as tier 2 & 3 of the emergency fund. Maintain a 75/25 AA.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by Bob's not my name »

I believe this article addresses your question directly: http://thefinancebuff.com/tax-efficienc ... olute.html
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by grabiner »

johnanglemen wrote:Which is better to store in tax-advantaged space for a young person with a long investment horizon who wants to take risk?

a) Fast-growing but tax efficient assets, such as Total US Stock Market Equity
b) Slower growing but tax inefficient assets, such as Total Bond Market

I have a tension between these two in my mind that I've never quite been able to reconcile. Thank you.
The answer depends on your time horizon. Over a very long time horizon, faster-growing tax-efficient assets will generate a larger tax bill than slower-growing tax-inefficient assets. However, when people have worked out this calculation, the necessary time horizon to make tax-deferred stocks better is usually longer than your lifespan.

However, with current very low yields, putting stocks in tax-deferred now might make sense, with the intention of switching to stocks in taxable when interest rates rise (and you can then sell your bonds for a capital loss). Putting stocks in tax-deferred will clearly be right if the tax break on qualified dividends goes away.

Here's a thread in which I created a rule of thumb: if a municipal-bond fund yields less than a stock index fund, it's probably better to hold the municipal-bond fund in taxable and the stock fund in tax-deferred, assuming that you have comparable-quality options for both bonds and stocks in tax-deferred.

When to prefer low-rate bonds to stocks in taxable

With current yields, Intermediate-Term Tax-Exempt makes sense in preference to a stock index in taxable, and a long-term fund from your own state also makes sense because of state taxes, but if you would be holding Long-Term Tax-Exempt, it's probably slightly better to hold Total Stock Market Index in your taxable account, particularly if you won't have the $50K to get Admiral shares of the muni fund.

(The answer also depends on your retirement plan options. If the only low-cost option in your 401(k) is an S&P 500 index, you should hold US stocks there; if you work for the US Government and have the TSP G fund which is better than any retail bond fund, you should hold bonds there.)
Last edited by grabiner on Tue Nov 27, 2012 10:13 pm, edited 1 time in total.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by grabiner »

Bob's not my name wrote:I believe this article addresses your question directly: http://thefinancebuff.com/tax-efficienc ... olute.html
There is a significant error in that article; it ignores the value of tax-deferral of gains.

You pay tax on the dividends from either a bond or stock fund every year, but you pay tax on the capital gains from a stock fund only when you sell the stock. If you buy a stock fund for $10,000 and the fund returns 8% which is $200 in qualified dividends and $600 in increased stock price, you pay $30 tax on the $200 immediately, but you won't owe the $90 tax on the $600 for years. If your investment triples in value, the $90 paid when you sell is equivalent to a loss of $30 this year, so the effective tax cost is 0.60%, not 1.20%. (And it could be even better, as you might not pay that tax at all, if you donate the stock to charity or leave it to your heirs.)
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by tfb »

grabiner wrote:
Bob's not my name wrote:I believe this article addresses your question directly: http://thefinancebuff.com/tax-efficienc ... olute.html
There is a significant error in that article; it ignores the value of tax-deferral of gains.
It does not ignore it. The value is rolled into how you amortize the eventual capital gains tax into an annual tax cost (the circles chart). The longer the deferral period, the lower the amortized annual tax cost.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by Cash »

tfb wrote:
grabiner wrote:
Bob's not my name wrote:I believe this article addresses your question directly: http://thefinancebuff.com/tax-efficienc ... olute.html
There is a significant error in that article; it ignores the value of tax-deferral of gains.
It does not ignore it. The value is rolled into how you amortize the eventual capital gains tax into an annual tax cost (the circles chart). The longer the deferral period, the lower the amortized annual tax cost.
Thanks for that analysis. It turns conventional wisdom on its head. I will have to reevaluate my future contributions.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by johnanglemen »

grabiner wrote:Here's a thread in which I created a rule of thumb: if a municipal-bond fund yields less than a stock index fund, it's probably better to hold the municipal-bond fund in taxable and the stock fund in tax-deferred, assuming that you have comparable-quality options for both bonds and stocks in tax-deferred.

When to prefer low-rate bonds to stocks in taxable

With current yields, Intermediate-Term Tax-Exempt makes sense in preference to a stock index in taxable
Sorry, not sure I followed this. Google Finance says Total Stock Admiral (VTSAX) is yielding 1.91% and Intermediate-Term Municipal Tax-Exempt (VWIUX‎) is yielding 3.19%. By your rule, doesn't that mean that one should continue to hold stock in taxable?
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by STC »

johnanglemen wrote:
grabiner wrote:Here's a thread in which I created a rule of thumb: if a municipal-bond fund yields less than a stock index fund, it's probably better to hold the municipal-bond fund in taxable and the stock fund in tax-deferred, assuming that you have comparable-quality options for both bonds and stocks in tax-deferred.

When to prefer low-rate bonds to stocks in taxable

With current yields, Intermediate-Term Tax-Exempt makes sense in preference to a stock index in taxable
Sorry, not sure I followed this. Google Finance says Total Stock Admiral (VTSAX) is yielding 1.91% and Intermediate-Term Municipal Tax-Exempt (VWIUX‎) is yielding 3.19%. By your rule, doesn't that mean that one should continue to hold stock in taxable?
You are looking at the wrong "yield" number. The one to look at is the SEC Yield. Try morningstar.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by Grt2bOutdoors »

johnanglemen wrote:
grabiner wrote:Here's a thread in which I created a rule of thumb: if a municipal-bond fund yields less than a stock index fund, it's probably better to hold the municipal-bond fund in taxable and the stock fund in tax-deferred, assuming that you have comparable-quality options for both bonds and stocks in tax-deferred.

When to prefer low-rate bonds to stocks in taxable

With current yields, Intermediate-Term Tax-Exempt makes sense in preference to a stock index in taxable
Sorry, not sure I followed this. Google Finance says Total Stock Admiral (VTSAX) is yielding 1.91% and Intermediate-Term Municipal Tax-Exempt (VWIUX‎) is yielding 3.19%. By your rule, doesn't that mean that one should continue to hold stock in taxable?
Use the Vanguard website for VWIUX - under Distributions, it will disclose 2 numbers - Distribution Yield (3.19%) and SEC Yield. You want to compare SEC Yield for the muni fund to Total Stock Admiral.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by johnanglemen »

Thank you. What kind of yield is Google Finance showing that makes it incorrect in this case?
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by STC »

johnanglemen wrote:Thank you. What kind of yield is Google Finance showing that makes it incorrect in this case?
they give this: http://www.investopedia.com/terms/t/ttm.asp

you want this: http://www.investopedia.com/terms/s/sec ... z2DWcIFJhw
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by johnanglemen »

tfb wrote:
grabiner wrote:
Bob's not my name wrote:I believe this article addresses your question directly: http://thefinancebuff.com/tax-efficienc ... olute.html
There is a significant error in that article; it ignores the value of tax-deferral of gains.
It does not ignore it. The value is rolled into how you amortize the eventual capital gains tax into an annual tax cost (the circles chart). The longer the deferral period, the lower the amortized annual tax cost.
This debate between tfb and grabiner, two of the people I most respect on Bogleheads, perfectly illustrates the tension I feel about this topic that I mentioned in my original post :) Grabiner, how would you respond to this?
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Fund location ?

Post by Taylor Larimore »

Bogleheads:
We must be very careful about violating the long-established rule to place taxable bonds in tax-advantage accounts and tax-efficients stocks in taxable accounts.

If we place stocks in tax-advantaged accounts now, when bond yields rise we will pay income tax (except roth) when we sell our stock funds to move them into a taxable account where most of their gain will be taxed at low capital-gain rates and losses can be deducted.

If large amounts are involved, the advice of a knowledgeable accountant should be obtained.

Best wishes.
Taylor
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by Doc »

johnanglemen wrote:This debate between tfb and grabiner, two of the people I most respect on Bogleheads, perfectly illustrates the tension I feel about this topic that I mentioned in my original post :) Grabiner, how would you respond to this?
I don't think they have a debate. TFB was just a little too subtle in the original article.
For simplicity’s sake, I spread the eventual capital gains tax when you finally sell the stock mutual fund into a constant tax rate per year.

[blue and red dots]

The blue dots represent the actual pattern of taxes on a stock mutual fund: smaller when you hold, larger when you sell. The red dots represent a normalized pattern: same amount every year.
The issue of the tax deferral that David refers to is accounted for in the analysis it just wasn't explicitly stated. The constant rate that TFB refers to is less than the statutory rate because of the tax deferral. It is the equivalent to comparing a coupon bond with a zero coupon bond using YTM on an after tax basis
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Re: Fund location ?

Post by tfb »

Taylor Larimore wrote:If we place stocks in tax-advantaged accounts now, when bond yields rise we will pay income tax (except roth) when we sell our stock funds to move them into a taxable account where most of their gain will be taxed at low capital-gain rates and losses can be deducted.
That's not necessary. Just sell stocks within tax deferred accounts to buy bonds but still keep them in tax deferred accounts. Meanwhile sell [muni] bond funds in taxable account for a capital loss. No wash sale when the [muni] bond funds you sell and the [taxable] bond funds are different.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by Dandy »

Usually the bulk of fixed income investments/savings should be in tax advantaged (not roth since growth and withdrawals are not taxed). I prefer to hold some equities in tax advantaged accounts and some muni funds in taxable. I think the equities in tax advantaged adds a good bit of growth and makes rebalancing decisions easier since you can sometimes avoid generating taxes.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by Doc »

Dandy wrote:Usually the bulk of fixed income investments/savings should be in tax advantaged (not roth since growth and withdrawals are not taxed).
There is no difference in the after tax return in a ROTH or traditional (deductible) IRA (tIRA) provided the tax rate does not change. Both are commonly referred to tax advantaged accounts as opposed to taxable accounts. There is no tax on the again on your share in either type of account. Under some conditions a ROTH may be slightly different than a TIRA because of inheritance or maximum contribution limits but these are not the topic of this thread.

In choosing between a tax advantaged account and a taxable account the key metric is the amount of tax that would accrue in the taxable account. That tax is the return times the effective tax rate. It is neither the tax rate or rate of return by itself. The effective LTCG tax rate is less than the statutory rate because of deferral of the tax due. This effective tax rate is what Grabiner and TFB have been addressing earlier.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by johnanglemen »

Doc wrote:
Dandy wrote:Usually the bulk of fixed income investments/savings should be in tax advantaged (not roth since growth and withdrawals are not taxed).
There is no difference in the after tax return in a ROTH or traditional (deductible) IRA (tIRA) provided the tax rate does not change. Both are commonly referred to tax advantaged accounts as opposed to taxable accounts. There is no tax on the again on your share in either type of account. Under some conditions a ROTH may be slightly different than a TIRA because of inheritance or maximum contribution limits but these are not the topic of this thread.

In choosing between a tax advantaged account and a taxable account the key metric is the amount of tax that would accrue in the taxable account. That tax is the return times the effective tax rate. It is neither the tax rate or rate of return by itself. The effective LTCG tax rate is less than the statutory rate because of deferral of the tax due. This effective tax rate is what Grabiner and TFB have been addressing earlier.
I don't follow this. You say "there is no tax on the gain of your share in either type of account," but the gain in a Traditional IRA is indeed taxed on withdrawal, no?
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by archbish99 »

johnanglemen wrote:I don't follow this. You say "there is no tax on the gain of your share in either type of account," but the gain in a Traditional IRA is indeed taxed on withdrawal, no?
There is a viewpoint that a Traditional IRA can be seen as divided into two subaccounts which coincidentally have the same investments:
  • [your tax rate]% of the account belongs to the government, and you are investing it on their behalf
  • [100 - [your tax rate]]% of the account belongs to you for retirement and is tax free
Seen that way, a Roth conversion is just handing the government their side of the account and saying you don't want to manage their investments any longer, and a Roth IRA is equivalent to "your" chunk of the Traditional IRA. This is true if the applicable tax rate is the same at both contribution and conversion/withdrawal. There are also advocates of adjusting your asset allocation to reduce the amounts of assets held in Traditional accounts because not all of them are "your" investments.

I tend not to look at it this way, because tax rates often aren't the same, and I'm too far from retirement to believe I could forecast them accurately. But there's some merit to it, particularly if you're close enough to (or in) retirement to "know" your effective tax rate.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by dharrythomas »

You may not pay the tax if you pass a tax-deferred account to your heirs but rest assured that your heirs will. Tax-Deferred Accounts don't get a stepped up basis when passed to heirs. The accounts may be subject to inheritance tax upon death and will be subject to income tax upon withdrawal. It's a pretty nasty cycle if the heirs need to take a distribution in order to pay the inheritance tax because they'll need to withdraw enough to pay the income tax also. :twisted:
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by Doc »

dharrythomas wrote:You may not pay the tax if you pass a tax-deferred account to your heirs but rest assured that your heirs will.
Try this thought process.

1) Do the math and make your descision on the amount you are left with after tax. After all what the hell do you care what Gov takes? All you care about is what you have left after Gov takes its "share". If you do this there is no difference between the two types of accounts if the tax rate doesn't change between the time of the investment and the time of the withdrawal.

2. If you pass the tax on to your heirs you have changed the premise "if the tax rate doesn't change"

We are talking about retirement accounts. It you want to take advantage of a tax provision to benefit people's retirement to generate a "loophole" in the tax code for your grandchildren's personal advantage you are completly justified to do so and I would not argue that you are not. But "loopholes" are not the subject of this thread and anyway are "banned" as tax something or other. :annoyed
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by grabiner »

johnanglemen wrote:
tfb wrote:
grabiner wrote:http://thefinancebuff.com/tax-efficienc ... olute.html

There is a significant error in that article; it ignores the value of tax-deferral of gains.
It does not ignore it. The value is rolled into how you amortize the eventual capital gains tax into an annual tax cost (the circles chart). The longer the deferral period, the lower the amortized annual tax cost.
This debate between tfb and grabiner, two of the people I most respect on Bogleheads, perfectly illustrates the tension I feel about this topic that I mentioned in my original post :) Grabiner, how would you respond to this?
The numbers in the article don't amortize the tax properly, because most of the tax is paid at the end.
■A stock mutual fund is expected to earn 7% a year; its returns are taxed at a 20% rate.
■A bond mutual fund is expected to earn 2% a year; its returns are taxed at a 40% rate.

That makes the stock mutual fund more tax efficient relatively. But on an absolute basis, the stock mutual fund loses 7% * 20% = 1.4% to taxes each year whereas the bond mutual fund only loses 2% * 40% = 0.8%.
The stock mutual fund is not losing 1.4% of annualized return. Given the example in the article, and assuming a 2% yield, the stock fund grows after tax at 6.6%, including 1.6% reinvested dividends. Thus, after ten years, $10,000 in the stock fund will grow to $18,948, including $2169 of reinvested dividends. The capital gain on the sale is $6779, with $1356 tax due for a final value of $17,592, for a 6.02% growth rate and a net tax cost of only 0.98%. In this example, the tax rate on the stock fund is still higher than on the bond fund, but not by the amount quoted in the article.

The wiki examples in Principles of Tax-Efficient Fund Placement were computed by this method, but assuming a 15% tax rate (except the last column, which assumes the rate rises to 20%). I recommend using the low-return assumption (5% annual return) for estimating the tax cost of a stock fund, as if the fund happens to return 8% rather than 5%, you'll probably have more money than you need in retirement and not sell all the stock.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by tfb »

grabiner wrote:The numbers in the article don't amortize the tax properly, because most of the tax is paid at the end.
■A stock mutual fund is expected to earn 7% a year; its returns are taxed at a 20% rate.
■A bond mutual fund is expected to earn 2% a year; its returns are taxed at a 40% rate.

That makes the stock mutual fund more tax efficient relatively. But on an absolute basis, the stock mutual fund loses 7% * 20% = 1.4% to taxes each year whereas the bond mutual fund only loses 2% * 40% = 0.8%.
The 20% number is just an example for the annual tax rate *after* you amortize the capital gains tax in the end. It's not the statutory capital gains tax rate or any other rate. The exact number depends on the number of years, dividend yield, tax rate on dividends, and the capital gains tax rate in the future. If by your assumptions and calculations the amortized rate comes out to 14%, use 14%. I wanted to emphasize the concept: absolute vs relative, not the exact numbers. The concept still holds: 14% < 40% relatively, but in absolute terms, 7% * 14% > 2% * 40%. The absolute number is the more important number, not the relative one (14% vs 40%). Sorry if the 20% round number confused anybody.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by grabiner »

STC wrote:
johnanglemen wrote:
grabiner wrote:Here's a thread in which I created a rule of thumb: if a municipal-bond fund yields less than a stock index fund, it's probably better to hold the municipal-bond fund in taxable and the stock fund in tax-deferred, assuming that you have comparable-quality options for both bonds and stocks in tax-deferred.

When to prefer low-rate bonds to stocks in taxable

With current yields, Intermediate-Term Tax-Exempt makes sense in preference to a stock index in taxable
Sorry, not sure I followed this. Google Finance says Total Stock Admiral (VTSAX) is yielding 1.91% and Intermediate-Term Municipal Tax-Exempt (VWIUX‎) is yielding 3.19%. By your rule, doesn't that mean that one should continue to hold stock in taxable?
You are looking at the wrong "yield" number. The one to look at is the SEC Yield. Try morningstar.
Morningstar also quotes the distribution yield (the dividends paid over the last year as a percentage of share price). Mutual fund companies themselves are required to quote the SEC yield, which is 2.08% for Total Stock Market Index (current dividend yield of all stocks) and 1.55% for Intermediate-Term Tax-Exempt (yield to maturity). And 1/3 of the SEC yield is probably the best estimate of the effective tax cost of a municipal-bond fund.

The effective tax cost of a municipal-bond fund is the difference between municipal-bond and taxable-bond yields of equal risk. Normally, that is break-even at about a 25% tax rate; that is, an investor in a 25% tax bracket would be indifferent between buying munis and corporates of equal risk. But when you buy a bond, the SEC and distribution yield will be equal; if you buy a bond at a premium, the premium is amortized over the life of the bond and reduces the taxable dividend. And while an investor who already holds a corporate bond at a premium is paying a higher tax rate than the SEC yield, he may not want to change his choice, as selling the bond would result in a taxable capital gain.

In contrast, the distribution yield is more relevant as an estimate of the tax cost of a taxable bond fund. The distribution yield of a taxable bond fund is the amount you pay immediate tax on. If the distribution yield is higher than the SEC yield, then you expect a capital loss equal to the difference (assuming rates don't change), and the capital loss may not give you an immediate benefit if you do not sell immediately (or cannot sell because it only reduces your capital gain).
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by grabiner »

tfb wrote:
grabiner wrote:The numbers in the article don't amortize the tax properly, because most of the tax is paid at the end.
■A stock mutual fund is expected to earn 7% a year; its returns are taxed at a 20% rate.
■A bond mutual fund is expected to earn 2% a year; its returns are taxed at a 40% rate.

That makes the stock mutual fund more tax efficient relatively. But on an absolute basis, the stock mutual fund loses 7% * 20% = 1.4% to taxes each year whereas the bond mutual fund only loses 2% * 40% = 0.8%.
The 20% number is just an example for the annual tax rate *after* you amortize the capital gains tax in the end. It's not the statutory capital gains tax rate or any other rate. The exact number depends on the number of years, dividend yield, tax rate on dividends, and the capital gains tax rate in the future. If by your assumptions and calculations the amortized rate comes out to 14%, use 14%. I wanted to emphasize the concept: absolute vs relative, not the exact numbers. The concept still holds: 14% < 40% relatively, but in absolute terms, 7% * 14% > 2% * 40%. The absolute number is the more important number, not the relative one (14% vs 40%).
In that case, I agree with you, but you have to look at the actual rates. With 15% tax rates on stock dividends and capital gains, the amortized tax rate on a stock fund is much less than 15% I got a 14% rate assuming 20% statutory tax (which might include state taxes). And, for that matter, the amortized tax rate on a bond fund should not normally be much more than 25%; if you pay more than that in taxes, you would hold munis which have an effective tax rate of about 25% of the equivalent corporate yield.

This was the basis for my rule of thumb; if muni and stock yields are equal, the tax costs are also about equal under current tax law.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by tfb »

archbish99 wrote:There is a viewpoint that a Traditional IRA can be seen as divided into two subaccounts which coincidentally have the same investments:
  • [your tax rate]% of the account belongs to the government, and you are investing it on their behalf
  • [100 - [your tax rate]]% of the account belongs to you for retirement and is tax free
Seen that way, a Roth conversion is just handing the government their side of the account and saying you don't want to manage their investments any longer, and a Roth IRA is equivalent to "your" chunk of the Traditional IRA. This is true if the applicable tax rate is the same at both contribution and conversion/withdrawal. There are also advocates of adjusting your asset allocation to reduce the amounts of assets held in Traditional accounts because not all of them are "your" investments.

I tend not to look at it this way, because tax rates often aren't the same, and I'm too far from retirement to believe I could forecast them accurately. But there's some merit to it, particularly if you're close enough to (or in) retirement to "know" your effective tax rate.
The viewpoint does not require that the applicable tax rate is the same at both contribution and conversion/withdrawal. There's going to be a tax rate when you withdraw. This tax rate does not depend on your current rate or whether you are able to forecast it. It's out there, unknown now, but will be known after all is said and done. This X% belongs to the government. If you know it now, you can mentally set it aside. The remainder [1-X%] grows tax free. Whether you know X or not, your [1 - X%] still grows tax free.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by tfb »

grabiner wrote:In that case, I agree with you, but you have to look at the actual rates. With 15% tax rates on stock dividends and capital gains, the amortized tax rate on a stock fund is much less than 15% I got a 14% rate assuming 20% statutory tax (which might include state taxes). And, for that matter, the amortized tax rate on a bond fund should not normally be much more than 25%; if you pay more than that in taxes, you would hold munis which have an effective tax rate of about 25% of the equivalent corporate yield.
Glad we are finally in agreement. Rather than giving just one set of numbers, I offered a calculator in the comments. It allows different assumptions about dividend yield, tax rate on dividends (could be full ordinary income as it had been before Bush), number of years, capital gains tax rate (could be 28% or higher as seen before Clinton), muni yield, etc.
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Re: Allocating tax-advantaged: fast growing or least efficie

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tfb wrote:The viewpoint does not require that the applicable tax rate is the same at both contribution and conversion/withdrawal. There's going to be a tax rate when you withdraw. This tax rate does not depend on your current rate or whether you are able to forecast it. It's out there, unknown now, but will be known after all is said and done. This X% belongs to the government. If you know it now, you can mentally set it aside. The remainder [1-X%] grows tax free. Whether you know X or not, your [1 - X%] still grows tax free.
True, but not (in my view) particularly useful. If I don't know X, I can't discount Traditional assets correctly to adjust my asset allocation and make intelligent Traditional vs. Roth allocation decisions. If tax rates are not the same, then I'm no longer indifferent to Traditional vs. Roth contributions, since the use of Traditional allows me to arbitrage the tax rates. It's certainly a valid way to look at the world regardless of knowing X, but I haven't found a situation in which, without knowledge of X, it informs my real-world decisions.

Which forum was this in again? Oh -- it is theory, in which case I'll leave it alone. :D
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by Doc »

David and TFB,

I just pulled this from a three year old spread sheet and haven't check'd it. But for a 15% statutory LTCG rate and no dividends you get the following for the effective tax rates:

Code: Select all

Rate of Return ->	                   6%	  8%	     10%
Term (years)  
10 	                              12.07%	11.29% 	10.59%
20	                                9.60% 	8.44%     7.49%
30	                                7.77%	 6.52%     5.58
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by dharrythomas »

Doc,

My earlier post about taxes was in response to a comment by grabiner
(And it could be even better, as you might not pay that tax at all, if you donate the stock to charity or leave it to your heirs.)
If a consideration of not paying taxes if the account is passed to heirs is on topic, then a comment to ensure that the tax ramifications were not misinterpreted by others would appear to be on topic also.

Harry
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by Doc »

dharrythomas wrote:Doc,

My earlier post about taxes was in response to a comment by grabiner
(And it could be even better, as you might not pay that tax at all, if you donate the stock to charity or leave it to your heirs.)
If a consideration of not paying taxes if the account is passed to heirs is on topic, then a comment to ensure that the tax ramifications were not misinterpreted by others would appear to be on topic also.

Harry
Huh? I was just trying to point out that passing taxable assets to heirs is simply another factor in calculating your effective tax rate when doing the asset placement analysis. If your effective tax rate is zero the tax penalty for all assets classes is zero and it doesn't matter what assets go in which account.

OK If your tax rate is 25% now and zero in the future because of inheritance factors than the ROTH/tIRA equivalence breaks down. But the thread is about taxable vs. tax advantaged not ROTH vs. tIRA.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by Ketawa »

A question for the two different Tax-Adjusted Allocation gurus here, TFB and Grabiner. I'm incorporating TAA into my plan, and am trying to understand the differences between your calculators for determining effective tax rate in a taxable account.

Here is an example set of assumptions for a total market fund, with my actual inputs into each calculator in case I'm doing something wrong.

TFB's calculator
https://public.sheet.zoho.com/public/th ... calculator
7% total return
2% dividend yield
20% tax rate on capital gains
20% tax rate on dividends
40 years to withdrawal

Grabiner's calculator
http://www.remarque.org/~grabiner/assetalloc.html
5% unrealized gain rate
2% taxable distribution rate
0.40% tax on distributions (20% times 2% distribution rate)
20% long-term capital gains tax rate
40 years to withdrawal

In TFB's calculator, these assumptions result in a 0.75% tax cost. Multiplying by 40 years this is a 30% effective tax rate. However, I'm not sure this is the correct way to convert the tax cost for an apples to apples comparison. If I just take 7%, compound it for 40 years, and calculate the reduction caused by a 6.25% return (adjusted to account for the 0.75% tax cost), the difference is a 25% tax rate.

In Grabiner's calculator, these assumptions result in a 27% effective tax rate.

I am just trying to understand the difference in methodology so I can tax-adjust appropriately, or gain greater insight into how you're approaching the problem. Any input? Thanks!
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by tfb »

Ketawa wrote:In TFB's calculator, these assumptions result in a 0.75% tax cost. Multiplying by 40 years this is a 30% effective tax rate. However, I'm not sure this is the correct way to convert the tax cost for an apples to apples comparison. If I just take 7%, compound it for 40 years, and calculate the reduction caused by a 6.25% return (adjusted to account for the 0.75% tax cost), the difference is a 25% tax rate.

In Grabiner's calculator, these assumptions result in a 27% effective tax rate.
In my spreadsheet, with your inputs, you see

Return after capital gains tax 6.20%

You then take (1.062 / 1.07) ^ 40 = 74%. Loss of 26% is close enough to David's 27%. The 0.75% annual tax cost refers to 1 - 1.062 / 1.07 = 0.75%.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by grabiner »

Ketawa wrote:In TFB's calculator, these assumptions result in a 0.75% tax cost. Multiplying by 40 years this is a 30% effective tax rate. However, I'm not sure this is the correct way to convert the tax cost for an apples to apples comparison. If I just take 7%, compound it for 40 years, and calculate the reduction caused by a 6.25% return (adjusted to account for the 0.75% tax cost), the difference is a 25% tax rate.

In Grabiner's calculator, these assumptions result in a 27% effective tax rate.
The difference between the two calculations is that I calculate the percentage of gains that are lost to taxes, rather than the percentage of the account. The percentage of the account that is lost to taxes depends on the basis; TFB's calculation assumes that the basis is equal to the current balance.

Which calculation is correct depends on what you are trying to do. TFB's calculator is designed to estimate whether stocks or bonds are better in a taxable account, so it needs to estimate the final after-tax amount. My spreadsheet is intended to tax-adjust your asset allocation after you have already decided which assets to hold in taxable; the risk of holding stocks in an account is based on the after-tax value of any gains or losses you have in the account, independent of your unrealized gains.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by Ketawa »

Ahh, ok. Thanks for the explanations!
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by Ketawa »

tfb wrote:In my spreadsheet, with your inputs, you see

Return after capital gains tax 6.20%

You then take (1.062 / 1.07) ^ 40 = 74%. Loss of 26% is close enough to David's 27%. The 0.75% annual tax cost refers to 1 - 1.062 / 1.07 = 0.75%.
Thanks for this. I saw 0.75% and subtracted the difference instead of using the other calculation.
grabiner wrote:The difference between the two calculations is that I calculate the percentage of gains that are lost to taxes, rather than the percentage of the account. The percentage of the account that is lost to taxes depends on the basis; TFB's calculation assumes that the basis is equal to the current balance.

Which calculation is correct depends on what you are trying to do. TFB's calculator is designed to estimate whether stocks or bonds are better in a taxable account, so it needs to estimate the final after-tax amount. My spreadsheet is intended to tax-adjust your asset allocation after you have already decided which assets to hold in taxable; the risk of holding stocks in an account is based on the after-tax value of any gains or losses you have in the account, independent of your unrealized gains.
I think one more example would help me understand what is going on. Just a hypothetical, let's say I plan to draw down the rest of my taxable account in one year.

5% unrealized gain rate
2% taxable distribution rate
0.40% tax on distributions (20% times 2% distribution rate)
20% long-term capital gains tax rate
1 year to withdrawal

The calculation determines a 15.5% effective tax rate. I'm still a little confused where this number applies. In one year, I only need to pay 1% + 0.4% of my gains in taxes, 20% of the gains. Is this related to the concept of optimizing for risk, e.g. using only the top marginal tax rate for a Traditional account despite the average tax rate likely being lower? Do you also adjust downward separately for unrealized capital gains?
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by grabiner »

Ketawa wrote:
grabiner wrote:The difference between the two calculations is that I calculate the percentage of gains that are lost to taxes, rather than the percentage of the account. The percentage of the account that is lost to taxes depends on the basis; TFB's calculation assumes that the basis is equal to the current balance.

Which calculation is correct depends on what you are trying to do. TFB's calculator is designed to estimate whether stocks or bonds are better in a taxable account, so it needs to estimate the final after-tax amount. My spreadsheet is intended to tax-adjust your asset allocation after you have already decided which assets to hold in taxable; the risk of holding stocks in an account is based on the after-tax value of any gains or losses you have in the account, independent of your unrealized gains.
I think one more example would help me understand what is going on. Just a hypothetical, let's say I plan to draw down the rest of my taxable account in one year.

5% unrealized gain rate
2% taxable distribution rate
0.40% tax on distributions (20% times 2% distribution rate)
20% long-term capital gains tax rate
1 year to withdrawal

The calculation determines a 15.5% effective tax rate. I'm still a little confused where this number applies. In one year, I only need to pay 1% + 0.4% of my gains in taxes, 20% of the gains. Is this related to the concept of optimizing for risk, e.g. using only the top marginal tax rate for a Traditional account despite the average tax rate likely being lower? Do you also adjust downward separately for unrealized capital gains?
This is my logic. If the investment has higher or lower returns than expected, the after-tax return will also change, so what I am doing is equivalent to computing a marginal tax rate. If the entire account is gains, then you will lose 15.5% of the account to taxes when you sell it in one year, as you will lose 0.4% this year to taxes on the dividends, and 15.5% to capital gains (not 20% because 1.6%/6.6% of the account is your basis). The tax you actually owe will depend on your basis, but any tax you owe on the basis is a constant.

As your holding period gets longer, the difference between the two methods gets smaller, as most of the account does consist of gains and thus the treatment of the initial basis varies.
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Re: Allocating tax-advantaged: fast growing or least efficie

Post by Ketawa »

grabiner wrote:This is my logic. If the investment has higher or lower returns than expected, the after-tax return will also change, so what I am doing is equivalent to computing a marginal tax rate. If the entire account is gains, then you will lose 15.5% of the account to taxes when you sell it in one year, as you will lose 0.4% this year to taxes on the dividends, and 15.5% to capital gains (not 20% because 1.6%/6.6% of the account is your basis). The tax you actually owe will depend on your basis, but any tax you owe on the basis is a constant.

As your holding period gets longer, the difference between the two methods gets smaller, as most of the account does consist of gains and thus the treatment of the initial basis varies.
Thanks, this makes sense. I'm going to read through the papers by Reichenstein as well.
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