The Dramatic Impact of Taxes

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Robert T
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The Dramatic Impact of Taxes

Post by Robert T »

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A few thoughts on taxes...

1. Current tax rates are at an historic low

Capital gains taxes are about half what they were in 1980 and dividend tax rates are about a fifth of what they were in 1980 (according to the table below from Swensen’s book). Looks like the future direction of tax rates may be up.

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Historical Federal Tax Rates 

              LT capital         ST capital gains          
              gains rate         and current income       Dividends 
1980            28.0                   70.0                  70.0 
1990            28.0                   31.0                  31.0 
2000            20.0                   39.6                  39.6 
2003            15.0                   35.0                  15.0 

Source: Swensen’s Unconventional Success
2. Recent tax efficiency may not be indicative of future tax efficiency

If we take funds with long track records (some often discussed on the forum) tax efficiency looks much worse than recent tax cost ratios suggest. For the first three funds in the table below (assuming Vanguard’s numbers are right) from the 1930s to end 2007 taxes would have eroded over 90% of portfolio value (i.e the after tax portfolio value at end 2007 would have been about one tenth the value of the portfolio had it not been taxed). For the last two funds in the table with shorter histories (from 50s and 60s to end 2007), taxes would have eroded 60-70% of portfolio value.

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                                          Annualized Returns        Indicative*         Ratio 
                                              To 03/31/08           $1 Growth       After/Pre-tax    
FUND                          INCEPTION    Pre-tax   After-Tax   Pre-Tax  After-Tax    End Value
                                                                                             
CGM Mutual (LOMMX)            11/06/29      9.06      5.81         867       82         0.09 
Fidelity (FFIDX)              04/30/30     10.33      6.69        2138      156         0.07
AF Inv. Co. America (AIVSX)   01/02/34     12.53      9.15        6221      651         0.10
T.Rowe Price Growth (PRGFX)   04/11/50     10.81      8.55         385      117         0.30
Dodge and Cox Stock (DODGX)   01/04/65     11.69      9.37         116       47         0.41

Source: Pre and post tax returns from Vanguard.
*Indicative estimates using the funds inception dates as the start or end of year when they started – which ever was closer.
3. Tax efficient investing

IMO (and as the above illustrates) tax sensitive investing can yield significant returns (or rather reduce significant losses).

In this respect this may be useful: How to be a tax-savvy investor

FWIW – here are some TM funds which I like:
  • Vanguard Tax-Managed Capital Appreciation
    Vanguard Tax-Managed Small Cap
    Vanguard Tax-Managed International
..and for value tilters
  • DFA Tax-Managed US Marketwide Value
    DFA Tax-Managed US Targeted Value
    DFA Tax-Managed International Value
…and micro cap tilters
  • Bridgeway Ultra-Small Company Market
ETFs can also help (although some question whether the ‘tax loop hole’ they currently benefit from will remain). FWIW I still prefer TM funds (although use both TM funds and ETFs).

Two articles I found useful on ETFs and taxes which may be useful to others... Robert
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Last edited by Robert T on Wed Jun 18, 2008 8:26 am, edited 1 time in total.
pkcrafter
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Taxes

Post by pkcrafter »

Thanks Robert,

I agree that taxes will become a bigger issue in the near future.

You may want to note that all your figures are based on maximum tax rate.

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.
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Post by Wagnerjb »

Great post Robert!

Many investors pay more attention to the ER of a fund, but overlook that its turnover may be just as important, since it affects the tax liability (which can be considerably larger than the ER in many cases).

Best wishes.
Andy
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Post by Robert T »

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Paul,
You may want to note that all your figures are based on maximum tax rate.
Yes - that's important.

"After-tax returns are calculated using the highest individual federal income tax rates in effect at the time of each distribution. They do not reflect the impact of state and local taxes." [from the Vanguard website which was the source of the after-tax returns].

I presume this means that the after-tax returns from the 1930s reflect the income tax rates at time time of each distribution since then (and does not just use the current rates for past distributions).

Robert
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Post by Waiting for Godot »

Interesting. The Tax Managed Capital Appreciation seems more tax efficient than the total stock market if you look at their performance from inception. However, they started a few years apart, so it's hard to tell. One is not exactly comparing apples to apples here. Wonder if a combo of that fund with TM Small cap would prove better over the long haul in terms of tax efficiency. Did you look at that by chance? Also, I wonder how tax efficient VEU (FTSE INTL FUND) will be versus a combo of TM International and Emerging Markets. At least with the combo, you know one is tax managed.
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Post by Robert T »

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Wonder if a combo of that fund with TM Small cap would prove better over the long haul in terms of tax efficiency. Did you look at that by chance?
My take on ordering of tax efficiency is TM funds as most efficient, then ETFs, then conventional funds, even with potentially larger loss harvesting opportunities with ETFs and conventional funds (the benefits of loss harvesting seem to decline as portfolio size increases relative to TM funds). TSM is still fairly tax-efficient, but still think TM capital appreciation will be more tax efficient over the long-term (distributing less capital gains and better managing dividends to lower taxes). Could be wrong just my take. I don’t think the TM small cap fund needs to be added to TM capital appreciation to replicate the broader market TSM. The 650 or so stocks in TM capital appreciation likely make up about 85-90% of total market cap, so it already almost there.
Also, I wonder how tax efficient VEU (FTSE INTL FUND) will be versus a combo of TM International and Emerging Markets.
Personally I would go with a TM Intl:EM combination over the FTSE Intl Fund. The combination has a lower ER (0.15 and 0.37 versus 0.40 for the open-end fund versions; and 0.12 and 0.25 versus 0.25 for the ETF comparison) and will also generally be more tax efficient. There is an explicit tax-management focus on 80%+ of the combination (if EM held in same portion as FTSE Intl fund) – a benefit in my view. When countries shift from the ‘emerging’ to the ‘developed’ market index there will be a higher tax cost to the TM Intl:EM combination, and there may be more opportunities to loss-harvest with the FTSE Intl fund but do not think this will offset the benefits (I could be wrong).

FWIW – a few more articles that may be of interest if you have not seem them.

How Well Have Taxable Investors Been Served in the 1980s and 1990s?
Loss Harvesting: What’s It Worth to the Taxable Investor?

Robert
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Post by Waiting for Godot »

Thanks Robert for the articles. Will read them. I should have been more clear. I was thinking if one wanted to add a small cap tilt to the total stock market, then holding the combo of the Tax Managed Appreciation and Tax Managed Small Cap may yield a slightly higher return due their tax efficiency than tilting the total stock market toward small caps. If I recall correctly, I think you did an extensive analysis on the after tax results of holding small value, mid-cap value and large value in taxable accounts. However, I cannot recall the results from that analysis.
looking
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Post by looking »

HI Robert

exellent information thank you

i wonder if you can comment on my AA below regarding tax issues

so waht is the best approach for retired all taxable accounts

this is i have now all vangurads funds

TSM ( 50% fund 50% ETF VTI )
Large Value
small cap index
small cap value ( ETF ) VBR )

REIT ( ETF VNQ )

FSTE all world ex US ( 40% ETF VEU )
emerging ( ETF vwo )

total bond
tips
ST invest grade

best wishes

tomser
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Post by Sidney »

Anyone considering tax gain harvesting in 2008?
I always wanted to be a procrastinator.
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Post by gbs »

Tomser,

what tax bracket are you in?

Regards, gbs
tomser wrote:HI Robert

exellent information thank you

i wonder if you can comment on my AA below regarding tax issues

so waht is the best approach for retired all taxable accounts

this is i have now all vangurads funds

TSM ( 50% fund 50% ETF VTI )
Large Value
small cap index
small cap value ( ETF ) VBR )

REIT ( ETF VNQ )

FSTE all world ex US ( 40% ETF VEU )
emerging ( ETF vwo )

total bond
tips
ST invest grade

best wishes

tomser
looking
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Post by looking »

hi gbs
25% tax bracket
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gbs
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Post by gbs »

tomser,

First an observation regarding bonds. In your case, 25% marginal tax bracket, you might also want to consider tax-exempt bonds. Possible to use state municipal bonds from your state.

Otherwise three portfolio suggestions for you:


1.

40% TSM, 20% FTSE, 5% Money market, 25% shot term bonds (tax extempt or not), 10% intermediate or long term bonds.


2. 30% TSM, 5% VTMSX (small cap tax managed), 5% IJS (small cap value),
10% FSTE, 5% EM, 5% money market, 25% short term bonds, 15% intermediate/long term bonds.


3.

20% TSM, 10% VTMSX (small cap tax managed), 10% IJS (small cap value),
10% EM, 5% money market, 25% short term bonds, 20% intermediate/long term bonds.


In all cases at the intermediate/long term bond you can include:
- state specific tax extempt bonds
- intermediate tax extempt bonds
- tips
- total bond
- intermediate treasuries
- look into I-bonds

for short term bonds: corporates are taxed at federal and state level so make sure that after tax you will come ahead over short term tax extempt bonds or short term treasuries.


Hope this helps, gbs
tomser wrote:HI Robert

exellent information thank you

i wonder if you can comment on my AA below regarding tax issues

so waht is the best approach for retired all taxable accounts

this is i have now all vangurads funds

TSM ( 50% fund 50% ETF VTI )
Large Value
small cap index
small cap value ( ETF ) VBR )

REIT ( ETF VNQ )

FSTE all world ex US ( 40% ETF VEU )
emerging ( ETF vwo )

total bond
tips
ST invest grade

best wishes

tomser
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Post by Robert T »

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Waiting,
I was thinking if one wanted to add a small cap tilt to the total stock market, then holding the combo of the Tax Managed Appreciation and Tax Managed Small Cap may yield a slightly higher return due their tax efficiency.
I agree that TM funds should be more tax-efficient than funds that are not tax-managed. The iShares S&P 600 ETF should also be relatively tax efficient.
If I recall correctly, I think you did an extensive analysis on the after tax results of holding small value, mid-cap value and large value in taxable accounts. However, I cannot recall the results from that analysis
The results vary by index, but in general the ETF value funds have been relatively tax efficient (tax costs may be higher in the future). FWIW – here are a few earlier looks at value fund tax efficiency.

http://www.bogleheads.org/forum/viewtopic.php?p=85530
http://www.bogleheads.org/forum/viewtop ... highlight=

_______________________________________


Tomser
wonder if you can comment on my AA below regarding tax issues
In addition to gbs, just a few points to add/emphasize

1. I would skip REITs as they are tax inefficient.

2. Consider muni’s for fixed income (US treasuries are also exempt from state taxes).

3. If you want small/micro cap exposure – consider the Vanguard TM Small Cap or Bridgeway Ultra Small Co. Market (BRSIX).

4. For value I prefer mid over large caps, and this can simply be used in combination with a small/micro cap market fund to jointly get value and small cap exposure, or could simply use a SV fund to cover both. The iShares S&P600 value fund may be more tax efficient that VBR (obviously no guarantees).

Robert
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Post by Waiting for Godot »

Robert, those were the threads that I was referencing. Thanks for reposting.
looking
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Post by looking »

gbs and bob

thank you very much for time helping me
best wishes

tomser
looking
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Post by looking »

Hi bob
sorry i ask many.

i just wonder if you can tell me a bit detail __ for value I prefer mid over large cap---

thank you

tomser
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Post by Robert T »

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tomser,
just wonder if you can tell me a bit detail __ for value I prefer mid over large cap---
(1) large cap value funds typically have a negative size loading which subtracts from a portfolio that targets a positive size loading (i.e. IMO a large cap value fund does not make an efficient contribution to a portfolio targeting a small cap and value tilt – its adds to one and subtracts from the other). The link below show some earlier estimates of the size loadings of a few large cap value indexes.

Efficient ways to tilt to value

(2) Midcap value indexes are still relatively tax efficient (at least this is what the earlier analysis in the link below shows for the Russell and S&P midcap value indexes).

Large-Mid-Small cap tax efficiency comparison

Robert
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Post by Waiting for Godot »

Robert wrote: "If both approaches lead to the same portfolio size and value loadings and have the same expenses then the expected returns will be the same.

In my opinion it mainly comes down to asset class tracking error regret. For those with low tolerance (i.e. don’t like to see asset classes that they don’t hold do well, which in this case would be large value and small cap funds), the TSM, LV, SM & SV approach maybe the better option. For those with higher asset class tracking error tolerance the TSM & SV approach should suffice [FWIW I lean towards the former group]."

Question: Do you know how much was lost to taxes holding a value tilted portfolio like the ones you mentioned during one of the periods of high taxes that you referenced? As you pointed out, due to the lower current tax rates and the bear market of 2001 and 2002 along with the small correction we are undergoing right now, most funds look a lot more tax efficient than they probably will be in the future.

Also, let's say you decide that a combo of TSM, LV, SM & SV would probably be less tax efficient than TSM & SV combo in a taxable account, because you would have to rebalance among 4 funds and would hold two tax inefficient funds. I generally struggle with the question, will a combo of TSM and Tax Managed Small Cap vs. a combo of TSM and SV provide higher after tax returns? I find this a difficult question, because many of the value funds available do not compare that well with the TM SC. For example, Vanguard's tracks 1750 companies and has more mid caps. Ishares S&P 600 compares well but isn't that valuey, and I question how much it will differ in performance from vangaurd's TM SC. The rydex pure value will probably prove very tax inefficient. Also, size of premiums and future tax rates are obviously unknowable.
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Post by Robert T »

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Waiting,
In my opinion it mainly comes down to asset class tracking error regret. For those with low tolerance (i.e. don’t like to see asset classes that they don’t hold do well, which in this case would be large value and small cap funds), the TSM, LV, SM & SV approach maybe the better option. For those with higher asset class tracking error tolerance the TSM & SV approach should suffice [FWIW I lean towards the former group].
IMO it depends on the unit of analysis/focus – asset classes or the performance of the three equity factor premiums. Equity asset classes mostly just reflect differing mixes of the three premiums - market, size and value, just like most colors we see reflect differing mixes of three primary colors - red, green, and blue. If investors focus on asset class performance, then tracking error can be an issue, if they focus of factor premium performance – then asset class tracking error is less of an issue.

And my favorite quote from Bill Bernstein - “What matters over the long haul if factor exposure and expense.”
Question: Do you know how much was lost to taxes holding a value tilted portfolio like the ones you mentioned during one of the periods of high taxes that you referenced?
No, but you could probably estimate these with current distributions and higher tax rates as an indicative estimate. IMO recent tax-efficiency provides a useful indication of the relative ordering of impacts across portfolios. Time will tell.
I generally struggle with the question, will a combo of TSM and Tax Managed Small Cap vs. a combo of TSM and SV provide higher after tax returns?
It depends on what small and value loads you are trying to target. If your value load targets are modest then a TSM-TM SC may be preferable (the underlying benchmark for the TM SC fund [S&P 600] already has a value load of about 0.4 – at least the last time I checked using monthly data from Feb 94 – Sept 06, and the fund has tracked this index fairly closely). If your target value load is large, then a TSM-SV fund combo may be preferable.
Also, size of premiums and future tax rates are obviously unknowable.
Yes, as Bernstein said – “It's like everything else in finance. There is no certainty, only probabilities, and you go where they are the highest. (This is also true of the value and small premia. If they were absolutely certain, then they would have been arbitraged away. And, in 2006, maybe they have already. But the rational investor should still place his or her bets there.)”

Robert
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