which fund to start with in taxable investing?

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which fund to start with in taxable investing?

Postby novice90046 » Thu May 31, 2007 12:46 am

Now that I reached my goal for an emergency fund, contributed already to Roth IRA for 2007, and am contributing regularly to 401(k) to get my employer's match, I would like to start with taxable investing. I have hard time deciding which (Vanguard) fund to choose.

My goal is to buy a home in about 5 years or so. I'm just starting and choosing short-term bonds (as suggested by many questionnaires) does not sound very promising. Therefore, I'm ready to take a bigger risk and would like to focus on stocks (even 100% stocks). This is how I see it: if I get lucky and market makes more than 5%, I'll take the money as soon as I have 20% for downpayment. If market goes down, I'll just keep it there and wait for market to come back, even though that might mean no home in next 10 years.

I have only about $3K to start with, and since it's the minimum amount required by Vanguard (except for STAR fund), I was wandering which single fund to choose. Vanguard's STAR fund allows for min of $1K, it is balanced (though only ~60% stocks), but has e/r of 0.35% and no index funds in it. Ideally, I would choose TargetRetirement2040 because of its diversified asset allocation, but that one is known not to be tax-efficient. The problem I have with TotalStockMarketIndex fund is that it includes only domestic and no international stocks.

Other things of interest: I'm single, in mid 30s, tax bracket 28%, TR2030 fund (or similar) in non-taxable accounts.

Is there anything I'm not aware of that should drive my decision which fund to choose?

Thanks a lot!
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Postby Kevinm1986 » Thu May 31, 2007 1:12 am

One idea would be to max out any 401k/Roths available to you before starting a taxable account. The Roth contributions can always be withdrawn without penalties or taxes (and there's an additional provision for withdrawing money to put toward a house), so that can go towards a house (it could even be an emergency fund, too). The downside is losing the great benefit of a Roth--no taxes, but from one point of view, it's better to have the money avoiding taxes, even if just for a few years, than in a taxable account.

Then, of course, there's the whole buying vs. owning a house debate. If buying a house will be better for you financially, would you really want to put it off for several years if the stock market doesn't fare well?

The question I would ask myself is "How much money will I need for a down payment?" Then I would ask, "How much can I afford to save each year for this house?" If you can save enough each year that by the end of five years you'll be fine with a money market kind of return, why take any more risk? And if you need to get 10+% a year on your savings for a house, do you have a realistic chance of acheiving those returns without an undue amount of risk? Probably not.

Basically, I would say this: take as little risk as possible. If it's not possible to meet your goals without a lot of risk, then you need to decide whether to change when to buy your house or to change how much it will cost.
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Postby darko » Thu May 31, 2007 6:23 am

Kevinm1986 wrote:One idea would be to max out any 401k ... before starting a taxable account.


This is indeed the case if you are investing for retirement or another goal in some distant future. But if you need money in a few years, say for a downpayment on your home, then you can't "lock" that money into 401k.

As for the original question: I'd start taxable investing with the Total Market Index if you'll buy-and-hold for long. But if you need money in a few years, you probably need something less risky. Bond funds or money market funds sound like a good choice, but you should take into account tax efficiency. Maybe muni bonds would work the best for you? From your ZIP code, it seems you're in California, so you should also look into funds that take state tax into account.
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Postby livesoft » Thu May 31, 2007 8:20 am

I do not believe a house down payment should be saved in CD or money market fund unless you have a drop-dead date where you must absolutely use the money.

Most house-buying goals are nebulous as in "I want to buy a house in 5 years or so." To me that means that if you don't have the money in 5 years, you could wait another year if you had to.

We saved for our house down payment by investing in equity mutual funds. We used Vanguard Windsor II. Sure it went up and down while we were saving, but we put more money in each year than any unrealized gain or loss. The idea of using total stock market is also good. Even a target retirement fund (date 2040 to 2050) is good.

I say forget about munis, CDs, money markets for this. If the stock market does well, you buy a bigger house or buy sooner. If the stock market does poorly, you buy later.
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Postby YDNAL » Thu May 31, 2007 8:59 am

novice90046,

If you have a pre-determined place you'll like to own first (say, the nice condo on the hill), consider an option that I discussed on another thread. There's a lease-option (NOT lease-purchase) contract:
- You lease the property for X years with a pre-determined price at the end of the contract.
- If the market price goes down, you walk away, if the market price goes up, you go for it. You are making money here.
- A portion of the lease, typically 5%-20% is applied towards a down payment. You are saving money here.
- A typical contract is 1-3 years. Sellers typically don't want to wait longer, but who knows?
- Always consult an Attorney before signing anything legal. A sharp real estate person can help you negotiate.

To the main question..... If the goal to have enough money for a downpayment is 5 years, then the Tax Managed funds (must hold 5 years) are excellent for taxable accounts. I also agree with Kevinm1986.... "take as little risk as possible".

Regards,
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Postby Kevinm1986 » Thu May 31, 2007 2:27 pm

darko wrote:
Kevinm1986 wrote:One idea would be to max out any 401k ... before starting a taxable account.


This is indeed the case if you are investing for retirement or another goal in some distant future. But if you need money in a few years, say for a downpayment on your home, then you can't "lock" that money into 401k.


You don't want it "locked" into a 401k, but you can withdraw from a Roth. So you could increase 401k contributions to offset the fact that you plan to withdraw from your Roth later.
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Postby darko » Fri Jun 01, 2007 12:17 am

Kevinm1986 wrote:You don't want it "locked" into a 401k, but you can withdraw from a Roth. So you could increase 401k contributions to offset the fact that you plan to withdraw from your Roth later.


I understand now what you wanted to say. It's a neat idea in theory. In practice, one needs to consider how the investment options in 401k compare to saving some tax for a few years. Also, where can one find the exact rules for withdrawing from Roth IRA? I remember reading something about five years but not exactly what it referred to.
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Postby Dino » Fri Jun 01, 2007 6:05 pm

I decided on the Target Retirement 2045 for my taxable account. My reasoning is that it has only 10% bonds and some international exposure, so by starting out with the minimum of $3000 I won't be facing a large tax problem for quite some time. Then maybe I could switch to a more tax efficient fund. I don't know how sound my reasoning is on this. :?:

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Postby BigBird » Fri Jun 01, 2007 6:28 pm

darko wrote:Also, where can one find the exact rules for withdrawing from Roth IRA? I remember reading something about five years but not exactly what it referred to.


Your original contribution amounts can be withdrawn tax-free and penalty-free at any time. The earnings, however, are subject to the 5 year period and a qualifying event.

Here is a good source of detailed information: http://www.fairmark.com/rothira/
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Dino--Target fund in taxable account?

Postby Taylor Larimore » Fri Jun 01, 2007 8:23 pm

I decided on the Target Retirement 2045 for my taxable account. My reasoning is that it has only 10% bonds and some international exposure, so by starting out with the minimum of $3000 I won't be facing a large tax problem for quite some time. Then maybe I could switch to a more tax efficient fund. I don't know how sound my reasoning is on this."


Your instinct is correct. You are probably making a mistake.

It is true that your Target Retirement 2045 Fund will not make large taxable distributions in the early years, However, in later years, when the fund becomes much larger and bond heavy, your fund will distribute large distributions each year mostly taxed at income tax rates.

The problem will come when you want to switch to a permanent tax-efficient fund. At that time, you will pay a capital gain tax on all your profit leaving that much less to reinvest.

I would exchange to a more tax-efficient fund(s) in your taxable account as soon as it is reasonable to do so. Total Stock Market Index Fund is usually the best choice.

Best wishes.
Taylor

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Postby Dino » Sun Jun 03, 2007 12:53 am

Thanks for the good advice, Taylor. I may keep the fund for just a year or 2 while it is still small (I won't have much to contribute to my taxable acc.) and then switch to TSM or something as efficient. What I like about the TR fund is the better diversification in one fund.

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Postby novice90046 » Sun Jun 03, 2007 2:27 pm

Thank you all for your replies. I got many ideas, I see there are many options available, and I still need to investigate more on each.

I also did some calculations in the meantime. Based on my last year's expenses, I estimate that it would take me about 4 years to save for home downpayment if the interest on that (after-tax) money is 0%, today's dollars (no salary increase, no inflation). Therefore, I compared total amounts I would have if I invested each year 15K in 2 hypothetical accounts, one with 5% returns (as with regular savings, or money market fund) and the other with 10% returns (as with stocks), and 28% tax bracket. The difference at the end of the 4th year was about $3K5, which is probably not worth the risk of investing on stocks for such a short period.

A couple of questions:
1.
Kevinm1986 wrote:Then, of course, there's the whole buying vs. owning a house debate.

I'm afraid I don't quite understand what is meant by this.

2.
Taylor Larimore wrote:It is true that your Target Retirement 2045 Fund will not make large taxable distributions in the early years, However, in later years, when the fund becomes much larger and bond heavy, your fund will distribute large distributions each year mostly taxed at income tax rates.

The problem will come when you want to switch to a permanent tax-efficient fund. At that time, you will pay a capital gain tax on all your profit leaving that much less to reinvest.

Does this mean that switching from TR2045 to some other fund in 5 years from now would not make large taxable distributions, since TR2045 in 5 years would have pretty much the same amount of bonds as TR2040 has now? Both TR2045 and TR2040 have less than 10% in bonds now.

3. Also, is there any regulation about using 401(k) funds for buying a home without penalties, or that would be considered as early withdrawal?

Thanks, again!
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Novice--TR fund in taxable?

Postby Taylor Larimore » Sun Jun 03, 2007 3:16 pm

Taylor Larimore wrote:
"It is true that your Target Retirement 2045 Fund will not make large taxable distributions in the early years, However, in later years, when the fund becomes much larger and bond heavy, your fund will distribute large distributions each year mostly taxed at income tax rates.

The problem will come when you want to switch to a permanent tax-efficient fund. At that time, you will pay a capital gain tax on all your profit leaving that much less to reinvest."
---------------------------------------------------

Does this mean that switching from TR2045 to some other fund in 5 years from now would not make large taxable distributions, since TR2045 in 5 years would have pretty much the same amount of bonds as TR2040 has now? Both TR2045 and TR2040 have less than 10% in bonds now.

No. Switching from TR 2045 in five years could result in a large taxable distribution because all of the profit will subject to a capital gain tax leaving that much less to reinvest in a new fund.

Best wishes.
Taylor
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Postby grabiner » Sun Jun 03, 2007 3:53 pm

novice90046 wrote:A couple of questions:
1.
Kevinm1986 wrote:Then, of course, there's the whole buying vs. owning a house debate.

I'm afraid I don't quite understand what is meant by this.


You have to decide whether buying or renting a house is the better decision, and it isn't so clear; it depends on a variety of factors. There are several other discussions on this board.

2.
Taylor Larimore wrote:It is true that your Target Retirement 2045 Fund will not make large taxable distributions in the early years, However, in later years, when the fund becomes much larger and bond heavy, your fund will distribute large distributions each year mostly taxed at income tax rates.

The problem will come when you want to switch to a permanent tax-efficient fund. At that time, you will pay a capital gain tax on all your profit leaving that much less to reinvest.


Does this mean that switching from TR2045 to some other fund in 5 years from now would not make large taxable distributions, since TR2045 in 5 years would have pretty much the same amount of bonds as TR2040 has now? Both TR2045 and TR2040 have less than 10% in bonds now.


If you buy and hold TR2045, it won't make large taxable distributions now, but it will eventually shift to holding more bonds and those distributions will be taxable. But if you buy TR2045 now and sell it in five years, you'll pay capital-gains tax on all of the fund's gains, even if you reinvest in the individual funds that it holds, or in another fund which has the same holdings.

This is why you don't want to hold a balanced fund in a taxable account. If you have both stocks and bonds in the same fund, you have to sell stocks in order to change your bond holdings, and you will pay an unnecessary tax bill.

In contrast, if your first taxable investment is Total Stock Market, or FTSE All-World Ex US, you won't need to sell that fund as long as you have the money invested. The amount you hold in Total Stock Market may vary over time, but the fund will still belong in your investment plan.

3. Also, is there any regulation about using 401(k) funds for buying a home without penalties, or that would be considered as early withdrawal?


Some 401(k) plans allow you to take a loan from the plan for buying a home; do this only if your job is secure, as you will have to pay off the loan immediately if you leave your job, or else the outstanding loan will be converted to an early withdrawal and a big tax bill. You can make limited Roth IRA withdrawals for a first-time home purchase.
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