Taxable account dilemma

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smartin
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Taxable account dilemma

Post by smartin »

I'm in the process of trying to revamp our investment portfolio. I've done a fair amount of reading on asset allocation and learned a lot from this forum. Thank you all so much for your edifying posts!

Here is my fundamental problem: I have a portfolio big enough to slice and dice to my hearts content but the vast majority (over 90%) is in taxable accounts. And we'll never have enough in tax exempt to make a dent in this problem, no matter what contributions we make to retirement accounts.

Does that mean I should just give up on things like REIT's or small value? Or might it still be worth it to hold these in taxable (since it's hold them in taxable or don't hold them at all)? How do I go about figuring out this tradeoff? I'm starting to look at after tax return estimates on all the Vanguard index funds but don't know how best to research this.

Thanks for any guidance.
Sally Martin
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alvinsch
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Post by alvinsch »

We are also more than 90% taxable but before offering any ideas it might be useful to all to know your marginal tax bracket (federal and state).
- Al
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smartin
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Marginal tax rates

Post by smartin »

I'm sorry, I should have included that. We are definitively in federal 28% bracket and can slip into 33% depending on income from investments. Our state tax is 5% (Massachusetts).

Thanks, Sally
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alvinsch
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Post by alvinsch »

One compromise we have made is that instead of "slicing and dicing to our hearts content", we "sliver and quiver" in the face of the tax code. Basically, we try to choose the parts of slice and dice that might make the biggest difference. So for example we use TSM mixed with SV but no LV or MV tho we do have some intl value (would recommend VTMGX or new V ETF as core however).

Regarding REITs, we do have REITs but have a smaller allocation than I'd like as we evenly split our IRA's between bonds and REITs but the majority of our bonds are in tax exempt. However, we are in the 25% bracket (no state tax), but if one is in higher tax bracket then one could think about the REIT-VA. Personally, I would only consider this if I was in the 33-35% brackets but others may feel differently.

In MA you'll want to think about state specific TE funds since I assume you want at least some bonds. Should have reminded you to specify your target allocation. Vanguard's only MA fund appears to be long term so you might consider it but keep all other bonds short to compensate.

The good news for slice and dice in taxable is the advent of so many ETF choices. For SV, it seems like IJS is currently the most tax efficient (possibly more efficient than TSM due to lower dividends), but not as valuey or small as other choices. Seems like EFV wouldn't be a bad choice for value tilting in international.

The ETF's really should lower the probability of capital gains distributions but one still needs to watch the dividend level, especially if the special qualified dividend rate is allowed to expire in 2011 as it now appears will happen.

So bottom line is that you don't have to totally give up on slice and dice but you might want to be judicious about how far you go and what you use. However, I wouldn't suggest putting REITs in taxable because besides the tax cost, it also will complicate your filing since REIT 1099's come very late and are likely to have non-taxable distributions that affect your basis making record keeping potentially very complicated.

BTW: You might want to list your target allocation to refine the advice. Also is AMT an issue?

Hope this helps and other chime in with more suggestions.
- Al
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nick22
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On the positive side

Post by nick22 »

It at least sounds like you have a lot of money saved. Having taxable accounts will certainly limit your moves, and impact rebalancing and AA equations. I'm not sure you will want to slice and dice, unless you want to tax protection by paying the 0.3% cost premium for a Vanguard Variable Annuity. If most of your money will be in taxable, then you will probably want to stuff any REiTs on the tax-advantaged side followed by any remaining % for bonds. You may end up with municipal bonds in the taxable account too, depending on your AA. As far as funds are concerned, in taxable accounts I like the tax-managed funds and I avoid frequent transactions.

Am I crazy for considering the Vanguard variable annuity here? It may not be cost effective, but it is a thought.
Nick22
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Murray Boyd
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Post by Murray Boyd »

Tilting value is pretty much out. Value would have to outperform by about a couple percent just to break even with the total market after taxes. William Bernstein (Mr. Slice and Dice) recommends a ration of large to small of 2:1 for taxable accounts. You could invest in Tax-Managed Small-Cap, but a lot of folks are worried it's going to have to distribute big gains soon.

I'm almost all taxable too. I just stick with Total Stock Market. If it's any consolation there's no guarantee that S&D will work in the future.
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Doc
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On compromising.

Post by Doc »

Al wrote:
One compromise we have made …
Back when I was making investment decisions for a living I learned that you should never make a decision to invest or not invest based on tax implications. If the decision doesn’t make sense before taxes don’t do it. In this situation you have the reverse. If REITS make sense to you they should be part of your asset allocation regardless if you have a tax preferenced account.

Another thing to consider is that the list of which assets to put in sheltered accounts are probably out of date. At one time REITS kicked out 10+ % of distributions annually taxed at ordinary rates. That number is now closer to 3% making them arguably more tax efficient than bonds. Similarly, the large dividends from value stocks currently are taxed at favorable capital gains rates making them more tax efficient than in the past.

One thing you can still do with slice and dice is put treasury securities in taxable and corporates in tax advantaged accounts to retain the state tax deduction if it applies to you.

Remember, the easiest way to reduce taxes on your investments is to lose all your money. :(
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.
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alvinsch
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Re: On compromising.

Post by alvinsch »

Doc wrote:Back when I was making investment decisions for a living I learned that you should never make a decision to invest or not invest based on tax implications.
So no one should ever own tax exempt bonds since they earn less than taxable bonds? ;)

I agree it seldom makes sense to base an investment solely on taxation but seems crazy to ignore the tax implications. Haven't heard that suggested before. Did I misunderstand?

Good point about REITs being more tax efficient than they use to be.

- Al
Laura
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The Four Pillars of Investing

Post by Laura »

William Bernstein in his book The Four Pillars of Investing addresses this type of situation. He is the king of slice and dice but for people with only taxable accounts he gives most of that up and focuses on tax efficiency. He suggests holding REITs in a variable annuity.
If you haven't read the book I highly recommend it.

Laura
The views presented are my own and not necessarily those of the Department of State or the U.S. Government.
PatrickS
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Post by PatrickS »

I'm in a similar situation regarding taxable verus tax-advantaged. Bordering on 28/33% plus a 9.3% state rate (CA). I built a spread sheet comparing holding reits in a taxable versus Vanguard variable annuity. Break even occurred at the eight year mark and I was ahead after that with the VA, even assuming retirement one year later (with lower bracket).

Recommendations made by others sound good. Do whatever you can to increase your tax-advantaged accounts. If you have any kids, or other family that you plan to help with school, you can fund a 529 plan. You can make non-deductible IRA contributions and (hopefully) convert to roth in 2010. These will give you at least some space for rebalancing without tax consequences.

Make sure you direct all cap gains and dividend distributions from taxable account funds to a money market account rather than auto re-invest them. You can use that money to help you rebalance without additional taxation.
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smartin
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Thank you!

Post by smartin »

Thanks so much for the suggestions! You have suggested many things I had never considered (or heard of for that matter e.g. a VA which I will now research).

I have read Four Pillars of Investing but it was a while ago and I will read it again now that I have a better handle on my issues.

We are in our mid 40's. We sometimes have AMT issues - we have high state/property tax and mortgage interest deductions (the joys of life in Massachusetts!).

My target allocation is 75% stocks, 25% bonds. I could fill up my tax advantaged accounts with bonds and I would still need bonds in taxable. That is one the the things I'm trying to sort out - whether it's better to 1) fill up tax advantaged accounts with bonds with the balance of the bonds in muni's or 2) use tax advantaged accounts for SV and REIT and have 100% of bond allocation in munis in the taxable account. Sounds like I need to really get some hard numbers and put pencil to paper to figure that out.

- Sally
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Doc
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Al, on compromising.

Post by Doc »

Al wrote:
So no one should ever own tax exempt bonds since they earn less than taxable bonds?
Do they make sense on there own? Yes. They often earn as much as MM accounts or short term CD’s so they can make sense without the tax considerations. They may not be the best but they still make sense. The tax considerations just sweeten the pot.

I’m not saying that tax considerations should be ignored, just that tax considerations shouldn’t dominate the decision.

In their zeal for minimizing taxes people often forget that the objective is not to minimize taxes but to maximize (after tax) return.

On second thought, I don’t need no stink’n muni’s anyways. :)
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.
BrianTH
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Post by BrianTH »

One more idea:

I think to some extent you can swap the small premium for the value premium. For example, roughly speaking, if you would have held 10% of equity in SV, I think you could justifying holding up to 20% in SB instead (10% for the small premium in SV, and 10% more to replace the value premium in SV). Similarly, if you would have held another 10% in LV, I think you could add that 10% to SB. Holding aside the reservation mentioned above (about a possible gains overhang), you could then use Tax-Managed Small Cap in place of SV and LV in a taxable portfolio.

Unfortunately, I don't think this works for REITs. One thing I would note, though, is that you should check how much in REITs you other funds hold, because it may add up to a decent amount.
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alvinsch
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Re: The Four Pillars of Investing

Post by alvinsch »

Laura wrote:William Bernstein in his book The Four Pillars of Investing addresses this type of situation. He is the king of slice and dice but for people with only taxable accounts he gives most of that up and focuses on tax efficiency. He suggests holding REITs in a variable annuity.
If you haven't read the book I highly recommend it.

Laura
Since the book came out long before the advent of more tax efficient ETF's, I wonder if anyone has read anything more recently about whether he feels the same way.
Murray Boyd wrote:Tilting value is pretty much out.
When you rule out any value tilting do you base that more on the tax cost of the funds or the tax cost of rebalancing?

I keep coming back to things like IJS (small value), that I believe should lose less to taxes than the total stock market fund VTSMX, and wonder to what extend ETF's have changed the debate.

Regards,
- Al
Laura
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From Dr. Bernstein

Post by Laura »

I found this on Dr. Bernstein's website addressing ETFs

http://www.efficientfrontier.com/ef/104/stupid.htm

Laura
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Laura
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Here is another

Post by Laura »

Here is another article from the Dr. but with a different view

http://www.efficientfrontier.com/ef/901/shootout.htm

Laura
The views presented are my own and not necessarily those of the Department of State or the U.S. Government.
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lucky7
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smartin' in case you revisit-

Post by lucky7 »

Smartin' one of the my first post questions was very similiar to yours. I wanted to know if could emulate the Coffeehouse portfolio in a taxable account with Vanguard. See original forum post # 50685 if wish. Taylor's response (#5) within the post was basically in keeping with a prior poster and suggested for me within Vanguard: 30% TSM; 10% SCV; 10%TM (tax managed) international; 10% REIT (in an annuity); and 40% Intermediate tax Exempt Bond. As an aside I have REIT index option within a 403b, but the e.r. a lot more than Vanguard's V.A. Also since am in high tax state went with NJ tax exempt fund. Perhaps similiar for Mass. The Vanguard DHs reply were very helpful and since our situations may overlap perhaps it could help. Anyways good luck.

Bob
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