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Impact of tax (in)efficiency

Posted: Sat Feb 09, 2019 6:48 pm
by bck63
I'm still a newbie and trying to figure out the impact of taxes on distributions in the Fidelity Total Market and Vanguard Total Market index funds in my taxable account.

When I compare the "return after taxes on distributions", the Fidelity Total Market Index Fund (FSKAX) 10-year return was 12.71% and Vanguard Total Market Index Fund was 12.79% -- a difference of 8 basis points (correct?). This is all new to me, but I found a handy basis point calculator which tells me that the difference is $80 per $100,000.

Is all the discussion about tax efficiency really worth it? It may very well be. I honestly don't know. But I'm not going to lose sleep over eighty bucks per 100K invested.

Of course, I've only recently begun paying very close attention to my investing, so my calculations and assumptions might be totally wrong. Someone please tell me if I'm correct or not. Thank you.

Re: Impact of tax (in)efficiency

Posted: Sat Feb 09, 2019 6:53 pm
by bluquark
It doesn't matter in that context. The main reason is that stock fund tax efficiency has improved so much over the years, like ER. Both ER and tax efficiency are not good reasons anymore to pick one reputable stock index fund over another.

Tax considerations still matters a *lot* when it comes to where you put your bonds, whether you should use tax-exempt bonds, and how you rebalance in taxable accounts. Those are the contexts where you should be laser focused on tax considerations.

Re: Impact of tax (in)efficiency

Posted: Sat Feb 09, 2019 6:57 pm
by bck63
bluquark wrote:
Sat Feb 09, 2019 6:53 pm
It doesn't matter in that context. The main reason is that stock fund tax efficiency has improved so much over the years, like ER. Both ER and tax efficiency are not good reasons anymore to pick one reputable stock index fund over another.

Tax efficiency still matters a *lot* when it comes to bonds.
Okay thanks. If you have a minute could you explain tax efficiency with regard to bonds? And do you mean bond funds?

Re: Impact of tax (in)efficiency

Posted: Sat Feb 09, 2019 7:04 pm
by bluquark
See https://www.bogleheads.org/wiki/Tax-eff ... _placement the section "Tax-efficiency of bonds".

For tax purposes, there's no difference between bonds and bond funds. (I don't recommend holding individual bonds.)

Re: Impact of tax (in)efficiency

Posted: Sun Feb 10, 2019 8:47 am
by bck63
bluquark wrote:
Sat Feb 09, 2019 7:04 pm
See https://www.bogleheads.org/wiki/Tax-eff ... _placement the section "Tax-efficiency of bonds".

For tax purposes, there's no difference between bonds and bond funds. (I don't recommend holding individual bonds.)
Thanks for the link.

Re: Impact of tax (in)efficiency

Posted: Sun Feb 10, 2019 12:26 pm
by grabiner
bck63 wrote:
Sat Feb 09, 2019 6:48 pm
I'm still a newbie and trying to figure out the impact of taxes on distributions in the Fidelity Total Market and Vanguard Total Market index funds in my taxable account.

When I compare the "return after taxes on distributions", the Fidelity Total Market Index Fund (FSKAX) 10-year return was 12.71% and Vanguard Total Market Index Fund was 12.79% -- a difference of 8 basis points (correct?). This is all new to me, but I found a handy basis point calculator which tells me that the difference is $80 per $100,000.
It's an annual cost, so it would be $800 for a 10-year investment.

It may also not match your tax situation. The standardized calculations assume the highest federal tax bracket (but ignores the 3.8% Medicare surtax) and no state tax. If you buy a fund which distributes 0.5% of its value in long-term capital gains each year, the cost to you may be 0.08% (15% tax on capital gains, no state tax) or 0.17% (20% federal tax, 3.8% Medicare surtax, 9-10% state tax).

Re: Impact of tax (in)efficiency

Posted: Sun Feb 10, 2019 3:29 pm
by bck63
grabiner wrote:
Sun Feb 10, 2019 12:26 pm
bck63 wrote:
Sat Feb 09, 2019 6:48 pm
I'm still a newbie and trying to figure out the impact of taxes on distributions in the Fidelity Total Market and Vanguard Total Market index funds in my taxable account.

When I compare the "return after taxes on distributions", the Fidelity Total Market Index Fund (FSKAX) 10-year return was 12.71% and Vanguard Total Market Index Fund was 12.79% -- a difference of 8 basis points (correct?). This is all new to me, but I found a handy basis point calculator which tells me that the difference is $80 per $100,000.
It's an annual cost, so it would be $800 for a 10-year investment.

It may also not match your tax situation. The standardized calculations assume the highest federal tax bracket (but ignores the 3.8% Medicare surtax) and no state tax. If you buy a fund which distributes 0.5% of its value in long-term capital gains each year, the cost to you may be 0.08% (15% tax on capital gains, no state tax) or 0.17% (20% federal tax, 3.8% Medicare surtax, 9-10% state tax).
Thanks so much Grabiner. I am in the 22% federal tax bracket and pay 5.5% state taxes. Trying to figure out how to calculate what my cost would be then.

Re: Impact of tax (in)efficiency

Posted: Sun Feb 10, 2019 4:01 pm
by livesoft
There is a spreadsheet available to figure out one's personal cost. But one has to understand the spreadsheet and populate the cells with proper numbers.

See: viewtopic.php?t=242137

Re: Impact of tax (in)efficiency

Posted: Sun Feb 10, 2019 5:26 pm
by willthrill81
bluquark wrote:
Sat Feb 09, 2019 7:04 pm
For tax purposes, there's no difference between bonds and bond funds. (I don't recommend holding individual bonds.)
I'm assuming that you would be okay with holding individual Treasuries and TIPS.

Re: Impact of tax (in)efficiency

Posted: Sun Feb 10, 2019 9:01 pm
by anil686
I think the big thing about tax efficiency (IMHO) is that it is an additional expense that is a little more difficult to plan for. For example, with your ER - it comes out of the dividends typically distributed from the funds. For taxes, you are responsible for that $80. You have to either withold more per month, pay it at tax time (instead of investing the $80 which would be $160 potentially in 10 years, $320 in 20 years, $640 in 30 years) or sell shares to pay the taxes. It is phantom income to you if you are not receiving the dividends and instead are just re-investing them. Thus, it is beneficial when all things are equal, to use funds with more tax efficiency if - again - all things are equal. However, sometimes customer service at Fidelity may matter more, or automating investments in mutual funds over ETFs may matter more. So things may not be equal in your case. I don't think, however, that taxes are not an important consideration. Again, IMO, tax efficiency is more important than the ridiculously low ER differences between Vg, Schwab and Fidelity.

Last point, tax efficiency should not be viewed in isolation of a particular year, but thought of as if you did not sell for the desired holding time period. If your plan is to hold it for 40 years, the tax consequences could be more significant in terms of opportunity cost as well as yearly tax payments. Again, JMO though...

Re: Impact of tax (in)efficiency

Posted: Mon Feb 11, 2019 2:51 pm
by bck63
Thanks to everyone for their great replies.