Why all the talk about owning some funds in taxable accounts vs tax preferred accounts

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vm81
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Joined: Fri Jan 03, 2020 2:24 pm

Why all the talk about owning some funds in taxable accounts vs tax preferred accounts

Post by vm81 »

I keep reading here how VTI or VSUX are great. Some Fidelity funds are great but "dont like owning them in taxable accounts". I am just trying to understand what makes some of these market funds better in tax advantaged accounts vs taxable accounts? I understand the benefits of tax preferred vs taxable account ofcourse - just trying to get a sense of why one fund is better in certain account. Is there something I should be looking at that tells me if the fund is tax preferred somehow?

Thank you
MotoTrojan
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Re: Why all the talk about owning some funds in taxable accounts vs tax preferred accounts

Post by MotoTrojan »

When funds sell they can incur capital gains just like you, and have to pass them along. ETFs and any VG mutual fund with an ETF share class can almost always avoid passing these on, making them more tax-efficient.

Also some equities have less qualified dividends (REITs in particular), making them less tax efficient as you’ll pay full income tax on dividends.
petulant
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Re: Why all the talk about owning some funds in taxable accounts vs tax preferred accounts

Post by petulant »

Mutual funds must pass dividend and capital gain income to their shareholders--that is, you, the investor. For a mutual fund that invests in a stock index, that means transactions necessary to track the index like selling shares to reflect the reduced market cap from buybacks, or sales recognized due to mergers and acquisitions, would be passed on to shareholders. ETFs and Vanguard mutual funds that are structured as share classes of ETFs avoid this effect because they can "wash" the gains out through ETF basket purchases and redemptions. The bottom line is that non-Vanguard mutual funds can lead to surprise tax bills for shareholders, while ETFs do not. ETFs and Vanguard mutual funds are therefore preferred in taxable accounts.
almostretired1965
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Re: Why all the talk about owning some funds in taxable accounts vs tax preferred accounts

Post by almostretired1965 »

It is all about taxes. In a tax advantaged account, all else being equal, you should go with whatever fund is expected to generate the highest expected return. In a taxable account, if the higher return is the result of lots of turnover, that may generate excess capital gains that will be taxed immediately, whereas, e.g., Vanguard's various stock index funds will generate no capital gains in the short term. The cost of paying those taxes "early" may outweigh the benefits from the higher returns.
dbr
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Re: Why all the talk about owning some funds in taxable accounts vs tax preferred accounts

Post by dbr »

Yes, it is about taxes, but the language should probably not be "don't like" so much as "have a disadvantage that." Word such as "like" are ambiguous and also emotive when the case comes down to quantitative facts.
MittensMoney
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Re: Why all the talk about owning some funds in taxable accounts vs tax preferred accounts

Post by MittensMoney »

Taking money out of a tax advantaged account as a retiree means you'll be taxing that money as ordinary income. High growth stocks going into a taxable account then taxed at Long Term Gains (10%) when divested to pay for your lifestyle can often be more tax efficient than that same funds gains being counted as ordinary income if held in an IRA. This is different in a ROTH IRA, where you pay the taxes up front on your income and then are able to take money out tax-free when the time comes.
MittensMoney
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Re: Why all the talk about owning some funds in taxable accounts vs tax preferred accounts

Post by MittensMoney »

almostretired1965 wrote: Mon Aug 24, 2020 2:38 pm It is all about taxes. In a tax advantaged account, all else being equal, you should go with whatever fund is expected to generate the highest expected return.
Isn't a regular IRA one of the worst places to hold your high growth stocks? You'll pay ordinary income on those gains when taken out, versus a taxable account where you're only paying 10% long term cap gains rates.
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FiveK
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Re: Why all the talk about owning some funds in taxable accounts vs tax preferred accounts

Post by FiveK »

MittensMoney wrote: Mon Aug 24, 2020 2:58 pm
almostretired1965 wrote: Mon Aug 24, 2020 2:38 pm It is all about taxes. In a tax advantaged account, all else being equal, you should go with whatever fund is expected to generate the highest expected return.
Isn't a regular IRA one of the worst places to hold your high growth stocks? You'll pay ordinary income on those gains when taken out, versus a taxable account where you're only paying 10% long term cap gains rates.
See Tax-efficient fund placement - Bogleheads for a more detailed discussion.

Note that in taxable account, your initial investment amount is post-tax while a regular IRA contribution is pre-tax, so the taxable investment would be lower than the corresponding regular IRA investment. Then the taxable account is also subject to annual taxes on interest, dividends, etc., and then federal capital gains tax (15% is the lowest non-zero bracket) and likely ordinary income state tax when sold.

But yes, a Roth IRA would likely be better than a traditional IRA for any 100-bagger stocks you plan to have.
GMT-8
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Re: Why all the talk about owning some funds in taxable accounts vs tax preferred accounts

Post by GMT-8 »

But yes, a Roth IRA would likely be better than a traditional IRA for any 100-bagger stocks you plan to have.
Could you please state this in plain English? I cannot understand what you mean.

Thank you

GMT
petulant
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Re: Why all the talk about owning some funds in taxable accounts vs tax preferred accounts

Post by petulant »

GMT-8 wrote: Mon Aug 24, 2020 4:55 pm
But yes, a Roth IRA would likely be better than a traditional IRA for any 100-bagger stocks you plan to have.
Could you please state this in plain English? I cannot understand what you mean.

Thank you

GMT
"100-bagger" means a stock that grows to be worth 100 times what it cost for investment. He is making a sarcastic reference to the poster's expectation of investing in high-growth stocks.

The Roth IRA would be better for these stocks because, once paid, the investment will no longer incur tax, whereas in a traditional IRA the very high returns could force income into a higher tax bracket.
GMT-8
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Re: Why all the talk about owning some funds in taxable accounts vs tax preferred accounts

Post by GMT-8 »

Thank you
Topic Author
vm81
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Re: Why all the talk about owning some funds in taxable accounts vs tax preferred accounts

Post by vm81 »

Thanks a lot everyone for your input. Generally I try to keep track of all nuances but somehow never thought about this issue. Well have a better understanding now :)

I have mostly always been single stock guy, so moving into funds is new.
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LilyFleur
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Re: Why all the talk about owning some funds in taxable accounts vs tax preferred accounts

Post by LilyFleur »

MittensMoney wrote: Mon Aug 24, 2020 2:55 pm Taking money out of a tax advantaged account as a retiree means you'll be taxing that money as ordinary income. High growth stocks going into a taxable account then taxed at Long Term Gains (10%) when divested to pay for your lifestyle can often be more tax efficient than that same funds gains being counted as ordinary income if held in an IRA. This is different in a ROTH IRA, where you pay the taxes up front on your income and then are able to take money out tax-free when the time comes.
This is all true under current tax laws, which--as we saw recently in the case of the "stretch IRA"--are subject to change.
chrisam314
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Re: Why all the talk about owning some funds in taxable accounts vs tax preferred accounts

Post by chrisam314 »

Using a fund like VSMGX that is a diversified one stop shop that people like (numbers are hypothetical to give you a good rule of thumb)

If you were to invest $5000 per year into a fund that pays out 2% in dividends and capital gains in a taxable account you would pay a total of $4,368 in taxes on those payouts over a 20 year time horizon.

This assumes a 3% unrealized return(as in price increase) and a 2% payout per year, or a total return of 5%. it also assumes you qualify for 15% LTCG and dividends (so you arent raking in $400K or more). All dividends and Cap gains were considered qualified for simplicity sake and reinvested. And lastly it assumes you buy and hold.

Some people view that as the cost of simplicity & leads to avoiding behavioral pitfalls (selling at bad times). You can have one fund in every account thats well diversified. You can see that unless you have a substantial amount of money the taxes are relatively small (the total taxes paid through year 10 are $962 or a simple average of $96 per year in this example). It works out to about 0.3% per year. When you start getting large balances it gets more material.

At the end of this example (year 20) you would have a balance of $163K, with $44K of unrealized gains. Under current tax code if you had taxable income of less than $80K per year (married filing jointly) you could sell and realize those gains at a zero tax rate. So think someone who is retired or semi-retired for this example. If the dollars were in a 401K you would pay your normal income tax when you take distributions. If its Roth its tax free to distribute earnings assuming you are 59.5 or older.

The analysis is highly sensitive to assumptions/tax code/ personal situation and goals.
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