Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

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Topic Author
ltv
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Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by ltv »

Hi All! We are high W2 earners in California so we face some pretty steep taxes. I am hoping to get some opinions on how I should think about our tax efficiency. Please see details below.

Emergency funds: yes
Debt: 1.7 million mortgage (i know) - 30 year fixed at 2.875%
Tax Filing Status: MFJ
Tax Rate: 37% Federal, 12.3% State
State of Residence: CA
Age: 32
Desired Asset allocation: 80% stocks / 20% bonds
Desired International allocation: 25% of stocks
Current Portfolio: ~1.25 million

Current retirement assets
Taxable currently at Vanguard
0% Cash
23% VTSAX
10.75% VTIAX

His 401k - 70% pre-tax 30% After tax(will soon to be rolled over to a new solo 401k at Fidelity)
17.67% VBTIX
3.89% Institutional 500

His Roth IRA at Vanguard
2.63% VTSAX
1.23% VTIAX

Her 401k at Fidelity (75% pre tax 25%After tax
28.92% State Street U.S. Total Market Index Securities Lending Series Fund Class II (.015% ER)
6.53% International large blend (.045% ER)

Her Roth IRA at Vanguard
3.49% VTSAX
1.93% VTIAX

Contributions
  • $400k for the taxable account over the next 2 months (bonus, stock vest, and a house sale)
  • $6k in each IRA each year
  • $58k in each 401k year
  • ~$600k taxable annually. It’s looking like this amount of savings will continue for the foreseeable future
Goals and other info
  • Thanks to this forum I’ve set up an easy set it and forget it 3 fund portfolio. I have an excel sheet tracking all allocations and “rebalancing” is done by simply adjusting the ratios of new purchases/contributions.
  • My goal is to continue a sustainable and somewhat simple portfolio. Simple to me means that I can plug in a few numbers on my excel sheet, and know how to rebalance or purchase to keep my AA. I don't mind deviating from a 3 fund portfolio but I do want a strategy that is sustainable and wont need to change for the next 5-10 years.
  • I’m going to be moving all of our accounts to Fidelity in the coming months, so please bear that in mind when making fund suggestions.
Questions:
  1. Our income has really picked up the last two years which has me thinking a lot more about tax efficiency. I’ve followed the conventional wisdom thus far, but other similar threads have had suggestions at this high of a tax level to move to muni bonds in taxable and keep bonds out of the tax advantaged accounts. Does that seem right here? How do I choose the right muni bonds?
  2. I haven't been taking advantage of tax loss harvesting but would like to moving forward. Other threads have recommended keeping VTI in taxable and then Fidelity funds in the tax advantaged accounts. (FZROX and FZILX).
  3. Moving forward we will have low 100-200k chunks to invest at discrete intervals, rather than continual monthly contributions. I imagine the wisdom doesn’t change here and I should keep closing my eyes and stuffing cash into VTSAX? Does the calculus on dollar cost averaging vs. lump sum change as the investment amount gets higher?
Last edited by ltv on Sun Apr 11, 2021 10:54 am, edited 2 times in total.
mc7
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by mc7 »

Bonds and bond-like investments are certainly interesting for tax optimization.

Some opinions:

The bond index is a weird best. It includes Treasuries, which notably are free of state tax, and therefore sort-of-OK in your taxable accounts. But it also has "federal" bonds like housing agencies that are not. After years of Vanguard bond index investing I eventually "broke it up" into different components.

Apart from the state tax advantage, Treasuries are currently inferior to CDs. So long as you keep to the FDIC limits, they are both extremely low default risk. Depending on duration and marginal state rate, CDs may or may not make sense for you. It's also somewhat of a hassle to get the best CD rates in tax deferred--the secondary market rates available through brokers have been trailing what you get directly from the bank.

Munis are clearly higher risk, but exactly how much higher is a whole can of worms.

If you are willing to take higher risk for fixed income, and really excited about tax deferral, you could consider a multi-year "guaranteed" annuity. I think of these as safer than junk bonds but riskier than investment-grade corporate bonds.

Curious to hear how your tax optimization adventure unfolds.

Good luck!


(Edited to clarify reference to "investment-grade corporate bonds")
Tingting1013
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by Tingting1013 »

At that high of a tax rate I would not use VTSAX at all. You’re paying close to 0.5% annually in tax cost on the dividends.

SCHG in taxable, VTV in tax advantaged. 50/50 ratio.
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anon_investor
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by anon_investor »

Since the OP's taxable account is at Vanguard, why not just buy Vanguard Tax-Managed Capital Appreciation Fund Admiral Shares (VTCLX)?
Tingting1013
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by Tingting1013 »

anon_investor wrote: Sat Apr 10, 2021 3:11 pm Since the OP's taxable account is at Vanguard, why not just buy Vanguard Tax-Managed Capital Appreciation Fund Admiral Shares (VTCLX)?
Because its tax efficiency is pretty much the same as VTSAX
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anon_investor
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by anon_investor »

Tingting1013 wrote: Sat Apr 10, 2021 3:12 pm
anon_investor wrote: Sat Apr 10, 2021 3:11 pm Since the OP's taxable account is at Vanguard, why not just buy Vanguard Tax-Managed Capital Appreciation Fund Admiral Shares (VTCLX)?
Because its tax efficiency is pretty much the same as VTSAX
Except for the lower dividend yield, which is what the OP is being taxed on. Also 100% qualified dividends vs. 95%+. It probably will not make a huge difference, but might make sense at the top tax bracket.
Tingting1013
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by Tingting1013 »

anon_investor wrote: Sat Apr 10, 2021 4:18 pm
Tingting1013 wrote: Sat Apr 10, 2021 3:12 pm
anon_investor wrote: Sat Apr 10, 2021 3:11 pm Since the OP's taxable account is at Vanguard, why not just buy Vanguard Tax-Managed Capital Appreciation Fund Admiral Shares (VTCLX)?
Because its tax efficiency is pretty much the same as VTSAX
Except for the lower dividend yield, which is what the OP is being taxed on. Also 100% qualified dividends vs. 95%+. It probably will not make a huge difference, but might make sense at the top tax bracket.
1.36% vs 1.2% yield is not a big difference.

Not like 1.36% vs 0.4% per my suggestion above.
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anon_investor
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by anon_investor »

Tingting1013 wrote: Sat Apr 10, 2021 4:20 pm
anon_investor wrote: Sat Apr 10, 2021 4:18 pm
Tingting1013 wrote: Sat Apr 10, 2021 3:12 pm
anon_investor wrote: Sat Apr 10, 2021 3:11 pm Since the OP's taxable account is at Vanguard, why not just buy Vanguard Tax-Managed Capital Appreciation Fund Admiral Shares (VTCLX)?
Because its tax efficiency is pretty much the same as VTSAX
Except for the lower dividend yield, which is what the OP is being taxed on. Also 100% qualified dividends vs. 95%+. It probably will not make a huge difference, but might make sense at the top tax bracket.
1.36% vs 1.2% yield is not a big difference.

Not like 1.36% vs 0.4% per my suggestion above.
True, I think the yield spread between VTSAX and VTCLX has been larger in the past. But certainly easier to just have VTCLX in taxable and VTSAX in IRA versus 50/50 value index in IRAs and growth index in taxable.
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retired@50
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by retired@50 »

ltv wrote: Sat Apr 10, 2021 2:40 pm
Questions:
  1. Our income has really picked up the last two years which has me thinking a lot more about tax efficiency. I’ve followed the conventional wisdom thus far, but other similar threads have had suggestions at this high of a tax level to move to muni bonds in taxable and keep bonds out of the tax advantaged accounts. Does that seem right here? How do I choose the right muni bonds?
It does seem right to me.

I'd suggest keeping the account at Vanguard to have easy access to their excellent CA muni bond funds.
Consider VCADX (intermediate term, Admiral with $50,000 initial buy-in or use VCAIX with $3,000 initial investment)
Also VCLAX (long term, Admiral with $50,000 initial buy-in or use VCITX with $3,000 initial investment)

Regards,
This is one person's opinion. Nothing more.
corp_sharecropper
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by corp_sharecropper »

40%+? Wow. I'm trying to figure out what it takes to get to that level. To clarify, this is not your marginal rate, right? Literally 40%+ of your gross income is taken by fed/state/local taxes, not various payroll deferrals for retirement/insurance/whatever, all to tax man?

That's insane. Good grief, what are the state & local taxes where you live?
Tingting1013
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by Tingting1013 »

corp_sharecropper wrote: Sat Apr 10, 2021 5:43 pm 40%+? Wow. I'm trying to figure out what it takes to get to that level. To clarify, this is not your marginal rate, right? Literally 40%+ of your gross income is taken by fed/state/local taxes, not various payroll deferrals for retirement/insurance/whatever, all to tax man?

That's insane. Good grief, what are the state & local taxes where you live?
For salary: 37% Federal + 13.3% CA + 1% Additional Medicare tax = 51.3%

For qualified dividends (relevant for this discussion on taxable investment tax efficiency): 20% Federal + 3.8% NIIT + 13.3% CA = 37.1%

Reading between the lines, I’m guessing OP is grossing $1.5M per year in income
Topic Author
ltv
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by ltv »

mc7 wrote: Sat Apr 10, 2021 2:53 pm The bond index is a weird best. It includes Treasuries, which notably are free of state tax, and therefore sort-of-OK in your taxable accounts. But it also has "federal" bonds like housing agencies that are not. After years of Vanguard bond index investing I eventually "broke it up" into different components.
Thanks for all of your insight, after further reading and all of the comments here, you are right that I need to bite the bullet and break up my fixed income portion. Appreciate your suggestions, I'll need some time to dive into those.

Tingting1013 wrote: Sat Apr 10, 2021 2:56 pm SCHG in taxable, VTV in tax advantaged. 50/50 ratio.
1) Apologies for the noob question, but why SCHG so much more tax efficient than VTSAX? Trying to learn as I go here. 0.5% cost is way higher than I was expecting
2) How does SCHG compare to the wiki suggestion of 90% Vanguard Tax-Managed Capital Appreciation (lower dividend yield) and 10% Tax-Managed Small-Cap (100% qualified dividends)

anon_investor wrote: Sat Apr 10, 2021 4:26 pm True, I think the yield spread between VTSAX and VTCLX has been larger in the past. But certainly easier to just have VTCLX in taxable and VTSAX in IRA versus 50/50 value index in IRAs and growth index in taxable.
Thanks for your insights

retired@50 wrote: Sat Apr 10, 2021 4:37 pm It does seem right to me.

I'd suggest keeping the account at Vanguard to have easy access to their excellent CA muni bond funds.
Consider VCADX (intermediate term, Admiral with $50,000 initial buy-in or use VCAIX with $3,000 initial investment)
Also VCLAX (long term, Admiral with $50,000 initial buy-in or use VCITX with $3,000 initial investment)
Thanks suggestions. I've had on my list to dive into muni bonds a bit further. I'll start with the two you recommended. This would kill my dream of one login to rule them all (ive been really into the Fidelity as a one stop shop idea), but I guess that's how it goes

corp_sharecropper wrote: Sat Apr 10, 2021 5:43 pm 40%+? Wow. I'm trying to figure out what it takes to get to that level. To clarify, this is not your marginal rate, right? Literally 40%+ of your gross income is taken by fed/state/local taxes, not various payroll deferrals for retirement/insurance/whatever, all to tax man?

That's insane. Good grief, what are the state & local taxes where you live?
Yes, when I calculate how much of a stock vest or a bonus we can plan on keeping I literally type *0.6 into the calculator. Total insanity. I recognize how fortunate our situation is though so I don't sweat it.

Tingting1013 wrote: Sat Apr 10, 2021 5:46 pm For salary: 37% Federal + 13.3% CA + 1% Additional Medicare tax = 51.3%

For qualified dividends (relevant for this discussion on taxable investment tax efficiency): 20% Federal + 3.8% NIIT + 13.3% CA = 37.1%

Reading between the lines, I’m guessing OP is grossing $1.5M per year in income
Yea just about. We have some schedule C and Schedule E income from a couple real estate investments so there is a little more involved.

AGI was right about 1 million for 2020. $308k Federal taxes for a 31.3% effective rate and $95k to CA for a 9.4% effective rate. Will be higher this year as AGI for 2021 is going to be around 1.7 basically all of which will be W2. I'm still reeling at these numbers, 5 years ago we ago we were making $250k combined....
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retired@50
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by retired@50 »

ltv wrote: Sat Apr 10, 2021 6:36 pm
retired@50 wrote: Sat Apr 10, 2021 4:37 pm It does seem right to me.

I'd suggest keeping the account at Vanguard to have easy access to their excellent CA muni bond funds.
Consider VCADX (intermediate term, Admiral with $50,000 initial buy-in or use VCAIX with $3,000 initial investment)
Also VCLAX (long term, Admiral with $50,000 initial buy-in or use VCITX with $3,000 initial investment)
Thanks suggestions. I've had on my list to dive into muni bonds a bit further. I'll start with the two you recommended. This would kill my dream of one login to rule them all (ive been really into the Fidelity as a one stop shop idea), but I guess that's how it goes
Consider that you'll be able to keep 100% of the monthly dividends paid out by the tax exempt bond funds.

When you compare that to keeping whatever (lower) percentage of dividends you're actually allowed to keep when using stock index funds, then the decision starts to get easier to comprehend.

I'd suggest you send a private message to user "grabiner", who frequently analyzes tax implications for situations like this.

Finally, if you really want to hold the Vanguard funds at Fidelity, it's possible, but you'll have to put up with the annoying (perhaps petty) fee of $75 to purchase. If you purchase in large lots, like $50,000 a pop, then it may not be so bad. Double check with Fidelity about the fee structure and whether or not you're allowed to hold the Vanguard California Tax-Exempt bond funds AT Fidelity.

Regards,
This is one person's opinion. Nothing more.
Tingting1013
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by Tingting1013 »

ltv wrote: Sat Apr 10, 2021 6:36 pm
Tingting1013 wrote: Sat Apr 10, 2021 2:56 pm SCHG in taxable, VTV in tax advantaged. 50/50 ratio.
1) Apologies for the noob question, but why SCHG so much more tax efficient than VTSAX? Trying to learn as I go here. 0.5% cost is way higher than I was expecting
2) How does SCHG compare to the wiki suggestion of 90% Vanguard Tax-Managed Capital Appreciation (lower dividend yield) and 10% Tax-Managed Small-Cap (100% qualified dividends)
VTSAX contains all stocks, including the ones that pay dividends. You are taxed 37% on every dollar of dividend.

VTSAX is essentially half growth stocks (that generally don’t pay dividends) and half value stocks (that generally do pay dividends):

https://www.portfoliovisualizer.com/bac ... tion3_2=50

VTSAX is yielding 1.3% right now. You are paying 37% tax on that yield. So you are paying 0.5% taxes on every dollar you invest into VTSAX in taxable.

SCHG only contains growth stocks. It’s yielding 0.4%. So your tax cost for holding SCHG in taxable is only 0.1%.

Let’s say you have $2M total portfolio, $1M in taxable and $1M in 401k/IRA.

Holding VTSAX for all $2M means you are paying $5k per year in taxes.

Holding SCHG for the $1M taxable and VTV (or similar low cost value index fund) for the $1M in 401k/IRA means you are only paying $1k per year in taxes, resulting in $4k per year in tax savings.

The tax managed fund you mention is still yielding 1.2%. That doesn’t do much to lower your taxes, you might as well just hold VTSAX.
Last edited by Tingting1013 on Sat Apr 10, 2021 7:10 pm, edited 3 times in total.
Mollinska
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by Mollinska »

I'll take your noob question and raise you a noob question :happy :

How are you able to invest in an IRA when your income is so high? I make way less $ than you, but I may not invest in an IRA because my income is too high. Or are you describing a "backdoor IRA" when you refer to contributing "$6k in each IRA each year"?

Thanks!
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ltv
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by ltv »

retired@50 wrote: Sat Apr 10, 2021 6:46 pm
ltv wrote: Sat Apr 10, 2021 6:36 pm
retired@50 wrote: Sat Apr 10, 2021 4:37 pm It does seem right to me.

I'd suggest keeping the account at Vanguard to have easy access to their excellent CA muni bond funds.
Consider VCADX (intermediate term, Admiral with $50,000 initial buy-in or use VCAIX with $3,000 initial investment)
Also VCLAX (long term, Admiral with $50,000 initial buy-in or use VCITX with $3,000 initial investment)
Thanks suggestions. I've had on my list to dive into muni bonds a bit further. I'll start with the two you recommended. This would kill my dream of one login to rule them all (ive been really into the Fidelity as a one stop shop idea), but I guess that's how it goes
Consider that you'll be able to keep 100% of the monthly dividends paid out by the tax exempt bond funds.

When you compare that to keeping whatever (lower) percentage of dividends you're actually allowed to keep when using stock index funds, then the decision starts to get easier to comprehend.

I'd suggest you send a private message to user "grabiner", who frequently analyzes tax implications for situations like this.

Finally, if you really want to hold the Vanguard funds at Fidelity, it's possible, but you'll have to put up with the annoying (perhaps petty) fee of $75 to purchase. If you purchase in large lots, like $50,000 a pop, then it may not be so bad. Double check with Fidelity about the fee structure and whether or not you're allowed to hold the Vanguard California Tax-Exempt bond funds AT Fidelity.

Regards,
Yea, that makes sense, I'll need to spend some time in excel to really see the difference, I think. Too many variables to wrap my head around. I'll definitely reach out to grabiner once I understand a bit more and can ask better questions. Cheers
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Prokofiev
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by Prokofiev »

corp_sharecropper wrote: Sat Apr 10, 2021 5:43 pm 40%+? Wow. I'm trying to figure out what it takes to get to that level.

That's insane. Good grief, what are the state & local taxes where you live?

You must be young. I started a job in 1978. By 1980-82 I was in a Fed marginal bracket of
50% or more each year. My Fed + state tax was 50-54%

But here is the kicker . . .

In 1980 I earned about $42k.
1981=$47k
1982 = $54k

Yes, in 2021 dollars I was relatively well paid. Around $150k/year.
But today I would pay around 26-29% on those amounts. Things have changed . . .
Everything should be made as simple as possible, but not simpler - Einstein
Topic Author
ltv
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by ltv »

Tingting1013 wrote: Sat Apr 10, 2021 7:00 pm
ltv wrote: Sat Apr 10, 2021 6:36 pm
Tingting1013 wrote: Sat Apr 10, 2021 2:56 pm SCHG in taxable, VTV in tax advantaged. 50/50 ratio.
1) Apologies for the noob question, but why SCHG so much more tax efficient than VTSAX? Trying to learn as I go here. 0.5% cost is way higher than I was expecting
2) How does SCHG compare to the wiki suggestion of 90% Vanguard Tax-Managed Capital Appreciation (lower dividend yield) and 10% Tax-Managed Small-Cap (100% qualified dividends)
VTSAX contains all stocks, including the ones that pay dividends. You are taxed 37% on every dollar of dividend.

VTSAX is essentially half growth stocks (that generally don’t pay dividends) and half value stocks (that generally do pay dividends):

https://www.portfoliovisualizer.com/bac ... tion3_2=50

VTSAX is yielding 1.3% right now. You are paying 37% tax on that yield. So you are paying 0.5% taxes on every dollar you invest into VTSAX in taxable.

SCHG only contains growth stocks. It’s yielding 0.4%. So your tax cost for holding SCHG in taxable is only 0.1%.

Let’s say you have $2M total portfolio, $1M in taxable and $1M in 401k/IRA.

Holding VTSAX for all $2M means you are paying $5k per year in taxes.

Holding SCHG for the $1M taxable and VTV (or similar low cost value index fund) for the $1M in 401k/IRA means you are only paying $1k per year in taxes, resulting in $4k per year in tax savings.

The tax managed fund you mention is still yielding 1.2%. That doesn’t do much to lower your taxes, you might as well just hold VTSAX.
This is very clear, thank you for taking the time to write this all out. I understand now. The only wrinkle in this is that my wife's 401k doesn't have any value funds. It has a cheap total market fund, a cheap international fund, some bond options, and the VG target date funds. I should be able to make the AA work for a bit, but eventually we'll have too much in the taxable. I can model this out and see how it looks over the next couple of years. Rolling my(his) 401k over to IRAs or a solo-401k will be help as I'll have access to VTV or similar.

Given the yield on VTIAX I assume it makes sense to hold the international allocation in my wife's 401k? That would free up some space for the SHCG/VTV strategy
Topic Author
ltv
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by ltv »

Mollinska wrote: Sat Apr 10, 2021 7:06 pm I'll take your noob question and raise you a noob question :happy :

How are you able to invest in an IRA when your income is so high? I make way less $ than you, but I may not invest in an IRA because my income is too high. Or are you describing a "backdoor IRA" when you refer to contributing "$6k in each IRA each year"?

Thanks!
You got it. Back door Roth IRA contributions for both
gjlynch17
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by gjlynch17 »

Congratulations on your career and financial success. You have gotten some good advice above and I would share the following based on me being in a similar situation (older and slightly lower state tax but same general tax challenges).

First, I would absolutely put all of your bond allocation in taxable munis. Unless you are highly certain you will be in a combined 50% marginal tax rate in retirement, the tax drag on dividends are likely to outweigh the benefits of holding higher yielding bond funds in tax deferred accounts. See the thread below for helpful calculators to estimate your specific situation.

viewtopic.php?f=1&t=286785

One challenge you will have is finding good bond funds if you are consolidating everything at Fidelity. One advantage that Vanguard has over Fidelity is that there bond funds are superior. At Vanguard, you could do the David Grabiner recommendation of combining California Long-Term Tax Exempt (VCLAX) with Limited Term Tax Exempt (VMLUX) for a good low-cost portfolio. At Fidelity, you would need to go with either an all national muni fund / ETF (e.g. Fidelity Muni Index (FMBIX), iShares Muni ETF (MUB), Vanguard Muni Index ETF (VTEB) or Fidelity Tax Free Bond Fund (FTABX)) or combine it with a higher cost ETF (e.g. iShares California Muni ETF (CMF)).

Second, I would not invest in the Vanguard Tax Managed Funds, especially if you want to consolidate at Fidelity. I have held Tax Managed Capital Appreciation (VTCLX) and Tax Managed Small Cap (VTMSX) for over 20 years and they are fine funds. However, with the advent of ETFs, the tax advantages that the Tax Managed funds once had have largely disappeared and IMO their disadvantages of slightly higher costs, lower lending revenue and lack of portability outweigh their advantages. I still hold my Tax Managed funds because of their built in capital gains but I no longer make new contributions to them.
Tingting1013
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by Tingting1013 »

ltv wrote: Sat Apr 10, 2021 7:43 pm
Tingting1013 wrote: Sat Apr 10, 2021 7:00 pm
ltv wrote: Sat Apr 10, 2021 6:36 pm
Tingting1013 wrote: Sat Apr 10, 2021 2:56 pm SCHG in taxable, VTV in tax advantaged. 50/50 ratio.
1) Apologies for the noob question, but why SCHG so much more tax efficient than VTSAX? Trying to learn as I go here. 0.5% cost is way higher than I was expecting
2) How does SCHG compare to the wiki suggestion of 90% Vanguard Tax-Managed Capital Appreciation (lower dividend yield) and 10% Tax-Managed Small-Cap (100% qualified dividends)
VTSAX contains all stocks, including the ones that pay dividends. You are taxed 37% on every dollar of dividend.

VTSAX is essentially half growth stocks (that generally don’t pay dividends) and half value stocks (that generally do pay dividends):

https://www.portfoliovisualizer.com/bac ... tion3_2=50

VTSAX is yielding 1.3% right now. You are paying 37% tax on that yield. So you are paying 0.5% taxes on every dollar you invest into VTSAX in taxable.

SCHG only contains growth stocks. It’s yielding 0.4%. So your tax cost for holding SCHG in taxable is only 0.1%.

Let’s say you have $2M total portfolio, $1M in taxable and $1M in 401k/IRA.

Holding VTSAX for all $2M means you are paying $5k per year in taxes.

Holding SCHG for the $1M taxable and VTV (or similar low cost value index fund) for the $1M in 401k/IRA means you are only paying $1k per year in taxes, resulting in $4k per year in tax savings.

The tax managed fund you mention is still yielding 1.2%. That doesn’t do much to lower your taxes, you might as well just hold VTSAX.
This is very clear, thank you for taking the time to write this all out. I understand now. The only wrinkle in this is that my wife's 401k doesn't have any value funds. It has a cheap total market fund, a cheap international fund, some bond options, and the VG target date funds. I should be able to make the AA work for a bit, but eventually we'll have too much in the taxable. I can model this out and see how it looks over the next couple of years. Rolling my(his) 401k over to IRAs or a solo-401k will be help as I'll have access to VTV or similar.

Given the yield on VTIAX I assume it makes sense to hold the international allocation in my wife's 401k? That would free up some space for the SHCG/VTV strategy
VTIAX does have a high yield but it is offset by foreign tax credit if you hold it in taxable. I actually prefer to hold international in taxable. With the foreign tax credit, its tax cost for you is somewhere between SCHG and VTSAX.

Does your wife’s 401k contain a self-directed brokerage option that allows you to invest in anything?

I would suggest a strategy like this:

1. Hold all of your international in taxable.
2. Hold your bonds entirely in CA muni bond fund in taxable or just cash.
3. Hold as much Value stock as possible in 401k/IRA
4. Hold an equal amount as #3 in Growth stock in taxable.
5. For any remaining taxable or non-taxable space hold VTSAX.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by Tingting1013 »

One major caveat to my post above. International is only appropriate to hold in taxable if you hold IXUS, iShares’s fund, instead of VTIAX. For some reason the Vanguard fund is much less tax efficient than iShares, even though they are both Total International index funds.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by grabiner »

Given your very high tax rate, I would recommend holding US stock in taxable where possible. You get the same foreign tax credit as everyone else, but you pay a higher tax cost on dividends, particularly on non-qualified dividends. Since international stock funds have higher dividend yields and more non-qualified dividends, this results in a higher tax cost to you.

For similar reasons, you may want to hold bonds in your taxable account as CA munis, rather than in your tax-advantaged account. You pay the same tax cost on CA munis as everyone else (about 1/3 of the muni yield, compared to taxable bonds of comparable risk), but you pay 31.1% tax on qualified dividends versus the usual 15%.

In your tax bracket, you would get a small net advantage from using 90% Vanguard Tax-Managed Capital Appreciation and 10% Tax-Managed Small-Cap over Total Stock Market Index. The tax-managed funds are more expensive, but given your high tax rate, you would save more in dividend tax than you pay in expenses. (This difference is only a few basis points, so it may not be worth making a more complex portfolio.)

But your best taxable investment is probably paying down the mortgage until it reaches $1M (or $750K if not grandfathered). This would pay down non-deductible debt, giving a risk-free return equal to the mortgage rate. Once you reach the limit for deductible interest, you probably don't want to pay it down any further, as deductions at 49.3% halve the after-tax return on mortgage paydown.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by dmcmahon »

I will second the idea of paying down the mortgage. You are unlikely net positive after taxes versus any bond holdings. Especially if you face deduction caps.
I’m in a similar position though not in the topmost bracket. But even at 35% + 3.8% + 12.3% I’m north of 50% on a marginal basis. Here’s the kicker: if you have any investment income, consider the marginal effect of kicking an investment income dollar across the line from 15% to 23.8%, and possibly higher rates in future. If you cost that tax drag against the income dollar that you could have avoided by retiring, your effective tax rate could be 75%.
This analysis convinced me that I need to restructure my investments to avoid taxable investment income. It suggests going all in on tax deferred vehicles, moving international to tax deferred, and holding yieldless growth investments in taxable. Unfortunately I’ve already locked in some level of unavoidable investment income thanks to past decisions to defer taxes by putting retirement assets into charitable trusts, which I do not regret but which I must now account for when planning. My biggest regret is holding bonds in tax-advantaged accounts and not going all in on Roth contributions. I’m currently in the process of aggressively converting those assets to Roth.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by ltv »

gjlynch17 wrote: Sat Apr 10, 2021 8:11 pm Congratulations on your career and financial success. You have gotten some good advice above and I would share the following based on me being in a similar situation (older and slightly lower state tax but same general tax challenges).

First, I would absolutely put all of your bond allocation in taxable munis. Unless you are highly certain you will be in a combined 50% marginal tax rate in retirement, the tax drag on dividends are likely to outweigh the benefits of holding higher yielding bond funds in tax deferred accounts. See the thread below for helpful calculators to estimate your specific situation.

viewtopic.php?f=1&t=286785

One challenge you will have is finding good bond funds if you are consolidating everything at Fidelity. One advantage that Vanguard has over Fidelity is that there bond funds are superior. At Vanguard, you could do the David Grabiner recommendation of combining California Long-Term Tax Exempt (VCLAX) with Limited Term Tax Exempt (VMLUX) for a good low-cost portfolio. At Fidelity, you would need to go with either an all national muni fund / ETF (e.g. Fidelity Muni Index (FMBIX), iShares Muni ETF (MUB), Vanguard Muni Index ETF (VTEB) or Fidelity Tax Free Bond Fund (FTABX)) or combine it with a higher cost ETF (e.g. iShares California Muni ETF (CMF)).

Second, I would not invest in the Vanguard Tax Managed Funds, especially if you want to consolidate at Fidelity. I have held Tax Managed Capital Appreciation (VTCLX) and Tax Managed Small Cap (VTMSX) for over 20 years and they are fine funds. However, with the advent of ETFs, the tax advantages that the Tax Managed funds once had have largely disappeared and IMO their disadvantages of slightly higher costs, lower lending revenue and lack of portability outweigh their advantages. I still hold my Tax Managed funds because of their built in capital gains but I no longer make new contributions to them.
This thread and the calculator were super helpful, thanks for sharing. There is so much great information in this forum it's incredible. I think the plan to consolidate at Fidelity is on hold for a bit while I figure out my new fund selection and placement. I will optimize for the best portfolio and then pick the Brokerages that match what I need.

Noted on the tax managed accounts. I'll spend a little time today understanding these better
Tingting1013 wrote: Sat Apr 10, 2021 8:16 pm
ltv wrote: Sat Apr 10, 2021 7:43 pm
Tingting1013 wrote: Sat Apr 10, 2021 7:00 pm
ltv wrote: Sat Apr 10, 2021 6:36 pm
Tingting1013 wrote: Sat Apr 10, 2021 2:56 pm SCHG in taxable, VTV in tax advantaged. 50/50 ratio.
1) Apologies for the noob question, but why SCHG so much more tax efficient than VTSAX? Trying to learn as I go here. 0.5% cost is way higher than I was expecting
2) How does SCHG compare to the wiki suggestion of 90% Vanguard Tax-Managed Capital Appreciation (lower dividend yield) and 10% Tax-Managed Small-Cap (100% qualified dividends)
VTSAX contains all stocks, including the ones that pay dividends. You are taxed 37% on every dollar of dividend.

VTSAX is essentially half growth stocks (that generally don’t pay dividends) and half value stocks (that generally do pay dividends):

https://www.portfoliovisualizer.com/bac ... tion3_2=50

VTSAX is yielding 1.3% right now. You are paying 37% tax on that yield. So you are paying 0.5% taxes on every dollar you invest into VTSAX in taxable.

SCHG only contains growth stocks. It’s yielding 0.4%. So your tax cost for holding SCHG in taxable is only 0.1%.

Let’s say you have $2M total portfolio, $1M in taxable and $1M in 401k/IRA.

Holding VTSAX for all $2M means you are paying $5k per year in taxes.

Holding SCHG for the $1M taxable and VTV (or similar low cost value index fund) for the $1M in 401k/IRA means you are only paying $1k per year in taxes, resulting in $4k per year in tax savings.

The tax managed fund you mention is still yielding 1.2%. That doesn’t do much to lower your taxes, you might as well just hold VTSAX.
This is very clear, thank you for taking the time to write this all out. I understand now. The only wrinkle in this is that my wife's 401k doesn't have any value funds. It has a cheap total market fund, a cheap international fund, some bond options, and the VG target date funds. I should be able to make the AA work for a bit, but eventually we'll have too much in the taxable. I can model this out and see how it looks over the next couple of years. Rolling my(his) 401k over to IRAs or a solo-401k will be help as I'll have access to VTV or similar.

Given the yield on VTIAX I assume it makes sense to hold the international allocation in my wife's 401k? That would free up some space for the SHCG/VTV strategy
VTIAX does have a high yield but it is offset by foreign tax credit if you hold it in taxable. I actually prefer to hold international in taxable. With the foreign tax credit, its tax cost for you is somewhere between SCHG and VTSAX.

Does your wife’s 401k contain a self-directed brokerage option that allows you to invest in anything?

I would suggest a strategy like this:

1. Hold all of your international in taxable.
2. Hold your bonds entirely in CA muni bond fund in taxable or just cash.
3. Hold as much Value stock as possible in 401k/IRA
4. Hold an equal amount as #3 in Growth stock in taxable.
5. For any remaining taxable or non-taxable space hold VTSAX.
Ah, yes she does. It's through Fidelity and there is a "brokerage link" option. I'll look into this further, thanks for the tip.

These recommendations are pretty clear, I just have a couple more basic questions.
1) I assume all of this movement is done through new contributions right? Meaning the VTSAX and VTIAX shares sitting in my taxable are going to stay there for the foreseeable future
2) How are you calculating "tax efficiency" of VTIAX vs. IXUS? Is it as simple as yield*tax - foreign tax credit?
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by ltv »

grabiner wrote: Sat Apr 10, 2021 10:29 pm Given your very high tax rate, I would recommend holding US stock in taxable where possible. You get the same foreign tax credit as everyone else, but you pay a higher tax cost on dividends, particularly on non-qualified dividends. Since international stock funds have higher dividend yields and more non-qualified dividends, this results in a higher tax cost to you.
Your recommendation is to hold all of my international portion in tax advantaged accounts? I guess some of this will depend on how much space of have in each account after moving bonds to taxable. It will take some time to get all of this sorted and moved, but fortunately this will be a pretty high contribution year, particularly the next few months.

grabiner wrote: Sat Apr 10, 2021 10:29 pm For similar reasons, you may want to hold bonds in your taxable account as CA munis, rather than in your tax-advantaged account. You pay the same tax cost on CA munis as everyone else (about 1/3 of the muni yield, compared to taxable bonds of comparable risk), but you pay 31.1% tax on qualified dividends versus the usual 15%.
This is clear to me now. I'll need to read a little bit more to pick which muni's but your posts elsewhere have already been helpful on this.

grabiner wrote: Sat Apr 10, 2021 10:29 pm In your tax bracket, you would get a small net advantage from using 90% Vanguard Tax-Managed Capital Appreciation and 10% Tax-Managed Small-Cap over Total Stock Market Index. The tax-managed funds are more expensive, but given your high tax rate, you would save more in dividend tax than you pay in expenses. (This difference is only a few basis points, so it may not be worth making a more complex portfolio.)
What is your opinion on a 50/50 split of SCHG and VTV holding the SCHG in taxable? Seems like there are pretty large tax savings for me by doing that.

grabiner wrote: Sat Apr 10, 2021 10:29 pm But your best taxable investment is probably paying down the mortgage until it reaches $1M (or $750K if not grandfathered). This would pay down non-deductible debt, giving a risk-free return equal to the mortgage rate. Once you reach the limit for deductible interest, you probably don't want to pay it down any further, as deductions at 49.3% halve the after-tax return on mortgage paydown.
The mortgage is a 30 year fixed at 2.75% (original post updated to include). How would this look in practice? I'm not sure I understand how I'd track this for AA purposes. I would pay down whatever my bond contribution would be to my taxable and then just track this extra pay down like a bond in my portfolio?

With my interest rate I was pretty confident that wasn't the right move, but perhaps I should revisit.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by ltv »

deleting duplicate post
Last edited by ltv on Mon Apr 12, 2021 5:03 pm, edited 1 time in total.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by Tingting1013 »

ltv wrote: Sun Apr 11, 2021 10:43 am Ah, yes she does. It's through Fidelity and there is a "brokerage link" option. I'll look into this further, thanks for the tip.
Brokeragelink opens up a ton more space in 401k for Value stocks. Just find a value index fund that Brokeragelink will buy for you automatically with each paycheck. You don’t want to be having to go in every two weeks to manually buy more.
These recommendations are pretty clear, I just have a couple more basic questions.
1) I assume all of this movement is done through new contributions right? Meaning the VTSAX and VTIAX shares sitting in my taxable are going to stay there for the foreseeable future
Yes if you are sitting on gains in taxable just leave them as they are. But keep an eye out for tax loss harvest opportunities the next time the market crashes.
2) How are you calculating "tax efficiency" of VTIAX vs. IXUS? Is it as simple as yield*tax - foreign tax credit?
Yield * % of dividends that are qualified * 37% tax rate +
Yield * % of dividends that are not qualified * 50% tax rate -
Foreign taxes paid as a % of share price

VTIAX has higher yield and lower QDI % than IXUS
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by ltv »

dmcmahon wrote: Sat Apr 10, 2021 11:58 pm I will second the idea of paying down the mortgage. You are unlikely net positive after taxes versus any bond holdings. Especially if you face deduction caps.
I'm surprised this came up twice! It wasn't even on my radar.
dmcmahon wrote: Sat Apr 10, 2021 11:58 pm I’m in a similar position though not in the topmost bracket. But even at 35% + 3.8% + 12.3% I’m north of 50% on a marginal basis. Here’s the kicker: if you have any investment income, consider the marginal effect of kicking an investment income dollar across the line from 15% to 23.8%, and possibly higher rates in future. If you cost that tax drag against the income dollar that you could have avoided by retiring, your effective tax rate could be 75%.
Could you help explain the bold portions? I'm having a hard time following.


Thanks for sharing your experience and perspective. At some point the taxable account becomes a large enough percentage of the total portfolio that significant investment income is unavoidable, right? We've been doing everything we can with the mega back door roth, etc. but in a few years our taxable account will be the significant majority of our portfolio.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by Tingting1013 »

ltv wrote: Sun Apr 11, 2021 11:02 am
dmcmahon wrote: Sat Apr 10, 2021 11:58 pm I will second the idea of paying down the mortgage. You are unlikely net positive after taxes versus any bond holdings. Especially if you face deduction caps.
I'm surprised this came up twice! It wasn't even on my radar.
I would not pay down your mortgage.

CA is a non-recourse loan state, meaning if the worst happens and your house goes significantly underwater, you can just hand the keys to the bank and not be on the hook for the balance. The more you pay down your mortgage the more you have to lose in this scenario.

This is a disaster insurance policy that you should not give up lightly. Especially given the volatility of the tech industry.

What I would do is look into refinancing your loan. Lots of banks will offer you preferential rates for moving $500k to $1M+ in investments to them.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by drk »

Tingting1013 wrote: Sat Apr 10, 2021 8:16 pm 1. Hold all of your international in taxable.
[...]
3. Hold as much Value stock as possible in 401k/IRA
4. Hold an equal amount as #3 in Growth stock in taxable.
It seems like these are counter-productive given OP's tax situation. I'm in a lower bracket with no state income taxes, and the tax costs of higher yields on international stocks outweighs the benefit of the foreign tax credit.

If the OP can make it work, the growth/value split would help, although I would pair SCHG with SCHV rather than VTV to expand the universe of stocks (~750 vs ~600) and avoid mismatching indexes.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by Tingting1013 »

drk wrote: Sun Apr 11, 2021 11:21 am
Tingting1013 wrote: Sat Apr 10, 2021 8:16 pm 1. Hold all of your international in taxable.
[...]
3. Hold as much Value stock as possible in 401k/IRA
4. Hold an equal amount as #3 in Growth stock in taxable.
It seems like these are counter-productive given OP's tax situation. I'm in a lower bracket with no state income taxes, and the tax costs of higher yields on international stocks outweighs the benefit of the foreign tax credit.

If the OP can make it work, the growth/value split would help, although I would pair SCHG with SCHV rather than VTV to expand the universe of stocks (~750 vs ~600) and avoid mismatching indexes.
If you do the math on IXUS, its tax cost is 0.5% for the OP, same as for VTSAX. VTIAX / VXUS is something crazy like 0.75%

Agree on SCHV, the 50/50 chart tracks even better with VTSAX:

https://www.portfoliovisualizer.com/bac ... ion3_2=100
Last edited by Tingting1013 on Sun Apr 11, 2021 11:29 am, edited 1 time in total.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by Firemenot »

Just a suggestion — if you are a two-worker high earning family, one of you should think of starting a business for the tax advantages. Don’t draw much salary and reinvest in business. You can structure your corporate entity such that you could realize $10 million tax free under founder share provisions.

This is what I’m trying to do. But currently I’m moonlighting until/if things start taking off enough. My endeavor is based on serious R&D for product design so you never know how things will turn out.

The higher tax rates go, the more two worker families should consider one spouse building something outside the typical W2 system.
Last edited by Firemenot on Sun Apr 11, 2021 11:33 am, edited 1 time in total.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by grabiner »

ltv wrote: Sun Apr 11, 2021 10:53 am
grabiner wrote: Sat Apr 10, 2021 10:29 pm Given your very high tax rate, I would recommend holding US stock in taxable where possible. You get the same foreign tax credit as everyone else, but you pay a higher tax cost on dividends, particularly on non-qualified dividends. Since international stock funds have higher dividend yields and more non-qualified dividends, this results in a higher tax cost to you.
Your recommendation is to hold all of my international portion in tax advantaged accounts? I guess some of this will depend on how much space of have in each account after moving bonds to taxable. It will take some time to get all of this sorted and moved, but fortunately this will be a pretty high contribution year, particularly the next few months.
I wouldn't recommend selling any stock for a capital gain to get it out of your taxable account, but direct new stock investments in your taxable account to US stocks, and new stock investments in your 401(k) and IRA to foreign stocks.

(I am in the same situation. My tax bracket isn't as high as yours, but it is still high enough that I prefer US stocks in taxable. I have some old Developed Markets Index in my taxable account that I don't want to sell, so I use it for charitable contributions, and replace it with an international fund in my employer plan to keep the same international allocation.)
grabiner wrote: Sat Apr 10, 2021 10:29 pm In your tax bracket, you would get a small net advantage from using 90% Vanguard Tax-Managed Capital Appreciation and 10% Tax-Managed Small-Cap over Total Stock Market Index. The tax-managed funds are more expensive, but given your high tax rate, you would save more in dividend tax than you pay in expenses. (This difference is only a few basis points, so it may not be worth making a more complex portfolio.)
What is your opinion on a 50/50 split of SCHG and VTV holding the SCHG in taxable? Seems like there are pretty large tax savings for me by doing that.
If you are willing to deal with the extra complexity, splitting the dividends this way would make sense, although I would probably prefer using Vanguard for both halves so that you cover the market better. At current yields, if you hold VUG (Vanguard Growth ETF) in taxable and VTV (Vanguard Value ETF) in tax-deferred, rather than VV (Large-Cap Index) in both, you reduce the dividend yield from 1.37% to 0.58%. With the dividends qualified, this is a tax savings of 31.3%*(0.79%)=0.25% on the taxable half, and 0.12% on the total.

You can do the same thing with small-cap, holding VBK (Vanguard Small-Cap Growth ETF) in taxable and VBR (Vanguard Small-Cap Value ETF) in tax-deferred.

But this isn't quite a free lunch, because you will have to rebalance. If growth outperforms value, you may have too much growth stock in your taxable account, and you will have to either live with this, add new taxable investments in value stocks, or sell growth stocks for a capital gain.
grabiner wrote: Sat Apr 10, 2021 10:29 pm But your best taxable investment is probably paying down the mortgage until it reaches $1M (or $750K if not grandfathered). This would pay down non-deductible debt, giving a risk-free return equal to the mortgage rate. Once you reach the limit for deductible interest, you probably don't want to pay it down any further, as deductions at 49.3% halve the after-tax return on mortgage paydown.
The mortgage is a 30 year fixed at 2.75% (original post updated to include). How would this look in practice? I'm not sure I understand how I'd track this for AA purposes. I would pay down whatever my bond contribution would be to my taxable and then just track this extra pay down like a bond in my portfolio?

With my interest rate I was pretty confident that wasn't the right move, but perhaps I should revisit.
I view a mortgage as a negative bond. If you have a bond portfolio which pays you $X every year, and a loan on which you pay $X every year, you can ignore both of them since the bond portfolio pays the loan.

Your interest rate is 2.75%, which is a pretty good risk-free rate for a long-term investment. For comparison, Vanguard CA Long-Term Tax-Exempt yields only 1.32%.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

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At your tax rate, I would stop making any 401K contributions on an after-tax basis. Do all pre-tax. Hold your fixed income by making 100% of your pre-tax 401K holdings stable value (if available) or bond. Hold all equities in taxable. I would also pay down the mortgage vs. holding muni's in taxable.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by drk »

Tingting1013 wrote: Sun Apr 11, 2021 11:22 am If you do the math on IXUS, its tax cost is 0.5% for the OP, same as for VTSAX. VTIAX / VXUS is something crazy like 0.75%

Agree on SCHV
Interesting. When I did the math in 2019, IXUS had a higher tax cost than VTI. I'll have to update the old spreadsheet.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by Tingting1013 »

grabiner wrote: Sun Apr 11, 2021 11:33 am
What is your opinion on a 50/50 split of SCHG and VTV holding the SCHG in taxable? Seems like there are pretty large tax savings for me by doing that.
If you are willing to deal with the extra complexity, splitting the dividends this way would make sense, although I would probably prefer using Vanguard for both halves so that you cover the market better. At current yields, if you hold VUG (Vanguard Growth ETF) in taxable and VTV (Vanguard Value ETF) in tax-deferred, rather than VV (Large-Cap Index) in both, you reduce the dividend yield from 1.37% to 0.58%. With the dividends qualified, this is a tax savings of 31.3%*(0.79%)=0.25% on the taxable half, and 0.12% on the total.
In theory VUG+VTV should produce the same results as SCHG+SCHV, but in practice SCHG is more tax efficient than VUG. This is because SCHG holds more stocks than VUG, and so the few Growth stocks that do pay dividends comprise a smaller proportion of the total, and so the SCHG’s yield is structurally lower than VUG.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by dmcmahon »

ltv wrote: Sun Apr 11, 2021 11:02 am
dmcmahon wrote: Sat Apr 10, 2021 11:58 pm I will second the idea of paying down the mortgage. You are unlikely net positive after taxes versus any bond holdings. Especially if you face deduction caps.
I'm surprised this came up twice! It wasn't even on my radar.
dmcmahon wrote: Sat Apr 10, 2021 11:58 pm I’m in a similar position though not in the topmost bracket. But even at 35% + 3.8% + 12.3% I’m north of 50% on a marginal basis. Here’s the kicker: if you have any investment income, consider the marginal effect of kicking an investment income dollar across the line from 15% to 23.8%, and possibly higher rates in future. If you cost that tax drag against the income dollar that you could have avoided by retiring, your effective tax rate could be 75%.
Could you help explain the bold portions? I'm having a hard time following.


Thanks for sharing your experience and perspective. At some point the taxable account becomes a large enough percentage of the total portfolio that significant investment income is unavoidable, right? We've been doing everything we can with the mega back door roth, etc. but in a few years our taxable account will be the significant majority of our portfolio.
I’ll try. Suppose you have no ordinary income, just whatever investment income your portfolio produces. Mostly qualified dividends. What tax rate do you pay? 0% or 15% federal, plus California’s rate. Now stack on some ordinary income up to the threshold that pushes $1 of investment income into the 20% bracket, or imposes the NIIT. That extra ordinary income dollar was taxed at some moderately high rate, like 45% or more when you include California. But that analysis fails to acknowledge the reality of incurring an extra 5-9% on an investment dollar. Once you account for that, you realize that the extra $1 of ordinary income was actually leaving you with less than 50 cents, and possibly less than 45 cents, to take home. Ergo, it was taxed at a higher marginal rate than you thought. Now run that out a little further, and while you’re at it, pencil in another even higher tax rate on that investment dollar. I have to stop there due to forum rules, but if the implications still aren’t clear PM me.

Update: to your second point, yes, the problem you’re encountering is that the relatively low limits on 401k/IRA types of plans means you cannot expect to produce a professional class retirement income without significant taxable savings. Most of the professionals I know here in my HCOL part of California have far more taxable savings than tax advantaged. Hence my point about regretting not maximizing my tax advantaged space by putting low yielding bonds there for a decade. Also, because of the foregoing analysis about the effect of work income on investment income, over time as you get closer to retirement the aforementioned drag will become worse and worse. This is why having an old fashioned defined benefit pension scheme could make sense for high earning professionals who aren’t W2 slaves like me, but who have some sort of partnership or practice to set up such a thing. I have one friend with exactly that arrangement at her firm (it’s a large partnership), but it’s rare outside of the public sector.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by dmcmahon »

Firemenot wrote: Sun Apr 11, 2021 11:28 am Just a suggestion — if you are a two-worker high earning family, one of you should think of starting a business for the tax advantages. Don’t draw much salary and reinvest in business. You can structure your corporate entity such that you could realize $10 million tax free under founder share provisions.

This is what I’m trying to do. But currently I’m moonlighting until/if things start taking off enough. My endeavor is based on serious R&D for product design so you never know how things will turn out.

The higher tax rates go, the more two worker families should consider one spouse building something outside the typical W2 system.
Bingo.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by dmcmahon »

Tingting1013 wrote: Sun Apr 11, 2021 11:05 am
ltv wrote: Sun Apr 11, 2021 11:02 am
dmcmahon wrote: Sat Apr 10, 2021 11:58 pm I will second the idea of paying down the mortgage. You are unlikely net positive after taxes versus any bond holdings. Especially if you face deduction caps.
I'm surprised this came up twice! It wasn't even on my radar.
I would not pay down your mortgage.

CA is a non-recourse loan state, meaning if the worst happens and your house goes significantly underwater, you can just hand the keys to the bank and not be on the hook for the balance. The more you pay down your mortgage the more you have to lose in this scenario.

This is a disaster insurance policy that you should not give up lightly. Especially given the volatility of the tech industry.

What I would do is look into refinancing your loan. Lots of banks will offer you preferential rates for moving $500k to $1M+ in investments to them.
Very few California homeowners with houses in that price range do not have significant skin in the game, high down payments to start and significant price appreciation in an HCOL area. IMO the value of your jingle mail put option is close to nil for the OP. Refinancing to a rate lower than what you earn on bonds seems unlikely unless you’re invested in high yield (low credit quality). The deduction for the mortgage needs to be netted against the tax owed on the bond interest. People always seem to neglect that when touting the tax savings from the mortgage interest.
Shalom Aleichem
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by Shalom Aleichem »

corp_sharecropper wrote: Sat Apr 10, 2021 5:43 pm 40%+? Wow. I'm trying to figure out what it takes to get to that level. To clarify, this is not your marginal rate, right? Literally 40%+ of your gross income is taken by fed/state/local taxes, not various payroll deferrals for retirement/insurance/whatever, all to tax man?

That's insane. Good grief, what are the state & local taxes where you live?
I’m in California is with all income I use from w2. It’s well over 50 percent marginal if you are hitting high numbers. I don’t hit the highest California tax rate but the second highest and marginal is sufficiently over 50 percent that it doesn’t really pay for me to work - the government takes the majority of all marginal tax dollars and leaves me with the minority! Forty percent overall seems high especially if using pretax dollars to fund retirement. Maybe no charitable donations? Otherwise I’d think closer to 33 give or take overall tax rate.
Shalom Aleichem
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by Shalom Aleichem »

grabiner wrote: Sun Apr 11, 2021 11:33 am
ltv wrote: Sun Apr 11, 2021 10:53 am
grabiner wrote: Sat Apr 10, 2021 10:29 pm Given your very high tax rate, I would recommend holding US stock in taxable where possible. You get the same foreign tax credit as everyone else, but you pay a higher tax cost on dividends, particularly on non-qualified dividends. Since international stock funds have higher dividend yields and more non-qualified dividends, this results in a higher tax cost to you.
Your recommendation is to hold all of my international portion in tax advantaged accounts? I guess some of this will depend on how much space of have in each account after moving bonds to taxable. It will take some time to get all of this sorted and moved, but fortunately this will be a pretty high contribution year, particularly the next few months.
I wouldn't recommend selling any stock for a capital gain to get it out of your taxable account, but direct new stock investments in your taxable account to US stocks, and new stock investments in your 401(k) and IRA to foreign stocks.

(I am in the same situation. My tax bracket isn't as high as yours, but it is still high enough that I prefer US stocks in taxable. I have some old Developed Markets Index in my taxable account that I don't want to sell, so I use it for charitable contributions, and replace it with an international fund in my employer plan to keep the same international allocation.)
grabiner wrote: Sat Apr 10, 2021 10:29 pm In your tax bracket, you would get a small net advantage from using 90% Vanguard Tax-Managed Capital Appreciation and 10% Tax-Managed Small-Cap over Total Stock Market Index. The tax-managed funds are more expensive, but given your high tax rate, you would save more in dividend tax than you pay in expenses. (This difference is only a few basis points, so it may not be worth making a more complex portfolio.)
What is your opinion on a 50/50 split of SCHG and VTV holding the SCHG in taxable? Seems like there are pretty large tax savings for me by doing that.
If you are willing to deal with the extra complexity, splitting the dividends this way would make sense, although I would probably prefer using Vanguard for both halves so that you cover the market better. At current yields, if you hold VUG (Vanguard Growth ETF) in taxable and VTV (Vanguard Value ETF) in tax-deferred, rather than VV (Large-Cap Index) in both, you reduce the dividend yield from 1.37% to 0.58%. With the dividends qualified, this is a tax savings of 31.3%*(0.79%)=0.25% on the taxable half, and 0.12% on the total.

You can do the same thing with small-cap, holding VBK (Vanguard Small-Cap Growth ETF) in taxable and VBR (Vanguard Small-Cap Value ETF) in tax-deferred.

But this isn't quite a free lunch, because you will have to rebalance. If growth outperforms value, you may have too much growth stock in your taxable account, and you will have to either live with this, add new taxable investments in value stocks, or sell growth stocks for a capital gain.
grabiner wrote: Sat Apr 10, 2021 10:29 pm But your best taxable investment is probably paying down the mortgage until it reaches $1M (or $750K if not grandfathered). This would pay down non-deductible debt, giving a risk-free return equal to the mortgage rate. Once you reach the limit for deductible interest, you probably don't want to pay it down any further, as deductions at 49.3% halve the after-tax return on mortgage paydown.
The mortgage is a 30 year fixed at 2.75% (original post updated to include). How would this look in practice? I'm not sure I understand how I'd track this for AA purposes. I would pay down whatever my bond contribution would be to my taxable and then just track this extra pay down like a bond in my portfolio?

With my interest rate I was pretty confident that wasn't the right move, but perhaps I should revisit.
I view a mortgage as a negative bond. If you have a bond portfolio which pays you $X every year, and a loan on which you pay $X every year, you can ignore both of them since the bond portfolio pays the loan.

Your interest rate is 2.75%, which is a pretty good risk-free rate for a long-term investment. For comparison, Vanguard CA Long-Term Tax-Exempt yields only 1.32%.
True but his mortgage is tax deductible so that 2.75 is more like 1.35 which is the same as the California bond. Except laying down the mortgage is risk free return and there is a risk of default on California bonds.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by grabiner »

Shalom Aleichem wrote: Sun Apr 11, 2021 5:51 pm
grabiner wrote: Sun Apr 11, 2021 11:33 am I view a mortgage as a negative bond. If you have a bond portfolio which pays you $X every year, and a loan on which you pay $X every year, you can ignore both of them since the bond portfolio pays the loan.

Your interest rate is 2.75%, which is a pretty good risk-free rate for a long-term investment. For comparison, Vanguard CA Long-Term Tax-Exempt yields only 1.32%.
True but his mortgage is tax deductible so that 2.75 is more like 1.35 which is the same as the California bond. Except laying down the mortgage is risk free return and there is a risk of default on California bonds.
His mortgage is over the limit for deductibility ($1M or $750K, depending on when it was taken out); paying it down to that limit is a 2.75% tax-free return. I would not recommend paying down a long-term deductible mortgage at such a low rate.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by dmcmahon »

grabiner wrote: Sun Apr 11, 2021 6:00 pm I would not recommend paying down a long-term deductible mortgage at such a low rate.
Why not? I did and I’ve never had cause to regret it. I’m currently earning as best 1.5%, federally taxable at a high rate, on a ladder of treasuries.

Not only is the rate differential favorable, clearing the loan while ending the bond income lowers my AGI. There are also proposals to further limit deductions that we’re not allowed to talk about in detail, but which are worth considering when weighing the alternatives.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by ltv »

grabiner wrote: Sun Apr 11, 2021 11:33 am
ltv wrote: Sun Apr 11, 2021 10:53 am
grabiner wrote: Sat Apr 10, 2021 10:29 pm Given your very high tax rate, I would recommend holding US stock in taxable where possible. You get the same foreign tax credit as everyone else, but you pay a higher tax cost on dividends, particularly on non-qualified dividends. Since international stock funds have higher dividend yields and more non-qualified dividends, this results in a higher tax cost to you.
Your recommendation is to hold all of my international portion in tax advantaged accounts? I guess some of this will depend on how much space of have in each account after moving bonds to taxable. It will take some time to get all of this sorted and moved, but fortunately this will be a pretty high contribution year, particularly the next few months.
I wouldn't recommend selling any stock for a capital gain to get it out of your taxable account, but direct new stock investments in your taxable account to US stocks, and new stock investments in your 401(k) and IRA to foreign stocks.

(I am in the same situation. My tax bracket isn't as high as yours, but it is still high enough that I prefer US stocks in taxable. I have some old Developed Markets Index in my taxable account that I don't want to sell, so I use it for charitable contributions, and replace it with an international fund in my employer plan to keep the same international allocation.)
grabiner wrote: Sat Apr 10, 2021 10:29 pm In your tax bracket, you would get a small net advantage from using 90% Vanguard Tax-Managed Capital Appreciation and 10% Tax-Managed Small-Cap over Total Stock Market Index. The tax-managed funds are more expensive, but given your high tax rate, you would save more in dividend tax than you pay in expenses. (This difference is only a few basis points, so it may not be worth making a more complex portfolio.)
What is your opinion on a 50/50 split of SCHG and VTV holding the SCHG in taxable? Seems like there are pretty large tax savings for me by doing that.
If you are willing to deal with the extra complexity, splitting the dividends this way would make sense, although I would probably prefer using Vanguard for both halves so that you cover the market better. At current yields, if you hold VUG (Vanguard Growth ETF) in taxable and VTV (Vanguard Value ETF) in tax-deferred, rather than VV (Large-Cap Index) in both, you reduce the dividend yield from 1.37% to 0.58%. With the dividends qualified, this is a tax savings of 31.3%*(0.79%)=0.25% on the taxable half, and 0.12% on the total.

You can do the same thing with small-cap, holding VBK (Vanguard Small-Cap Growth ETF) in taxable and VBR (Vanguard Small-Cap Value ETF) in tax-deferred.

But this isn't quite a free lunch, because you will have to rebalance. If growth outperforms value, you may have too much growth stock in your taxable account, and you will have to either live with this, add new taxable investments in value stocks, or sell growth stocks for a capital gain.
grabiner wrote: Sat Apr 10, 2021 10:29 pm But your best taxable investment is probably paying down the mortgage until it reaches $1M (or $750K if not grandfathered). This would pay down non-deductible debt, giving a risk-free return equal to the mortgage rate. Once you reach the limit for deductible interest, you probably don't want to pay it down any further, as deductions at 49.3% halve the after-tax return on mortgage paydown.
The mortgage is a 30 year fixed at 2.75% (original post updated to include). How would this look in practice? I'm not sure I understand how I'd track this for AA purposes. I would pay down whatever my bond contribution would be to my taxable and then just track this extra pay down like a bond in my portfolio?

With my interest rate I was pretty confident that wasn't the right move, but perhaps I should revisit.
I view a mortgage as a negative bond. If you have a bond portfolio which pays you $X every year, and a loan on which you pay $X every year, you can ignore both of them since the bond portfolio pays the loan.

Your interest rate is 2.75%, which is a pretty good risk-free rate for a long-term investment. For comparison, Vanguard CA Long-Term Tax-Exempt yields only 1.32%.
I spent a bunch of time today reading about the concept of a mortgage being a negative bond but what I'm still not clear on is how I should view this in terms of my asset allocation and how I logistically take action from here. If I'm truly viewing my mortgage as a negative bond, that I'm incredibly overweight on stocks currently, right? This doesn't feel right.

It feels like the right move would be to put all new money into my mortgage while subsequently shifting Bonds in my 401k to stocks. Then once I have no bonds left in my portfolio I put 80% of new after tax money into stocks and 20% into the mortgage.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by grabiner »

ltv wrote: Sun Apr 11, 2021 6:19 pm
grabiner wrote: Sun Apr 11, 2021 11:33 am I view a mortgage as a negative bond. If you have a bond portfolio which pays you $X every year, and a loan on which you pay $X every year, you can ignore both of them since the bond portfolio pays the loan.
I spent a bunch of time today reading about the concept of a mortgage being a negative bond but what I'm still not clear on is how I should view this in terms of my asset allocation and how I logistically take action from here. If I'm truly viewing my mortgage as a negative bond, that I'm incredibly overweight on stocks currently, right? This doesn't feel right.
If you compute your allocation with your mortgage as a negative bond, you can be considerably more aggressive. In addition, the mortgage does not exist in isolation; the ratio of your stock allocation to your net worth doesn't change that much when you both buy a house and take out a mortgage. Thus it is reasonable to have a similar asset allocation in your portfolio whether you rent, or have a home with a mortgage. It is also appropriate to have a significantly more aggressive portfolio allocation when you have a paid-off house, because the house is now behaving like an annuity which covers a significant part of your living expenses.

But regardless of how you view things, paying down a mortgage and buying a bond give the same benefit: a guaranteed payment at a future time. (For an extra mortgage payment, you will get back the money with interest when the mortgage is paid off, either as increased equity when you sell, or as a monthly payment you no longer need to make.)
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ltv
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by ltv »

dmcmahon wrote: Sun Apr 11, 2021 4:01 pm
ltv wrote: Sun Apr 11, 2021 11:02 am
dmcmahon wrote: Sat Apr 10, 2021 11:58 pm I will second the idea of paying down the mortgage. You are unlikely net positive after taxes versus any bond holdings. Especially if you face deduction caps.
I'm surprised this came up twice! It wasn't even on my radar.
dmcmahon wrote: Sat Apr 10, 2021 11:58 pm I’m in a similar position though not in the topmost bracket. But even at 35% + 3.8% + 12.3% I’m north of 50% on a marginal basis. Here’s the kicker: if you have any investment income, consider the marginal effect of kicking an investment income dollar across the line from 15% to 23.8%, and possibly higher rates in future. If you cost that tax drag against the income dollar that you could have avoided by retiring, your effective tax rate could be 75%.
Could you help explain the bold portions? I'm having a hard time following.

Thanks for sharing your experience and perspective. At some point the taxable account becomes a large enough percentage of the total portfolio that significant investment income is unavoidable, right? We've been doing everything we can with the mega back door roth, etc. but in a few years our taxable account will be the significant majority of our portfolio.
I’ll try. Suppose you have no ordinary income, just whatever investment income your portfolio produces. Mostly qualified dividends. What tax rate do you pay? 0% or 15% federal, plus California’s rate. Now stack on some ordinary income up to the threshold that pushes $1 of investment income into the 20% bracket, or imposes the NIIT. That extra ordinary income dollar was taxed at some moderately high rate, like 45% or more when you include California. But that analysis fails to acknowledge the reality of incurring an extra 5-9% on an investment dollar. Once you account for that, you realize that the extra $1 of ordinary income was actually leaving you with less than 50 cents, and possibly less than 45 cents, to take home. Ergo, it was taxed at a higher marginal rate than you thought. Now run that out a little further, and while you’re at it, pencil in another even higher tax rate on that investment dollar. I have to stop there due to forum rules, but if the implications still aren’t clear PM me.

Update: to your second point, yes, the problem you’re encountering is that the relatively low limits on 401k/IRA types of plans means you cannot expect to produce a professional class retirement income without significant taxable savings. Most of the professionals I know here in my HCOL part of California have far more taxable savings than tax advantaged. Hence my point about regretting not maximizing my tax advantaged space by putting low yielding bonds there for a decade. Also, because of the foregoing analysis about the effect of work income on investment income, over time as you get closer to retirement the aforementioned drag will become worse and worse. This is why having an old fashioned defined benefit pension scheme could make sense for high earning professionals who aren’t W2 slaves like me, but who have some sort of partnership or practice to set up such a thing. I have one friend with exactly that arrangement at her firm (it’s a large partnership), but it’s rare outside of the public sector.
Ok I'm getting closer to understanding. I think I need to model some of this out to really get it (I have a lot to dive into after this post :happy ). The part that is still tripping me up is the "tax drag that could have been avoiding by retiring causing the effective tax rate to be 75%)
Understood on how proposed policy could affect all of this.
Firemenot wrote: Sun Apr 11, 2021 11:28 am Just a suggestion — if you are a two-worker high earning family, one of you should think of starting a business for the tax advantages. Don’t draw much salary and reinvest in business. You can structure your corporate entity such that you could realize $10 million tax free under founder share provisions.

This is what I’m trying to do. But currently I’m moonlighting until/if things start taking off enough. My endeavor is based on serious R&D for product design so you never know how things will turn out.

The higher tax rates go, the more two worker families should consider one spouse building something outside the typical W2 system.
Thanks for the idea Firemenot. I've spent a ton of time thinking about this over the last few years and it's how I ended up with a couple of fairly active real estate plays. They are doing very very well but the current strategy just isn't as scalable as I'd like it to be. Right now we are enjoying the perks of megacorp, we're having our first child soon and the parental leave is a very real perk over the next few years. At some point in the future however, I'm sure we will venture off on our own.
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by ltv »

dmcmahon wrote: Sun Apr 11, 2021 4:23 pm
Tingting1013 wrote: Sun Apr 11, 2021 11:05 am
ltv wrote: Sun Apr 11, 2021 11:02 am
dmcmahon wrote: Sat Apr 10, 2021 11:58 pm I will second the idea of paying down the mortgage. You are unlikely net positive after taxes versus any bond holdings. Especially if you face deduction caps.
I'm surprised this came up twice! It wasn't even on my radar.
I would not pay down your mortgage.

CA is a non-recourse loan state, meaning if the worst happens and your house goes significantly underwater, you can just hand the keys to the bank and not be on the hook for the balance. The more you pay down your mortgage the more you have to lose in this scenario.

This is a disaster insurance policy that you should not give up lightly. Especially given the volatility of the tech industry.

What I would do is look into refinancing your loan. Lots of banks will offer you preferential rates for moving $500k to $1M+ in investments to them.
Very few California homeowners with houses in that price range do not have significant skin in the game, high down payments to start and significant price appreciation in an HCOL area. IMO the value of your jingle mail put option is close to nil for the OP. Refinancing to a rate lower than what you earn on bonds seems unlikely unless you’re invested in high yield (low credit quality). The deduction for the mortgage needs to be netted against the tax owed on the bond interest. People always seem to neglect that when touting the tax savings from the mortgage interest.
Yea this is right on. Between the down payment and the appreciation we're in deep. Good point about netting the mortgage deduction against investment income.
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ltv
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by ltv »

Outer Marker wrote: Sun Apr 11, 2021 11:33 am At your tax rate, I would stop making any 401K contributions on an after-tax basis. Do all pre-tax. Hold your fixed income by making 100% of your pre-tax 401K holdings stable value (if available) or bond. Hold all equities in taxable. I would also pay down the mortgage vs. holding muni's in taxable.
This isn't super clear to me. We max out our pre-tax 401k to the max, the after tax portion is the megaback door roth which lets us put $55k into each 401k. I'm essentially choosing between money going into an aftertax 401k and money going into a taxable account. In that situation an after tax 401k always wins, right?
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Re: Effective tax rate 40%+ Sanity check on strategy for tax efficient investing

Post by Tingting1013 »

ltv wrote: Sun Apr 11, 2021 6:38 pm
dmcmahon wrote: Sun Apr 11, 2021 4:23 pm
Tingting1013 wrote: Sun Apr 11, 2021 11:05 am
ltv wrote: Sun Apr 11, 2021 11:02 am
dmcmahon wrote: Sat Apr 10, 2021 11:58 pm I will second the idea of paying down the mortgage. You are unlikely net positive after taxes versus any bond holdings. Especially if you face deduction caps.
I'm surprised this came up twice! It wasn't even on my radar.
I would not pay down your mortgage.

CA is a non-recourse loan state, meaning if the worst happens and your house goes significantly underwater, you can just hand the keys to the bank and not be on the hook for the balance. The more you pay down your mortgage the more you have to lose in this scenario.

This is a disaster insurance policy that you should not give up lightly. Especially given the volatility of the tech industry.

What I would do is look into refinancing your loan. Lots of banks will offer you preferential rates for moving $500k to $1M+ in investments to them.
Very few California homeowners with houses in that price range do not have significant skin in the game, high down payments to start and significant price appreciation in an HCOL area. IMO the value of your jingle mail put option is close to nil for the OP. Refinancing to a rate lower than what you earn on bonds seems unlikely unless you’re invested in high yield (low credit quality). The deduction for the mortgage needs to be netted against the tax owed on the bond interest. People always seem to neglect that when touting the tax savings from the mortgage interest.
Yea this is right on. Between the down payment and the appreciation we're in deep. Good point about netting the mortgage deduction against investment income.
You’re in deep and so you should just keep digging? :confused

Honestly with your wealth trajectory here’s what I would do.

1. Refi to an interest only mortgage, lock in 1.75% for five years (or 2.0% for ten).
2. Plow the savings in interest and principal into the markets.
3. In 5/10 years’ time if the rate adjusts upward, the house will basically be a rounding error in your net worth and you could just pay it off.
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