Tax cost of "one fund in taxable"

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jefmafnl
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Tax cost of "one fund in taxable"

Post by jefmafnl » Sun Apr 20, 2014 9:39 am

The notion of making a transition from our present situation (moderate slice and dice in taxable and IRA accounts; about 6 years away from my retirement) to one fund (such as Vanguard LS Moderate Growth or Vanguard Balanced or Vanguard Wellington or a Vanguard Target Retirement Fund) is very appealing. When I'm 10 years into retirement, I don't want to be dealing with decisions about shuffling and rebalancing funds. Also, in case I pre-decease my wife: she has many wonderful qualities, but she is a big fan of simplicity and has no interest in doing anything more complicated than managing withdrawals from one fund (perhaps in several locations).

Obviously there's a series of one-time costs involved in a taxable account when exchanging mutual funds that have gains for the chosen fund, but this could be manageable if spread over many years.

Exactly why is holding, and gradually withdrawing from, one of the above funds in a taxable account less tax-efficient then doing so with a collection of funds (primarily stock funds, but also some bond funds due to limited space in IRA's relative to total assets) in a taxable account?

And what (approximately) is the consequence in extra tax paid per year as a portion of assets: 0.5%? 1%? 3%? 5%?

Thanks.

J

dbr
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Re: Tax cost of "one fund in taxable"

Post by dbr » Sun Apr 20, 2014 9:56 am

To know exactly the consequences of one way of holding the assets compared to another, you would have to calculate the actual tax costs over many years for each scenario using your personal situation. The answer, in short, is "It depends." Factors that will affect the outcome include your income, your personal exemptions and deductions, the amounts of money involved in the various accounts, interest rates, returns hence capital gains on assets held, and so on and so forth. You would probably need to create a spread sheet that could take into account expected inflation adjusted movement of tax brackets and exemptions, possible changes in tax rates, and so on. It is possible the biggest cost would be in realizing gains which could be big enough that it will be easy to see that the idea does not work very well, or maybe it does work.

It might be that you should show your wife what you have and talk through what would be involved if she were left with all the holdings. What, actually, would she have to do to manage the finances and how much would it help her to invest in a one fund model? It might be that having four or five funds in different accounts would not be much additional complexity over what has to be managed anyway. It is a question of the marginal challenge.

Calm Man
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Re: Tax cost of "one fund in taxable"

Post by Calm Man » Sun Apr 20, 2014 12:22 pm

I agree with you a lot. As I get older I will seriously look at simplifying from my 2 funds (Total stock market and NJ bond) to one if possible. As I am 50/50, I might just go with Tax Managed balanced even though it is not optimal in all regards. If you are not worried about he tax hit, I agree with a life strategy fund or balanced index fund. I have already made the change in my IRA as I figure I will be completely demented before that is used up, in fact, since I will take RMDs by definition it will outlive me.

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cfs
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Re: Tax cost of "one fund in taxable"

Post by cfs » Sun Apr 20, 2014 12:36 pm

Tax Managed Balanced

We have the Vanguard Tax-Managed Balanced (VTMFX) flying solo in taxable, and our goal is to keep the equities in our boring tax-minimizing portfolio at the 50% (or less level). Holding steady on course. I am bullish on USA.

Do Great Things! And thanks for reading this note.
~ Member of the Active Retired Force since 2014 ~

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pjstack
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Re: Tax cost of "one fund in taxable"

Post by pjstack » Sun Apr 20, 2014 12:49 pm

I have already taken the OP's approach, and for the same reason. I chose the 60/40 balanced fund, but I also kept a little Total Market to try and balance against my I-Bonds.
pjstack

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grabiner
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Re: Tax cost of "one fund in taxable"

Post by grabiner » Sun Apr 20, 2014 6:12 pm

The cost of holding a balanced fund in taxable is not in holding the fund, but in changing the fund. If you have separate stock and bond funds in taxable, and you want to sell bonds (to spend the money, or to hold more stocks, or to hold a different type of bonds, or to hold bonds in a different account), there is no tax cost. If you have a balanced fund, you have to sell stocks in order to sell bonds, and pay a capital-gains tax.

That is why I don't like Tax-Managed Balanced Fund. If you don't want to keep your taxable account at 49% US stock and 51% national munis, you will pay a tax bill to change. For example, if you move to CA or NY, you would probably prefer to hold munis from that state, but the tax cost of selling Tax-Managed Balanced to switch could easily be over 5% of the fund value (25% capital gain, taxed at 15% federal plus state).

If you value simplicity, are in a relatively low tax bracket (so that you don't want munis), and know that you will want to keep your allocation, it would be reasonable to keep a Target Retirement fund in both taxable and tax-deferred and declare that to be your permanent allocation. Target Retirement is better than a fixed allocation because it adjusts allocation over time; if you are five years from retirement and have LifeStrategy Moderate Growth or Balanced Index, this probably won't be what you want once you retire.
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jefmafnl
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Re: Tax cost of "one fund in taxable"

Post by jefmafnl » Mon Apr 21, 2014 3:20 am

Thanks for the replies.

Grabiner, could you please specify what you would consider a "relatively low tax bracket" for the purposes of this discussion?

Thanks.

J

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grabiner
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Re: Tax cost of "one fund in taxable"

Post by grabiner » Mon Apr 21, 2014 5:43 pm

jefmafnl wrote:Grabiner, could you please specify what you would consider a "relatively low tax bracket" for the purposes of this discussion?
My rule of thumb (not based on good data) is that munis are priced to break even with taxable bonds of comparable risk in a 25% bracket. Thus, if you are in a 25% bracket, you don't lose anything by holding corporate bonds rather than munis in taxable, although you would be better off if you are in a high-tax state with a muni fund for your state. If you are in a 28% bracket, the cost of holding taxable bonds rather than munis is still fairly low. If you are in a higher bracket, or in a 25% or 28% bracket with high state taxes, there is a significant tax cost to using taxable bonds rather than munis (for your state, if appropriate).
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