Tax-Efficient Fund Placement - Wiki

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Call_Me_Op
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Tax-Efficient Fund Placement - Wiki

Post by Call_Me_Op » Wed Jul 10, 2019 5:33 am

There is one statement from the Wiki on Tax-efficient fund placement that I find confusing. In the section called "Criticism of this tax-placement strategy" the Wiki states:

"Due to higher returns, equities have the potential to expand tax-advantaged space, leading to higher tax savings later on despite higher tax bills in the present. This is particularly true at the presently low bond yields, when the tax penalty from bonds in taxable is not as high as it has been in the past.[3]"

Can someone elaborate on what this is saying? (I underlined the specific statement that is confusing to me.)
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

AlohaJoe
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Re: Tax-Efficient Fund Placement - Wiki

Post by AlohaJoe » Wed Jul 10, 2019 5:51 am

Call_Me_Op wrote:
Wed Jul 10, 2019 5:33 am
"Due to higher returns, equities have the potential to expand tax-advantaged space, leading to higher tax savings later on despite higher tax bills in the present. This is particularly true at the presently low bond yields, when the tax penalty from bonds in taxable is not as high as it has been in the past.[3]"
Say you have $1000 for your 401k and $1000 for your taxable. You put bonds in your 401k -- they generate $40 a year in dividends (4% yield). You put equities in taxable -- they generate $20 a year in dividends (2% yield). But only $20 in taxable dividends. If you had done it the other way around, with equities in your 401k, then you would have had $40 (i.e. "more") in taxable dividends.

But then let the two scenarios grow for 30 years. The bonds will only grow to, say, $1,800. But the equities will have grown to $10,000. Now the bonds are generating $72 a year in dividends but the equities are generating $201 a year in dividends. Which one do you want to be tax-free?

Of course, the actual numbers will more complicated (reinvested dividends, etc), depend on exact growth & dividend rates, etc. But that's the general idea.

longinvest
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Re: Tax-Efficient Fund Placement - Wiki

Post by longinvest » Wed Jul 10, 2019 6:32 am

AlohaJoe wrote:
Wed Jul 10, 2019 5:51 am
Call_Me_Op wrote:
Wed Jul 10, 2019 5:33 am
"Due to higher returns, equities have the potential to expand tax-advantaged space, leading to higher tax savings later on despite higher tax bills in the present. This is particularly true at the presently low bond yields, when the tax penalty from bonds in taxable is not as high as it has been in the past.[3]"
Say you have $1000 for your 401k and $1000 for your taxable. You put bonds in your 401k -- they generate $40 a year in dividends (4% yield). You put equities in taxable -- they generate $20 a year in dividends (2% yield). But only $20 in taxable dividends. If you had done it the other way around, with equities in your 401k, then you would have had $40 (i.e. "more") in taxable dividends.

But then let the two scenarios grow for 30 years. The bonds will only grow to, say, $1,800. But the equities will have grown to $10,000. Now the bonds are generating $72 a year in dividends but the equities are generating $201 a year in dividends. Which one do you want to be tax-free?

Of course, the actual numbers will more complicated (reinvested dividends, etc), depend on exact growth & dividend rates, etc. But that's the general idea.
Exactly. Now, just to complicate things, one should also logically tax-adjust asset allocation according to asset location because a $10,000 loss in a traditional IRA doesn't have the same impact on spendable wealth as a $10,000 loss in a taxable account. But, the problem is that tax laws can change, and estimating taxes decades into the future is complex (some would say that it's impossible). See this wiki article: Tax-adjusted asset allocation.

At the end of the day, I personally think that a Mirrored asset allocation is probably good enough. It's automatically tax-adjusted and it doesn't concentrate specific assets into specific accounts. It probably won't be the (unknowable in advance) best asset location strategy, but it definitely will never result into the worst possible asset location choice.

As a bonus, a mirrored asset allocation allows for the use of a single all-in-one investment like a LifeStrategy Fund across accounts. It eliminates the need for rebalancing (sidestepping a long list of behavioral pitfalls) and it significantly simplifies portfolio management for one's spouse or future caretakers.
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Call_Me_Op
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Re: Tax-Efficient Fund Placement - Wiki

Post by Call_Me_Op » Wed Jul 10, 2019 7:08 am

AlohaJoe wrote:
Wed Jul 10, 2019 5:51 am
Call_Me_Op wrote:
Wed Jul 10, 2019 5:33 am
"Due to higher returns, equities have the potential to expand tax-advantaged space, leading to higher tax savings later on despite higher tax bills in the present. This is particularly true at the presently low bond yields, when the tax penalty from bonds in taxable is not as high as it has been in the past.[3]"
Say you have $1000 for your 401k and $1000 for your taxable. You put bonds in your 401k -- they generate $40 a year in dividends (4% yield). You put equities in taxable -- they generate $20 a year in dividends (2% yield). But only $20 in taxable dividends. If you had done it the other way around, with equities in your 401k, then you would have had $40 (i.e. "more") in taxable dividends.

But then let the two scenarios grow for 30 years. The bonds will only grow to, say, $1,800. But the equities will have grown to $10,000. Now the bonds are generating $72 a year in dividends but the equities are generating $201 a year in dividends. Which one do you want to be tax-free?
You are assuming tax-free, when I was thinking tax deferred. I think the answer is less straightforward when you consider tax-deferred and include capital gains from selling stocks (instead of just dividends).
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

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Re: Tax-Efficient Fund Placement - Wiki

Post by livesoft » Wed Jul 10, 2019 7:15 am

The most tax-efficient investment is the one that loses money, so that goes in taxable.

The next most tax-efficient investment is the one that makes no money or almost no money. That was bond fund, money market fund, or savings account paying 0.1% interest. That's what was happening around the time the wiki was being re-written and that's why that statement got put in there.

It seems to me that it is too much for people to actually use that spreadsheet on tax-efficiency created by triceratop to figure out their own personal tax situation. It is sometimes too difficult for people to even know their own personal tax situation in the first place and how it would change in the future.
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Re: Tax-Efficient Fund Placement - Wiki

Post by grabiner » Wed Jul 10, 2019 10:02 pm

Call_Me_Op wrote:
Wed Jul 10, 2019 5:33 am
There is one statement from the Wiki on Tax-efficient fund placement that I find confusing. In the section called "Criticism of this tax-placement strategy" the Wiki states:

"Due to higher returns, equities have the potential to expand tax-advantaged space, leading to higher tax savings later on despite higher tax bills in the present. This is particularly true at the presently low bond yields, when the tax penalty from bonds in taxable is not as high as it has been in the past.[3]"

Can someone elaborate on what this is saying? (I underlined the specific statement that is confusing to me.)
Suppose that, in your tax situation, bonds lose a higher percentage than stocks do to taxes. You might still have more money by putting stocks in your tax-deferred account, because the tax-deferred account would grow faster, giving you more tax-deferred money for investments in future years. (However, this is not a clear advantage. The reason you have bonds is the possibility that stocks will not perform well; if stocks perform poorly, you do not get this benefit from stocks in tax-deferred, while you will get the benefit of reduced capital gains if the stocks are in your taxable account.)

The second sentence, about low bond yields, is a different point. If you are in a 22% tax bracket, the tax cost on a bond fund yielding 2% is 0.44%, while the tax cost on a bond fund yielding 4% is 0.88%. Therefore, it may well be that holding bonds in a taxable account is more tax-efficient when yields are low, and less tax-efficient when yields are high.

At the current yield of 2.53% on Total Bond Market Index, bonds and stocks in taxable are about equally tax-efficient in a moderate tax bracket, and munis in taxable are better if you can use a muni fund for your high-tax state or you pay the Net Investment Income tax.
Wiki David Grabiner

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Re: Tax-Efficient Fund Placement - Wiki

Post by rossington » Thu Jul 11, 2019 3:40 am

grabiner wrote:
Wed Jul 10, 2019 10:02 pm
Call_Me_Op wrote:
Wed Jul 10, 2019 5:33 am
There is one statement from the Wiki on Tax-efficient fund placement that I find confusing. In the section called "Criticism of this tax-placement strategy" the Wiki states:

"Due to higher returns, equities have the potential to expand tax-advantaged space, leading to higher tax savings later on despite higher tax bills in the present. This is particularly true at the presently low bond yields, when the tax penalty from bonds in taxable is not as high as it has been in the past.[3]"

Can someone elaborate on what this is saying? (I underlined the specific statement that is confusing to me.)
Suppose that, in your tax situation, bonds lose a higher percentage than stocks do to taxes. You might still have more money by putting stocks in your tax-deferred account, because the tax-deferred account would grow faster, giving you more tax-deferred money for investments in future years. (However, this is not a clear advantage. The reason you have bonds is the possibility that stocks will not perform well; if stocks perform poorly, you do not get this benefit from stocks in tax-deferred, while you will get the benefit of reduced capital gains if the stocks are in your taxable account.)

The second sentence, about low bond yields, is a different point. If you are in a 22% tax bracket, the tax cost on a bond fund yielding 2% is 0.44%, while the tax cost on a bond fund yielding 4% is 0.88%. Therefore, it may well be that holding bonds in a taxable account is more tax-efficient when yields are low, and less tax-efficient when yields are high.

At the current yield of 2.53% on Total Bond Market Index, bonds and stocks in taxable are about equally tax-efficient in a moderate tax bracket, and munis in taxable are better if you can use a muni fund for your high-tax state or you pay the Net Investment Income tax.
Once you have determined your AA and then yields on bonds and stocks perform opposite your strategy (per examples noted above), rebalancing between the tax deferred and taxable will become an issue possibly skewing your AA...correct?
"Success is going from failure to failure without loss of enthusiasm." Winston Churchill.

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Re: Tax-Efficient Fund Placement - Wiki

Post by grabiner » Thu Jul 11, 2019 1:24 pm

rossington wrote:
Thu Jul 11, 2019 3:40 am
grabiner wrote:
Wed Jul 10, 2019 10:02 pm
The second sentence, about low bond yields, is a different point. If you are in a 22% tax bracket, the tax cost on a bond fund yielding 2% is 0.44%, while the tax cost on a bond fund yielding 4% is 0.88%. Therefore, it may well be that holding bonds in a taxable account is more tax-efficient when yields are low, and less tax-efficient when yields are high.

At the current yield of 2.53% on Total Bond Market Index, bonds and stocks in taxable are about equally tax-efficient in a moderate tax bracket, and munis in taxable are better if you can use a muni fund for your high-tax state or you pay the Net Investment Income tax.
Once you have determined your AA and then yields on bonds and stocks perform opposite your strategy (per examples noted above), rebalancing between the tax deferred and taxable will become an issue possibly skewing your AA...correct?
If you have bonds in your taxable account, and yields rise to make them less tax-efficient, you will have capital losses on your bond holdings, so you can switch to stocks in taxable.

If you have bonds in your tax-deferred account, and yields fall to make them more tax-efficient, you may not be able to switch because of the tax cost. You can still rebalance by investing taxable dividends and new money into bond funds, and, if necessary, selling recently-purchased stock for a small capital gain.
Wiki David Grabiner

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