Tax efficient investments tend to be risky

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
Topic Author
henryphseven
Posts: 122
Joined: Sun Feb 18, 2024 4:56 pm

Tax efficient investments tend to be risky

Post by henryphseven »

The most tax efficient stock funds are funds paying zero to low yields, which tend to be volatile growth funds.

The following table shows five US stock index funds tracking different indexes: (Risk is 3-year standard deviation and Sharpe is 5-year sharpe ratio)
Fund Yield Risk Sharpe
SCHG 0.43% 22.23 0.84
QUAL 1.11% 18.83 0.71
VTSAX 1.35% 17.86 0.69
VDADX 1.75% 15.69 0.70
VVIAX 2.36% 15.62 0.58

Apparently yield is negatively correlated with risk. Conservative investors are forced to pay more taxes in order to be safe.

The most tax efficient bond funds are muni bond funds, which are riskier than treasuries. State-specific muni bond funds are even more tax-efficient than national muni bond funds, but they are also riskier as well.

Due to their tax efficiency, they are suitable to be held in taxable accounts.
However, the money we put in taxable accounts are usually intended for short- to intermediate-term usage like education and home purchase.

How do you stike a balance between these two goals - tax efficient and stable?
Thank you.
Last edited by henryphseven on Sat Apr 06, 2024 11:38 am, edited 2 times in total.
User avatar
greenrebellion
Posts: 94
Joined: Fri Aug 25, 2023 4:26 pm

Re: The most tax efficient investments seem to be the riskiest too

Post by greenrebellion »

henryphseven wrote: Sun Mar 31, 2024 5:44 pm The most tax efficient stock funds are funds paying zero to low yields, which tend to be volatile growth funds.
The most tax efficient bond funds are muni bond funds, which are riskier than treasuries.

Due to their tax efficiency, they are suitable to be held in taxable accounts.
However, the money we put in taxable accounts are usually intended for short- to intermediate-term usage like education and home purchase.

How do you stike a balance between these two goals - tax efficient and stable?
Thank you.
Figure out the correct asset allocation for your situation. Then find the most tax efficient placement for that allocation.
- greenrebellion
livesoft
Posts: 86190
Joined: Thu Mar 01, 2007 7:00 pm

Re: The most tax efficient investments seem to be the riskiest too

Post by livesoft »

The most tax efficient investments are those that always lose money.

My compromise is that I just use broad-market, passively-managed, low-expense ratio index funds in my taxable account. That, and set cost basis method to Specific Identification and tax-loss harvest when opportunities present themselves. A review of our tax returns shows we did not pay capital gains taxes from about 2000 to 2023. Yes, we were paid dividends, but they were mostly qualified dividends so either taxed at 0% or 15%.
Wiki This signature message sponsored by sscritic: Learn to fish.
toddthebod
Posts: 6143
Joined: Wed May 18, 2022 12:42 pm

Re: The most tax efficient investments seem to be the riskiest too

Post by toddthebod »

henryphseven wrote: Sun Mar 31, 2024 5:44 pm The most tax efficient bond funds are muni bond funds, which are riskier than treasuries.
I do not make $750,000/year, so I do not invest in muni bond funds.

I also invest more than half my annual savings into accounts that are not subject to taxes on dividends and capital gains.
User avatar
grabiner
Advisory Board
Posts: 35426
Joined: Tue Feb 20, 2007 10:58 pm
Location: Columbia, MD

Re: The most tax efficient investments seem to be the riskiest too

Post by grabiner »

henryphseven wrote: Sun Mar 31, 2024 5:44 pm The most tax efficient bond funds are muni bond funds, which are riskier than treasuries.
This depends on your tax bracket. In a lower tax bracket, taxable bonds have a higher after-tax return than munis of comparable risk. If you pay state tax and are in a 24% or lower bracket, Treasuries are probably the best bonds for your taxable account.

If you are in a 32% or higher bracket, it is worth using munis, and taking the small additional risk.
henryphseven wrote: Sun Mar 31, 2024 5:44 pm How do you stike a balance between these two goals - tax efficient and stable?
With a large taxable account, you don't have to strike this balance. You can hold stocks in your taxable account, and if you need to spend money when the market is down, you can sell taxable stock, then move an equal amount from bonds to stock in your 401(k) or IRA, keeping the stock exposure.
Wiki David Grabiner
the_wiki
Posts: 3027
Joined: Thu Jul 28, 2022 11:14 am

Re: The most tax efficient investments seem to be the riskiest too

Post by the_wiki »

henryphseven wrote: Sun Mar 31, 2024 5:44 pm The most tax efficient stock funds are funds paying zero to low yields, which tend to be volatile growth funds.
The most tax efficient bond funds are muni bond funds, which are riskier than treasuries.

Due to their tax efficiency, they are suitable to be held in taxable accounts.
However, the money we put in taxable accounts are usually intended for short- to intermediate-term usage like education and home purchase.

How do you stike a balance between these two goals - tax efficient and stable?
Thank you.

You just pick the most tax efficient portfolio you can based on your needs and stop obsessing over taxes.

I mean the lowest taxes are for losses but nobody actually wants that.
User avatar
cosmos
Posts: 245
Joined: Thu Oct 16, 2008 4:11 pm
Location: Third rock from the Sun

Re: The most tax efficient investments seem to be the riskiest too

Post by cosmos »

the_wiki wrote: Mon Apr 01, 2024 8:24 pm
You just pick the most tax efficient portfolio you can based on your needs and stop obsessing over taxes.

I mean the lowest taxes are for losses but nobody actually wants that.
This is bogleheads though so obsessing over taxes is par for the course. :)

Seems everyone sees the tax bill not the 10 million accumulated over the past 30 years of saving.

*shrug*
It's 106 miles to Chicago, we've got a full tank of gas, half a pack of cigarettes, it's dark... and we're wearing sunglasses. Hit it.
Bulletproof
Posts: 18
Joined: Tue Feb 09, 2021 2:07 pm

Re: The most tax efficient investments seem to be the riskiest too

Post by Bulletproof »

I'm convinced that making poor decisions for you (eg. holding the BH-evangelized most tax efficient, lowest ER possible, fund in your taxable account) based on taxes and a few bips causes far more damage, performance drag, and headache than simply not letting the tax, single digit bip, or unknowable future tax legislation tail wag you, the dog.
Bulletproof
Posts: 18
Joined: Tue Feb 09, 2021 2:07 pm

Re: The most tax efficient investments seem to be the riskiest too

Post by Bulletproof »

I'm convinced that making poor decisions for you (eg. holding the BH-evangelized most tax efficient, lowest ER possible, fund in your taxable account) based on taxes and a few bips causes far more damage, performance drag, and headache than simply not letting the tax, single digit bip, or unknowable future tax legislation tail wag you, the dog.

I have some managed futures in my taxable. :o :o :o
Topic Author
henryphseven
Posts: 122
Joined: Sun Feb 18, 2024 4:56 pm

Re: The most tax efficient investments seem to be the riskiest too

Post by henryphseven »

grabiner wrote: Mon Apr 01, 2024 7:59 pm
henryphseven wrote: Sun Mar 31, 2024 5:44 pm The most tax efficient bond funds are muni bond funds, which are riskier than treasuries.
This depends on your tax bracket. In a lower tax bracket, taxable bonds have a higher after-tax return than munis of comparable risk. If you pay state tax and are in a 24% or lower bracket, Treasuries are probably the best bonds for your taxable account.

If you are in a 32% or higher bracket, it is worth using munis, and taking the small additional risk.
henryphseven wrote: Sun Mar 31, 2024 5:44 pm How do you stike a balance between these two goals - tax efficient and stable?
With a large taxable account, you don't have to strike this balance. You can hold stocks in your taxable account, and if you need to spend money when the market is down, you can sell taxable stock, then move an equal amount from bonds to stock in your 401(k) or IRA, keeping the stock exposure.
Suppose I want to use the money in my taxable account to purchase a home, I feel 100% stocks is too risky. Suppose I find a good deal but then the stock market crahses and the value of my taxable account loses 50%. Then I will have to give up the deal.

Even if I want to rebalance the stock position in the taxable account and the bond position in the retirement account, what if the loss amount in the taxable account exceeds the total value of the retirement account? Because the retirement account has annaul contribution limit and money cannot be withdrawn until you retire, I feel it is very difficult to rebalance between these two types of accounts.
User avatar
grabiner
Advisory Board
Posts: 35426
Joined: Tue Feb 20, 2007 10:58 pm
Location: Columbia, MD

Re: The most tax efficient investments seem to be the riskiest too

Post by grabiner »

henryphseven wrote: Sat Apr 06, 2024 10:21 am
grabiner wrote: Mon Apr 01, 2024 7:59 pm
henryphseven wrote: Sun Mar 31, 2024 5:44 pm How do you stike a balance between these two goals - tax efficient and stable?
With a large taxable account, you don't have to strike this balance. You can hold stocks in your taxable account, and if you need to spend money when the market is down, you can sell taxable stock, then move an equal amount from bonds to stock in your 401(k) or IRA, keeping the stock exposure.
Suppose I want to use the money in my taxable account to purchase a home, I feel 100% stocks is too risky. Suppose I find a good deal but then the stock market crahses and the value of my taxable account loses 50%. Then I will have to give up the deal.
This is why I said, "large taxable account"; see Placing cash needs in a tax-advantaged account on the wiki. If your taxable account is twice the size of your cash needs, then it will still be large enough even if the market crashes.
Even if I want to rebalance the stock position in the taxable account and the bond position in the retirement account, what if the loss amount in the taxable account exceeds the total value of the retirement account? Because the retirement account has annaul contribution limit and money cannot be withdrawn until you retire, I feel it is very difficult to rebalance between these two types of accounts.
If the loss in your taxable account could exceed the total value of the retirement account and you intend to spend from the taxable account soon, then you are taking too much risk. If you have, say, $300K in taxable and $100K in tax-deferred (which would cause this problem), and you intend to spend $150K on a home down payment, you should not have $300K in stock, because this means that your stock holding is more than your $250K retirement portfolio. If you kept the home down payment in cash instead, you would only have $250K to invest for retirement and could not hold $300K in stock.

But if you aren't planning to spend the money, this allocation would be fine. If you want 75% stock, you can hold $300K in stock in taxable and $100K in bonds in a retirement account. If the stock market crashes, you won't be able to hold $300K in stock, but that would be true regardless of which account holds the stock. You will rebalance after a crash to get the correct stock allocation.
Wiki David Grabiner
User avatar
firebirdparts
Posts: 4458
Joined: Thu Jun 13, 2019 4:21 pm
Location: Southern Appalachia

Re: Tax efficient investments tend to be risky

Post by firebirdparts »

henryphseven wrote: Sun Mar 31, 2024 5:44 pm Apparently yield is negatively correlated with risk.
Yield is correlated with making profit, really, and lower growth. The stock price will be low because people like us think it should be low. That's what brings it down, and brings the yield up. Those two things. If the executive team wants to use dividends to drive stock price, then they agree with the rest of us on the low earnings growth.

Hi yield outliers, as you know, are due to our opinion that there's going to be negative earnings growth. In that case the super high yield is not an indication of super safety.

What you really need, then, is a "sweet spot" index. This index should be based on market capitalization, since that's the denominator in the yield, and what would be ideal is if somebody would go through and exclude non-profitable companies. That's the perfect solution, really.
This time is the same
life_force_prana
Posts: 70
Joined: Wed Jan 31, 2024 2:44 pm

Re: Tax efficient investments tend to be risky

Post by life_force_prana »

henryphseven wrote: Sun Mar 31, 2024 5:44 pm The most tax efficient stock funds are funds paying zero to low yields, which tend to be volatile growth funds.

The following table shows five US stock index funds tracking different indexes: (Risk is 3-year standard deviation and Sharpe is 5-year sharpe ratio)
Fund Yield Risk Sharpe
SCHG 0.43% 22.23 0.84
QUAL 1.11% 18.83 0.71
VTSAX 1.35% 17.86 0.69
VDADX 1.75% 15.69 0.70
VVIAX 2.36% 15.62 0.58

Apparently yield is negatively correlated with risk. Conservative investors are forced to pay more taxes in order to be safe.

The most tax efficient bond funds are muni bond funds, which are riskier than treasuries. State-specific muni bond funds are even more tax-efficient than national muni bond funds, but they are also riskier as well.

Due to their tax efficiency, they are suitable to be held in taxable accounts.
However, the money we put in taxable accounts are usually intended for short- to intermediate-term usage like education and home purchase.

How do you stike a balance between these two goals - tax efficient and stable?
Thank you.
If you add considerations such as

(1) being in high tax bracket,
(2) needing funds in early retirement before access to retirement accounts,
(3) wanting to keep things simple without executing the oft-advised BH approach of rebalancing between 401k and taxable (let alone the fact that 401ks do not offer safe individual treasuries, and one has to deal with bond funds with constant duration), and
(4) inability to build bridges/ladders in tax deferred accounts

I have come to conclusion that I prefer to not let the tax tail wag investment/asset location decisions. When I am in high income years I will pay my share of taxes, which is price to pay for keeping things simple and safe. When I end up needing to use tax inefficient but safe bonds in taxable, I will be in low tax bracket and those tax inefficient assets will be getting consumed anyways.
steadyosmosis
Posts: 1089
Joined: Mon Dec 26, 2022 11:45 am

Re: Tax efficient investments tend to be risky

Post by steadyosmosis »

henryphseven wrote: Sun Mar 31, 2024 5:44 pm How do you stike a balance between these two goals - tax efficient and stable?
I think many tax-savvy people set up their accounts and holdings like Livesoft suggested.
Age<59.5. Early-retired. AA ~55/45. Taxable account, Roth IRA, HSA...all are 100% equities. 100% of fixed income is in tIRA. I spend from taxable account and rebalance in tIRA.
Florida Orange
Posts: 1200
Joined: Thu Jun 16, 2022 2:22 pm

Re: Tax efficient investments tend to be risky

Post by Florida Orange »

National municipal bond funds that hold bonds from thousands of municipalities are very safe. There has never been widespread default of municipal bonds. On the stock side, I sell as infrequently as possible which keeps my capital gains taxes very low. Between the tax exempt municipal bond interest and the low qualified dividend tax rate I have a nice income with very low taxes. And I live in a state with no state income tax.
Call_Me_Op
Posts: 9913
Joined: Mon Sep 07, 2009 2:57 pm
Location: Milky Way

Re: Tax efficient investments tend to be risky

Post by Call_Me_Op »

Florida Orange wrote: Sat Apr 06, 2024 4:30 pm National municipal bond funds that hold bonds from thousands of municipalities are very safe. There has never been widespread default of municipal bonds. On the stock side, I sell as infrequently as possible which keeps my capital gains taxes very low. Between the tax exempt municipal bond interest and the low qualified dividend tax rate I have a nice income with very low taxes. And I live in a state with no state income tax.
Yes, but to hold muni bonds, you really need to hold them in a fund. So the comparison between munis and treasuries is not just a comparison to be made based upon tax-equivalent yield. You ened to decide how big of a premium makes going with muni's worthwhile - even in your tax rate is high. For me, I stick to T-Bills for my taxable bonds even though my tax rate is fairly high. In fact, right now T-bills have a higher after-tax yield compared to munis, have zero default risk, and essentially no duration risk.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein
adave
Posts: 600
Joined: Thu Sep 13, 2007 7:17 pm
Location: Houston

Re: Tax efficient investments tend to be risky

Post by adave »

VXUS is a good example as it throws off non qualified dividends in a taxable account. I still hold it my taxable account tho. I don’t obsess of taxes.
Topic Author
henryphseven
Posts: 122
Joined: Sun Feb 18, 2024 4:56 pm

Re: The most tax efficient investments seem to be the riskiest too

Post by henryphseven »

grabiner wrote: Sat Apr 06, 2024 11:02 am
henryphseven wrote: Sat Apr 06, 2024 10:21 am
grabiner wrote: Mon Apr 01, 2024 7:59 pm
henryphseven wrote: Sun Mar 31, 2024 5:44 pm How do you stike a balance between these two goals - tax efficient and stable?
With a large taxable account, you don't have to strike this balance. You can hold stocks in your taxable account, and if you need to spend money when the market is down, you can sell taxable stock, then move an equal amount from bonds to stock in your 401(k) or IRA, keeping the stock exposure.
Suppose I want to use the money in my taxable account to purchase a home, I feel 100% stocks is too risky. Suppose I find a good deal but then the stock market crahses and the value of my taxable account loses 50%. Then I will have to give up the deal.
This is why I said, "large taxable account"; see Placing cash needs in a tax-advantaged account on the wiki. If your taxable account is twice the size of your cash needs, then it will still be large enough even if the market crashes.
Even if I want to rebalance the stock position in the taxable account and the bond position in the retirement account, what if the loss amount in the taxable account exceeds the total value of the retirement account? Because the retirement account has annaul contribution limit and money cannot be withdrawn until you retire, I feel it is very difficult to rebalance between these two types of accounts.
If the loss in your taxable account could exceed the total value of the retirement account and you intend to spend from the taxable account soon, then you are taking too much risk. If you have, say, $300K in taxable and $100K in tax-deferred (which would cause this problem), and you intend to spend $150K on a home down payment, you should not have $300K in stock, because this means that your stock holding is more than your $250K retirement portfolio. If you kept the home down payment in cash instead, you would only have $250K to invest for retirement and could not hold $300K in stock.

But if you aren't planning to spend the money, this allocation would be fine. If you want 75% stock, you can hold $300K in stock in taxable and $100K in bonds in a retirement account. If the stock market crashes, you won't be able to hold $300K in stock, but that would be true regardless of which account holds the stock. You will rebalance after a crash to get the correct stock allocation.
Thanks for the article. This is the first time I heard that we can save emergency fund in a retirement account. I used to think emergency fund should be in an FDIC-insured bank account.
Topic Author
henryphseven
Posts: 122
Joined: Sun Feb 18, 2024 4:56 pm

Re: Tax efficient investments tend to be risky

Post by henryphseven »

firebirdparts wrote: Sat Apr 06, 2024 12:00 pm
henryphseven wrote: Sun Mar 31, 2024 5:44 pm Apparently yield is negatively correlated with risk.
Yield is correlated with making profit, really, and lower growth. The stock price will be low because people like us think it should be low. That's what brings it down, and brings the yield up. Those two things. If the executive team wants to use dividends to drive stock price, then they agree with the rest of us on the low earnings growth.

Hi yield outliers, as you know, are due to our opinion that there's going to be negative earnings growth. In that case the super high yield is not an indication of super safety.

What you really need, then, is a "sweet spot" index. This index should be based on market capitalization, since that's the denominator in the yield, and what would be ideal is if somebody would go through and exclude non-profitable companies. That's the perfect solution, really.
What I really need is an index fund which holds stocks satisfying the following criteria:
- zero or low dividend yield
- low volatility

Currently we have growth index fund and low volatility index fund. I wonder if there is a low volatility growth index fund?
Topic Author
henryphseven
Posts: 122
Joined: Sun Feb 18, 2024 4:56 pm

Re: Tax efficient investments tend to be risky

Post by henryphseven »

Call_Me_Op wrote: Sat Apr 06, 2024 5:06 pm
Florida Orange wrote: Sat Apr 06, 2024 4:30 pm National municipal bond funds that hold bonds from thousands of municipalities are very safe. There has never been widespread default of municipal bonds. On the stock side, I sell as infrequently as possible which keeps my capital gains taxes very low. Between the tax exempt municipal bond interest and the low qualified dividend tax rate I have a nice income with very low taxes. And I live in a state with no state income tax.
Yes, but to hold muni bonds, you really need to hold them in a fund. So the comparison between munis and treasuries is not just a comparison to be made based upon tax-equivalent yield. You ened to decide how big of a premium makes going with muni's worthwhile - even in your tax rate is high. For me, I stick to T-Bills for my taxable bonds even though my tax rate is fairly high. In fact, right now T-bills have a higher after-tax yield compared to munis, have zero default risk, and essentially no duration risk.
Yeah I also notice that amomaly - short-term bond's yield is higher than that of intermediate-term bond and treasury's after-tax yield is higher than that of muni for most people. That's why I posted viewtopic.php?t=427202. Not sure how long this will persist.
Topic Author
henryphseven
Posts: 122
Joined: Sun Feb 18, 2024 4:56 pm

Re: Tax efficient investments tend to be risky

Post by henryphseven »

adave wrote: Sat Apr 06, 2024 6:19 pm VXUS is a good example as it throws off non qualified dividends in a taxable account. I still hold it my taxable account tho. I don’t obsess of taxes.
I also held that fund in my taxable account based on the advice in https://www.bogleheads.org/wiki/Tax-eff ... _placement. That fund's high dividend yield and low QDI percentage pushed me to the brink of tax penalty. :(
fyre4ce
Posts: 2567
Joined: Sun Aug 06, 2017 11:29 am

Re: Tax efficient investments tend to be risky

Post by fyre4ce »

The standard asset location strategy is to put tax-inefficient investments like bonds inside pre-tax accounts, and high-growth tax-efficient assets like broad market passive stock funds inside Roth or taxable accounts.

If you are finding you have more tax-inefficient investments that you can fit into pre-tax or Roth accounts, one option worth considering is a variable annuity. Most are junk sold by insurance salesmen, but Fidelity has one with a 0.25% annual fee, which drops to 0.1% if you have >$1M assets inside. VA's fully defer taxes until withdrawal, but also lack some of the benefits of a taxable account like reduced rates on long-term capital gains, and the step-up in basis at death. Both of these matter less for bond-like investments. You need to hold them for a long time (decades) for the advantage to become significant.

With a 5% fully-taxable yield and a 23.8% dividend tax rate, the 0.25% VA has about an 8% advantage over a taxable account after 30 years, and the 0.1% VA has a 12% advantage. Up to you whether these benefits are worth the trouble.
sycamore
Posts: 6464
Joined: Tue May 08, 2018 12:06 pm

Re: Tax efficient investments tend to be risky

Post by sycamore »

henryphseven wrote: Sat Apr 06, 2024 9:08 pm Currently we have growth index fund and low volatility index fund. I wonder if there is a low volatility growth index fund?
What's the difference in volatility between those two funds?
User avatar
Hacksawdave
Posts: 865
Joined: Tue Feb 14, 2023 4:44 pm

Re: Tax efficient investments tend to be risky

Post by Hacksawdave »

I have found this to be the opposite of what my long-term results were. The sector and highly active funds I had owned in the past such as FSPTX Select Technology and VAAPX Vanguard Asset Allocation Fund streamed out vast amounts of distributions. Wellington distributes quite a bit as well, but it is in held my Roth, and I view its holdings as less risky over sectors and timing funds.

My S&P index fund only distributes QDs, and my municipals are mostly all tax-exempt. On a rare occasion the municipal funds will have a tiny CG depending on what happens to interest rates. Vanguard STAR still has some sizable distributions, but it serves a purpose, so I still hang onto it.
Florida Orange
Posts: 1200
Joined: Thu Jun 16, 2022 2:22 pm

Re: Tax efficient investments tend to be risky

Post by Florida Orange »

Call_Me_Op wrote: Sat Apr 06, 2024 5:06 pm
Florida Orange wrote: Sat Apr 06, 2024 4:30 pm National municipal bond funds that hold bonds from thousands of municipalities are very safe. There has never been widespread default of municipal bonds. On the stock side, I sell as infrequently as possible which keeps my capital gains taxes very low. Between the tax exempt municipal bond interest and the low qualified dividend tax rate I have a nice income with very low taxes. And I live in a state with no state income tax.
Yes, but to hold muni bonds, you really need to hold them in a fund. So the comparison between munis and treasuries is not just a comparison to be made based upon tax-equivalent yield. You ened to decide how big of a premium makes going with muni's worthwhile - even in your tax rate is high. For me, I stick to T-Bills for my taxable bonds even though my tax rate is fairly high. In fact, right now T-bills have a higher after-tax yield compared to munis, have zero default risk, and essentially no duration risk.
I agree. But if by duration risk you are referring to the fact that municipal bonds are usually callable, that is not an uncompensated risk. If they were not callable the interest rate would be lower.
Post Reply