Tilting Asset Allocation and taxes

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
blevine
Posts: 1999
Joined: Sat Feb 27, 2010 3:57 pm
Location: New York

Tilting Asset Allocation and taxes

Post by blevine » Sat Nov 20, 2010 10:57 am

Has anyone found good studies comparing the benefits of slicing and dicing
(small vs large, value vs growth, domestic vs international, bond vs equity) and the impact that might be reduced due to taxation of gains realized ?

Just wonder would a portfolio of TSM or even Total World have significant enough tax advantages over constant reallocation between subsets of these funds to overcome the benefits of slicing, dicing and rebalancing ?

I realize this depends on your own tax rates, and tax policies that change over time, but as a general rule of thumb with some break even tax rates would be helpful.

My general inclination is to follow the KISS principal and have the sure benefit of tax avoidance ( I live in a high tax state and I only see Federal and State taxes rising, not falling going forward, IMO), but wondering if I am missing out on some huge upside ?

hsv_climber
Posts: 3969
Joined: Tue Sep 22, 2009 7:56 pm

Post by hsv_climber » Sat Nov 20, 2010 11:06 am

- Keep tax-inefficient assets in tax-advantage accounts

- For rebalancing - sell in tax-advantage accounts, buy in taxable, unless it is TLH.

In other words, if you do it properly then slice & dice is no different than TSM with respect to taxes.

GammaPoint
Posts: 2608
Joined: Sun Aug 02, 2009 10:25 am
Location: Washington

Post by GammaPoint » Sat Nov 20, 2010 11:12 am

Be tough to do any meaningful study that would also apply to you. It all depends on what your AA is exactly, when you buy and sell, the ratio of tax advantaged to taxable space that you have, your own tax rate, etc.

But as hsv_climber said, if you have enough tax-advantaged space then the taxman doesn't know you're doing S&D.

livesoft
Posts: 62716
Joined: Thu Mar 01, 2007 8:00 pm

Post by livesoft » Sat Nov 20, 2010 11:18 am

I am extremely tax-aware and have a slice-and-dice small-cap and value tilted portfolio.

However, the portfolio is split pretty evenly between taxable and tax-advantaged. This allows me to keeps taxes in check with the following techniques which are nothing new and should be intuitively obvious to the most casual observer:

1. Fixed income in tax-advantaged. No fixed income in taxable. Emergency fund in tax-advantage (after all it is fixed income). 2009 Form 1040 Schedule B had less than $10 of interest reported.

2. Tax efficient large cap foreign and large cap or total market in taxable accounts. Almost all our foreign equities are in the taxable side of our portfolio. These funds will pay dividends. There is no desire to avoid dividends either. The yield on such funds is about 2%, so on a million dollars you are going to get $20K or more in dividends that you can't get away from. The foreign funds pay foreign taxes, so you can get the foreign tax credit.

3. Diligent tax-loss harvesting. One should not have to pay capital gains taxes except maybe every 5 to 10 years because you avoid any sales that generate taxable gains. You make sales that generate taxable losses.

4. Take dividends in cash in taxable accounts. Use them for rebalancing. That $20K of dividends per million mentioned in point 2 is 2% of the value of your taxable portfolio and useful for rebalancing.

5. Try to do all your rebalancing sales in your tax-advantaged accounts. If you are still in the accumulation phase then use your contributions wisely to rebalance. If you use bands or ranges to trigger rebalancing, you should find that you need to move less than 3% of your money around. If you have at least a few percent of each asset class in tax advantaged, then you can for all practical purposes do all your rebalancing sales in tax-advantaged. You can do your rebalancing buys in tax-advantaged and taxable. Once you have built up a modest amount of carryover taxable losses (say several hundred thousand dollars), then you won't be too concerned about rebalancing in taxable.

6. The idea that a value index fund (small-cap or large-cap) is not tax efficient is a myth. It is relatively less tax efficient than a total stock market index fund, but not noticeably so. A small cap value index fund is still much more tax efficient than a taxable bond fund. I personally think you can keep a small cap value fund in taxable. Be sure to do tax-loss harvesting with it.

In summary, slice-and-dice can be just as tax-efficient as a total market index portfolio, and maybe even moreso due to more tax-loss harvesting opportunities.

blevine
Posts: 1999
Joined: Sat Feb 27, 2010 3:57 pm
Location: New York

Post by blevine » Sat Nov 20, 2010 11:21 am

If you follow asset location recommendations, people usually would put their bonds in an IRA/401k and equity in taxable accts.

So if you want to move amongst equity funds, you are taking gains
in your taxable acct then.

Guess it depends on your strategy, what is the optimal asset location.

If only all your assets could be tax advantaged !

Yeah, there are many variables, but there are some common parameters
and strategies.

If you have a small tax deferred acct, there is little impact on overall performance to just buy/sell within that small acct. If you have most of your assets in the tax deferred acct, you can day trade, of course.

In my particular case, I have all my tax advantaged assets in fixed income, and due to my overall AA more munis in taxable accts, and all my equities in taxable accts. So if I broke out my TSM to components I'd be taking taxable gains regularly. Seems to me that would offset some of the benefit.

hsv_climber
Posts: 3969
Joined: Tue Sep 22, 2009 7:56 pm

Post by hsv_climber » Sat Nov 20, 2010 12:19 pm

livesoft wrote: 4. Take dividends in cash in taxable accounts. Use them for rebalancing. That $20K of dividends per million mentioned in point 2 is 2% of the value of your taxable portfolio and useful for rebalancing.
As you know, there is a political risk with this approach, since we don't know how dividends will be accounted for in the 2011 tax law.

SDBoggled
Posts: 369
Joined: Wed Oct 27, 2010 4:35 pm

Post by SDBoggled » Sat Nov 20, 2010 12:21 pm

Livesoft:

I wondered have you thought of updating the wiki with your strategies... The current wiki is a great starting point but doesn't help a lot if your taxable >> tax advantaged.

I have not been able to find a great summarizing table for even just the Vanguard ETFs (best I found was VG compare). My reading of e.g. VB, VBR, VEU, VTV, VV says that after-tax-distribution makes a -0.26, 0.44, 0.3, 0.44,0.35% difference to return (using higest fed, no state)... but after-tax-distribution and sale makes -5.16, 4.54,2.12,2.45,3.32% difference to todays 1 year returns of 15.17,13.76,7.19,8.63.10.75.

[Edit as Livesoft points out, the following is garbage:]
So I think it says for me: that TLH sale costs may be much more significant in terms of loss of return than tax on distributions...

(I couldn't work out how to post excel table)
[Edit - upload attempt]
Image[/img]
Last edited by SDBoggled on Sat Nov 20, 2010 6:21 pm, edited 1 time in total.

livesoft
Posts: 62716
Joined: Thu Mar 01, 2007 8:00 pm

Post by livesoft » Sat Nov 20, 2010 12:29 pm

hsv_climber wrote:
livesoft wrote: 4. Take dividends in cash in taxable accounts. Use them for rebalancing. That $20K of dividends per million mentioned in point 2 is 2% of the value of your taxable portfolio and useful for rebalancing.
As you know, there is a political risk with this approach, since we don't know how dividends will be accounted for in the 2011 tax law.
I don't understand your comment at all. Help me out here please. Your equity funds will give you dividends whether they are total-stock-market-indexed or sliced-and-diced indexed.

livesoft
Posts: 62716
Joined: Thu Mar 01, 2007 8:00 pm

Post by livesoft » Sat Nov 20, 2010 12:31 pm

blevine wrote:....
So if I broke out my TSM to components I'd be taking taxable gains regularly. Seems to me that would offset some of the benefit.
Why would you be taking taxable gains regularly? I don't understand that at all. I haven't paid capital gains taxes in years.

Furthermore, an approach for S&D recommended in these forums is to hold a total stock market index fund and a small cap value fund. There is probably no reason for most folks to slice US equities finer than those 2 funds (unless you want a separate REIT fund to go in tax-advantaged).

livesoft
Posts: 62716
Joined: Thu Mar 01, 2007 8:00 pm

Post by livesoft » Sat Nov 20, 2010 12:40 pm

SDBoggled wrote:lll
So I think it says for me: that TLH sale costs may be much more significant in terms of loss of return than tax on distributions...
Sorry, why would TLH sales cost you any money whatsoever? Or did you mean something else?

SDBoggled
Posts: 369
Joined: Wed Oct 27, 2010 4:35 pm

Post by SDBoggled » Sat Nov 20, 2010 1:06 pm

livesoft wrote: Sorry, why would TLH sales cost you any money whatsoever? Or did you mean something else?
Doh! Apologies, I was interpreting that extra -5% cost in return as cost of selling the ETF... now I see it would just be the reduction in return due to tax on the 1 years gain, which of course would not apply to TLH.

Thanks again. I have found all your posts very valuable as I try to work out taxable implications... having never previously invested outside tax advantaged accounts, I am still struggling with the OP problem - how much to slice in taxable.

livesoft
Posts: 62716
Joined: Thu Mar 01, 2007 8:00 pm

Post by livesoft » Sat Nov 20, 2010 1:35 pm

SDBoggled wrote:I am still struggling with the OP problem - how much to slice in taxable.
Well, just start with a total stock market index fund then. That's simple. Then if any TSM shares drop to become a loss, tax-loss harvest by exchanging those lots into a small-cap value fund. This will start you on your way.

If your TSM shares do not drop in value, then you may wish to buy some small-cap value index fund with your contributions. You can even time this if you want: "I will invest in TSM periodically unless TSM has dropped 5% (10%, 20%?) from its recent high, if that happens, I will invest my contribution in a small cap value fund instead."

So you will end up with either 100% TSM or a mix of TSM and SCV. Not until your SCV gets to be equal in value to TSM will you need to ever sell SCV except to tax-loss harvest it. You will never need to sell TSM at a gain.
Last edited by livesoft on Sat Nov 20, 2010 1:40 pm, edited 2 times in total.

hsv_climber
Posts: 3969
Joined: Tue Sep 22, 2009 7:56 pm

Post by hsv_climber » Sat Nov 20, 2010 1:40 pm

livesoft wrote:
hsv_climber wrote:
livesoft wrote: 4. Take dividends in cash in taxable accounts. Use them for rebalancing. That $20K of dividends per million mentioned in point 2 is 2% of the value of your taxable portfolio and useful for rebalancing.
As you know, there is a political risk with this approach, since we don't know how dividends will be accounted for in the 2011 tax law.
I don't understand your comment at all. Help me out here please. Your equity funds will give you dividends whether they are total-stock-market-indexed or sliced-and-diced indexed.
Current dividend yields values from VG website:

Total Stock Market Index Fund yield is 1.48%
Large Cap Value Index Fund yield is 2.04%
Small Cap Value Index Fund yield is 1.97%

So, if you have $100K in Total Stock Market vs. Large Cap Value, you'd get $2,040 vs $1,480 in dividends (in your example, you've used $1 million, so you need to multiply by 10. Personally, I don't know what 1 million is :roll:, since it is too far out of my rich).

With the current tax law, the difference is $560*0.15, but with the new law in 2011 (i.e. if Congress will not make any changes), it would be $560 * your_tax_bracket.

livesoft
Posts: 62716
Joined: Thu Mar 01, 2007 8:00 pm

Post by livesoft » Sat Nov 20, 2010 1:44 pm

Do you think the value indexes will average an extra return annually over TSM to cover those extra taxes? I think so.

hsv_climber
Posts: 3969
Joined: Tue Sep 22, 2009 7:56 pm

Post by hsv_climber » Sat Nov 20, 2010 1:46 pm

livesoft wrote:Do you think the value indexes will average an extra return annually over TSM to cover those extra taxes? I think so.
I do, but that is not the point.
The point (as you wrote in your first post) that it does not matter where to keep value indexes in taxable vs tax-advantages, while it does, especially going forward where we have uncertainty with the tax code.

That is the quote I was referring to:
livesoft wrote:There is no desire to avoid dividends either.
Going forward, someone might pay more attention and keep funds that pay more dividends in tax-adv. accounts.
Last edited by hsv_climber on Sat Nov 20, 2010 1:48 pm, edited 1 time in total.

livesoft
Posts: 62716
Joined: Thu Mar 01, 2007 8:00 pm

Post by livesoft » Sat Nov 20, 2010 1:47 pm

Even if taxes on qualified dividends goes up, I stand by my previous comment:
It is relatively less tax efficient than a total stock market index fund, but not noticeably so.

fundtalk
Posts: 316
Joined: Tue Jun 05, 2007 3:52 pm

Post by fundtalk » Sat Nov 20, 2010 1:51 pm

Important to point out how much ETF's have changed this. When I started investing, you would've been crazy to buy a small cap or value index fund in taxable. Now, it really doesn't matter much.

Livesoft's advice is very good on this matter.

livesoft
Posts: 62716
Joined: Thu Mar 01, 2007 8:00 pm

Post by livesoft » Sat Nov 20, 2010 1:57 pm

hsv_climber wrote: Going forward, someone might pay more attention and keep funds that pay more dividends in tax-adv. accounts.
I agree with this.

For myself, I have a few restraints in tax-advantaged accounts: They are getting filled with fixed income, our 401(k)/403(b) plan offerings do not have value funds that I wish to use, and I prefer to put small-cap emerging markets in tax-advantaged for now.

SDBoggled
Posts: 369
Joined: Wed Oct 27, 2010 4:35 pm

Post by SDBoggled » Sat Nov 20, 2010 1:59 pm

livesoft wrote: Well, just start with a total stock market index fund then. That's simple. Then if any TSM shares drop to become a loss, tax-loss harvest by exchanging those lots into a small-cap value fund. This will start you on your way....
I don't mean to hijack the thread, but I wondered if your your advice would be different if you had to re-invest your total taxable portfolio today? I think this is more like our situation: Due to an inheritance > our total tax-deferred, future taxable contributions (which have been zero up to now) will be a much smaller percentage... and I think, offer much less chance to rebalance or slice going forward than if one was just starting a taxable.

Thanks again,

User avatar
jasonv
Posts: 232
Joined: Sun Sep 12, 2010 9:21 pm
Location: Austin, Texas

Post by jasonv » Sat Nov 20, 2010 2:05 pm

I have read and learned a lot about tax efficient investing here, and while I believe that tax considerations should always be taken into account, adhering to one's desired asset allocation should always take precedence.

livesoft
Posts: 62716
Joined: Thu Mar 01, 2007 8:00 pm

Post by livesoft » Sat Nov 20, 2010 4:18 pm

SDBoggled wrote:I don't mean to hijack the thread, but I wondered if your your advice would be different if you had to re-invest your total taxable portfolio today? I think this is more like our situation: Due to an inheritance > our total tax-deferred, future taxable contributions (which have been zero up to now) will be a much smaller percentage... and I think, offer much less chance to rebalance or slice going forward than if one was just starting a taxable.

Thanks again,
If I had to reinvest my total taxable TODAY, I would probably put 50% in and DCA/market time the rest over the next 10 months. The market timing would be buy something every month, but buy more on days/weeks when the market has dropped significantly. You can decide for yourself what significantly means.

My point was that if you cannot decide whether to do S&D or TSM, at least do the TSM part sooner rather than later. You can always add small cap value to TSM and call yourself a slice-and-dicer. Also if you can't decide what your asset allocation for US equities should be, I think it is OK to pick anywhere from 100% TSM to 50:50% TSM:SCV. That's a very large rebalancing band, so I cannot imagine that you would need to rebalance anytime soon.

BTW, I have only 2 funds of US stocks in taxable: VLCAX + VBR. I have never sold a single share of VLCAX. I have never sold a share of VBR with a gain.

blevine
Posts: 1999
Joined: Sat Feb 27, 2010 3:57 pm
Location: New York

Post by blevine » Sat Nov 20, 2010 5:26 pm

Thanks all, this was a very helpful discussion.

livesoft
Posts: 62716
Joined: Thu Mar 01, 2007 8:00 pm

Post by livesoft » Sat Nov 20, 2010 6:14 pm

hsv_climber wrote:...
With the current tax law, the difference is $560*0.15, but with the new law in 2011 (i.e. if Congress will not make any changes), it would be $560 * your_tax_bracket.
I wanted to revisit this. Suppose you have $2 million in your taxable account and had it split half TSM and half SCV. hsv_climber's math would suggest that you get an extra $5600 in dividends over holding 100% TSM. Let's suppose you are in the 40% tax bracket (Fed+State), so you pay an extra $2240. Who cares? You've got TWO miiiilllliooooon dollars in a taxable account. You are a MULTI-MILLIONAIRE. You are supposed to pay taxes and that extra 0.1% on your total taxable investments is not gonna bother you. You can make it up by investing on a "worst day". :)

Obviously, if you had less in taxable, you would pay less in taxes and maybe your tax rate would be lower as well.

SDBoggled
Posts: 369
Joined: Wed Oct 27, 2010 4:35 pm

Post by SDBoggled » Sat Nov 20, 2010 6:45 pm

I think as far as the OP goes VB over VTI would have paid off using numbers from VG 1 year returns (available today)... looking at the after tax returns... (I managed to edit my earlier post to include a table).

The effect of taxes seem like higher expense ratios... not necessarily absolutely prohibitive, though certainly provide a higher hurdle. Obviously, in future, taxes may go up and the VB advantage may fall or be negative... so at times you may be paying a higher % of tax for a lower return as compared to VTI.

Post Reply