Tax Efficiency - Something Investors Should Know

[Midpack]

Discussed many times, but for those who believe a picture is worth a thousand words (yours truly), this says it all...from arguably one of the best investing resources online. Principles of Tax-Efficient Fund Placement - Bogleheads. Something I consider every time I invest in a new asset (and has determined my AA to some extent).

Apologies if this has been shared in the past, I don't remember seeing it here at least in the past few years...

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General strategy Choose your basic asset allocation (stocks/bonds/cash) before worrying about taxes. If possible, put your most tax-inefficient funds in your tax-advantaged accounts (IRA, Roth IRA, 401(k), 403(b), etc.). If you would have to hold a tax-inefficient fund in a taxable account, consider a more tax-efficient alternative, such as a stock index fund rather than an active fund.

[Danmar]

Good post thanks. An even more efficient structure is holding solid dividend payers directly and not rebalancing very often.

[LOL!]

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Originally Posted by Danmar Good post thanks. An even more efficient structure is holding solid dividend payers directly and not rebalancing very often.

Uh, no.

[Sconie]

Thanks for posting---liked the "arrow" chart. Sconie

[haha]

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Originally Posted by Danmar Good post thanks. An even more efficient structure is holding solid dividend payers directly and not rebalancing very often.

One reason I am trying to get more more into a Roth. Without taxes on sales, I think solid incremental gains can come from at times selling good but overpriced stocks in favor of good but cheaper stocks, as long as you stay in the high quality, high dividend coverage and high dividend and earnings growth class.

Ha

[Danmar]

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Originally Posted by haha One reason I am trying to get more more into a Roth. Without taxes on sales, I think solid incremental gains can come from at times selling good but overpriced stocks in favor of good but cheaper stocks, as long as you stay in the high quality, high dividend coverage and high dividend and earnings growth class. Ha

Agree for a tax exempt account. I don't have a very big tax exempt account here in Canada(represents about 1% of total portfolio) because my pension was so generous.

[freebird5825]

The "tax efficiency" light bulb went off in my head within the first few years of investing. I made a lot of mistakes selecting tax inefficient funds. When I saw what I had to pay on cap gains/dividends from actively managed funds in taxable accounts during better market years, I got with the program very quickly. The good news is my investing plan was still in its infancy, so I didn't get burned too badly.
Post-FIRE, the only tax free acount I have right now is my Roth, created while I was still w*rking. I have VGENX, VBIAX, and DODIX in there, growing very nicely.
The screwy IRS rules prevent me, as a single person, from contributing to my Roth any further because I have no longer have earned income. Gee thanks!
So I keep index funds, managed funds with lower turnover, and TE munis in my taxable retirement portfolio.

[ERD50]

Another reason to weight your AA towards equities. Especially as long as cap gains have lower tax rates.

I'll question (and I mean question, 'cause I dunno) the conventional wisdom of "If possible, put your most tax-inefficient funds in your tax-advantaged accounts (IRA, Roth IRA, 401(k), 403(b), etc.)."

What I'm thinking, is that since the growth in a Roth is not taxed, I want my highest growth investments in the Roth. That is likely to be equities, which can fall into the 'tax efficient' category. Is there something wrong with that thinking?

-ERD50

[LOL!]

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Originally Posted by ERD50 What I'm thinking, is that since the growth in a Roth is not taxed, I want my highest growth investments in the Roth. That is likely to be equities, which can fall into the 'tax efficient' category. Is there something wrong with that thinking? -ERD50

Two things:

1. Roth is precious tax-free space, but at a cost: you pay taxes ahead of time, so on a pre-tax to post-tax basis it is really no different than a 401(k) or traditional IRA.

2. Highest growth investments mean highest chance of loss investments. Since the Roth is precious and cannot be topped up easily, you don't want to lose money in your Roth IRA. That means conservative investments when the market is overvalued. Sure, you can have risky investments when the market is undervalued, but it is probably wiser to have a balance.

[chinaco]

I have been looking into this for that last couple of years as I prepare to FIRE (Retire) and enter the withdrawal phase.

My focus has turned to "how do I optimize the use of our financial resources and spending decisions". This pertains to:

• My assets and Payment due to me (Income streams - Pension, SS) which will generate income (tax efficiency, manage risk, get a fair return)
• My spending (discretionary and non-discretionary)

[Aeowyn]

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Originally Posted by ERD50 Another reason to weight your AA towards equities. Especially as long as cap gains have lower tax rates. I'll question (and I mean question, 'cause I dunno) the conventional wisdom of "If possible, put your most tax-inefficient funds in your tax-advantaged accounts (IRA, Roth IRA, 401(k), 403(b), etc.)." What I'm thinking, is that since the growth in a Roth is not taxed, I want my highest growth investments in the Roth. That is likely to be equities, which can fall into the 'tax efficient' category. Is there something wrong with that thinking? -ERD50

I agree that you want to put you're higher return assets in Roth accounts regardless of tax efficiency.

If you have tax deferred accounts, I think these are a good place to put taxable bonds and other tax inefficient funds.

But I think a high return, low turn-over fund with no/low dividend may actually be better off in a non-sheltered account than a tax deferred account (of course Roth is still best). The reason is that everything you take out of a tax deferred account gets taxed as ordinary income. In a non-sheltered account, long term capital gains are taxed at a more favorable rate than income (at least for now).

[Ronnieboy]

This might be a light bulb moment for me (ta-da). Part of my retirement plan (I am still accumulating) was to buy and hold dividend stocks for a partial income stream

If I B&H in after tax, I will always be paying taxes on said dividends, which while the tax rate might be favorable now it can always change. 2nd held belief is that when I retire DW and I would be in a small enough tax bracket that the dividends would still be taxed at a low rate if dividends were taxed at ordinary income levels.

New plan: If I shift my dividend stock buying to a ROTH IRA then any and all dividends reinvested would be tax free while accumulating then when we retire and switch from dividends reinvested to paid out those monies are tax free too since they are in a ROTH IRA?
So in theory, if you had a large enough stash in ROTH IRA that was throwing out quarterly/monthly dividends to live off of you could essentially do that w/o paying any taxes on them?!?
Is this a correct assumption or am I planning a future tax evasion scheme

[nun]

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Originally Posted by ERD50 Another reason to weight your AA towards equities. Especially as long as cap gains have lower tax rates. I'll question (and I mean question, 'cause I dunno) the conventional wisdom of "If possible, put your most tax-inefficient funds in your tax-advantaged accounts (IRA, Roth IRA, 401(k), 403(b), etc.)." What I'm thinking, is that since the growth in a Roth is not taxed, I want my highest growth investments in the Roth. That is likely to be equities, which can fall into the 'tax efficient' category. Is there something wrong with that thinking? -ERD50

I was thinking that too, but compromised by having a big Wellesley allocation in my ROTH. Historically it's been a safe bet, good appreciation and throws off income that will never be taxed. So is Wellesley the perfect fund to have in a ROTH?

[MooreBonds]

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Originally Posted by LOL! Two things: 2. Highest growth investments mean highest chance of loss investments. Since the Roth is precious and cannot be topped up easily, you don't want to lose money in your Roth IRA. That means conservative investments when the market is overvalued. Sure, you can have risky investments when the market is undervalued, but it is probably wiser to have a balance.

+1. That has been my line of thought over the years.

Of course, when you go heavy on preferred stocks in your ROTH and Traditional IRAs, and some of them subsequently evaporate as some companies issuing them disappear , you have to rethink just what is truly "risky" and what is relatively safer.

[ERD50]

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Originally Posted by LOL! Two things: 1. Roth is precious tax-free space, but at a cost: you pay taxes ahead of time, so on a pre-tax to post-tax basis it is really no different than a 401(k) or traditional IRA. 2. Highest growth investments mean highest chance of loss investments. Since the Roth is precious and cannot be topped up easily, you don't want to lose money in your Roth IRA. That means conservative investments when the market is overvalued. Sure, you can have risky investments when the market is undervalued, but it is probably wiser to have a balance.

The above was in response to (still wishing for embedded quote option) - I edited it slightly for better hind-sight clarity:

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Originally Posted by ERD50 What I'm thinking, is that since the growth in a Roth is not taxed, I want my highest growth investments in the Roth. That is likely to be equities, which can (edit: ALSO) fall into the 'tax efficient' category. Is there something wrong with that thinking?

Thanks LOL!, that's good food for thought. In the end though, my main goal for increasing my ROTH allocation is tax diversity. Most of my net worth is personal or IRA, so they are taxed as I take gains or withdraw. The Roth will (if current regs stand) provide an option for pulling some income tax free, so I want to maximize that (which I can only do as long as DW prefers work to seeing me all day ). In the long run that might be more important than which investment is where, but I'll ponder on all this.

-ERD50

[freebird5825]

Here's a good summary article from M*

Tune Up Your Taxable Portfolio

[Hobo]

Strangely, I never found any great advantage to looking at tax consequences while investing or saving for retirement. I guess my life is not as consistent as most peoples, but for some reason or another after retirement I was always forced to pull money from a tax free IRA on a year I had low income. Money for my DW's illness is one example. The converse also held true. I felt an urgent need to pull out money from tech stocks before the "dot-com" bubble burst. It just so happened I had sold a rental house earlier that year and had a big, taxable profit.

Of course, it can't hurt to try and arrange your investments in a tax efficient manner, as long as you don't get obsessed with saving taxes at the expense of making wise investment decisions:
"Choose your basic asset allocation (stocks/bonds/cash) before worrying about taxes."

I found that having an in-depth knowledge of the IRS tax code to be a tremendous benefit when I was working. I was able to keep much more of my gross income by manipulating myself as private contractor or making myself a corporation. That strategy can have a huge tax benefit. Another strategy was taking my elderly mother as a dependent.

[FinanceDude]

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Originally Posted by LOL! Two things: 1. Roth is precious tax-free space, but at a cost: you pay taxes ahead of time, so on a pre-tax to post-tax basis it is really no different than a 401(k) or traditional IRA.

What if the contributions were taxed at a much lower tax rate than the withdrawals will be? If you paid the taxes when your margianl rate was 28%, and now withdrawals are taxed at 40%, you would be happy you did the Roth...........

[RunningBum]

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Originally Posted by ERD50 What I'm thinking, is that since the growth in a Roth is not taxed, I want my highest growth investments in the Roth. That is likely to be equities, which can fall into the 'tax efficient' category. Is there something wrong with that thinking? -ERD50

As others have pointed out, you may not want the risk of loss, plus if you hold, LTCG rates aren't that bad, for now anyway.

One exception to the risk component, is that if this is a conversion from a regular IRA, and you lose on the investment, you can recharacterize it back to a regular IRA, and then convert again later. This let's you convert the stock, and pay taxes, on the lower price of the stock. You get all of the benefits if the stock price increases, but reduce the losses if it goes down by reducing the conversion tax.

Just another angle to think about.

[Safe Harbour]

I have been thinking about the question of what part of the portfolio to hold in Tax Deferred account recently. I am stuck on the question of keeping bonds and cash in the IRA (non-ROTH) for tax efficiency verse keeping them in the non-deferred account for access incase of sever market downturns. I have been keeping 5 years of cash/bonds in the non-deferred to ride out such a downturn. This means I have very little bonds/cash for the IRA, 5 years is 25% of my portfolio and I am 65% stock. Any thoughts on why this issue is not discussed in Tax Strategy discussions? Any thoughts on the issue in general?