Growth Stocks in Taxable Account Without Divident/Phantom Income?

[stevemac]

Greetings, and I hope the title is reasonably understandable.

I've been consolidating accounts and now have one taxable and one tax-deferred, and am about to do my first "real" asset allocation/balancing (mostly in cash at the moment, and the taxable account is entirely cash). The taxable account is large enough after money market allocation that I'll have significant leftover for stocks (this thread assumes I should not have bonds or REITS in a taxable fund, or arguably dividend stocks, which I'll get to momentarily).

I could just put VTSAX in the taxable account, and had understood VTSAX to be a "growth" fund, but saw on Vanguard that it dispenses dividends. If I reinvest then I pay tax on phantom income, as I understand it. I could take the cash and pay tax now, but I'm not yet retired and would prefer not to pay at current tax rate (high due to work income).

VTSAX will be in my tax-deferred account anyway, so my question is this (and thank you for hanging on to this point): Are there stock "growth" funds for which there is no taxable event (i.e., LTCG) until the stock is sold that don't involve dividends? I looked into various Vanguard growth funds (small-cap, mid-, etc.) and in each case there are dividends.

So perhaps I don't fully appreciate the difference between "growth" and "income" funds, and very much appreciate the guidance here. The goal is to use the taxable account monies to generate future profits/income after I retire (other than money market payments, which I know I can't avoid in that account).

Thanks very much.

 

[OldShooter]

Well, a fund that receives dividend and/or interest income or sells stock nets out the gains and the losses, then "distributes" those to the shareholders. Taxation 101.

Passive funds don't trade much, so capital gains are minimized. There are also "tax managed" funds that attempt do what you are asking for but zero distributed gains are probably not achievable.

What the fund is called ("value," growth," etc.) has very little to do with it except to the extent that actively managed funds are almost certainly going to throw off more gains and losses. Not to mention that they will almost certainly underperform passive funds over a long period.

 

[stevemac]

Well, a fund that receives dividend and/or interest income or sells stock nets out the gains and the losses, then "distributes" those to the shareholders. Taxation 101.

Passive funds don't trade much, so capital gains are minimized. There are also "tax managed" funds that attempt do what you are asking for but zero distributed gains are probably not achievable.

What the fund is called ("value," growth," etc.) has very little to do with it except to the extent that actively managed funds are almost certainly going to throw off more gains and losses. Not to mention that they will almost certainly underperform passive funds over a long period.

This is very helpful, and I hadn't considered the part "sells stock, nets out the gains and the losses, then 'distributes'" as part of the dividend. Thanks for that part.

As for passive versus active funds, may I add 3 questions: (1) Would I be correct in characterizing VTSAX as active? (2) What is it about active funds that would make them "almost certainly underperform" passive funds? and (3) Are there one or more good passive Vanguard funds worth looking into?

Thanks again.

 

[Gumby]

I could just put VTSAX in the taxable account, and had understood VTSAX to be a "growth" fund, but saw on Vanguard that it dispenses dividends. If I reinvest then I pay tax on phantom income, as I understand it. I could take the cash and pay tax now, but I'm not yet retired and would prefer not to pay at current tax rate (high due to work income).

Why is it "phantom income" if you reinvest dividends? It is still the same dollars and cents received. You are just choosing to buy new stock with it.

As Oldshooter notes, the name/description of the fund is irrelevant; you almost certainly will have a distribution at the end of the year. If you don't want taxable income, you have essentially two choices: 1) buy individual stocks that don't pay a dividend and then never sell them so you never realize a capital gain or 2) municipal bonds or bond funds.

 

[pb4uski]

I think what the OP wants to do is to minimize taxable income from their taxable account investments.

If you have international stocks as part of your asset allocation, then it is best to have them in taxable accounts because while some of the dividends are ordinary income, you get a foreign tax credit for foreign taxes paid... and any foreign taxes paid go to waste in a tax-deferred account since you get not tax benefit for them.

Aside from that, I would go with VTSAX.... the dividends are modest and for most taxpayers are subject to either 0% or 15% tax depending on the level of their taxable income. What tax bracket are you in? If you're in the 12% or lower then dividends are tax-free so your question is moot... if you're in the 22% or higher then your tax on dividends is usually only 15%.

You could try to get fancy and buy some individual stocks like BRK.B that don't pay dividends but IMO the downsides of less diversification are not worth the minimal tax drag.

You also may want to read this: https://www.bogleheads.org/wiki/Tax-efficient_fund_placement

Also, there is no such thing as "phantom" income... it is income... the fact that you have chosen not to receive it and to reinvest it doesn't change it's character one iota.

If the OP is in a real high tax bracket they could invest in munis in their taxable account and then make commesurate adjustments to invest more in equities in their tax-deferred accounts.

 

[bingybear]

First VTSAX is not a growth fund. It is called Total stock market for a reason, it tries to provide the total return of of the US stock market which would include value stocks and more.

If you reinvest a dividend, it is not phantom income.... it is quite real.

Be careful of MF as they can distribute due to other people selling part of their holdings.

I've not looked for specific ETFs that would not kick out some dividends, but buying growth stocks that don't distribute (like Berkshire Hathaway would likely be one.

If you do look for an ETF that suits your desires, make sure it doesn't re-balance its holding as that could cause distributions.

 

[Gumby]

(1) Would I be correct in characterizing VTSAX as active? (2) What is it about active funds that would make them "almost certainly underperform" passive funds? and (3) Are there one or more good passive Vanguard funds worth looking into?

VTSAX is not strictly mechanistic like VFINX (S&P 500 Index fund). VFINX just buys all the stocks in the Standard and Poors 500 Index in the proportion they represent of the index. So it is completely passive. VTSAX, by contrast, attempts to track the performance of the entire market using a sampling methodology, so it buys an assortment of stocks that have been statistically demonstrated to be representative of the whole market. There is some "active" part that goes into selecting the sample, but it is not really an active fund.

Now, something like VWELX (Wellington) buys stocks that the managers pick as most likely to deliver the best total return for the fund. It is an active fund.

P.S. - you can read the prospectus for every Vanguard fund by going to their website. It will tell you exactly how they invest.

 

[OldShooter]

(1) Would I be correct in characterizing VTSAX as active?

No. It is a total market index fund and quite a good one. If you want to hold only US stocks this is the only fund you need. To add some international stocks (IMHO a very good idea) add VGTSX.

(2) What is it about active funds that would make them "almost certainly underperform" passive funds?

Here is the mathematical answer from a Nobel prize winner: https://web.stanford.edu/~wfsharpe/art/active/active.htm. As a practical matter we have 50 years of academic research and statistical analysis showing that only a few percent of active funds beat passive over five or ten year periods and, sadly, it is not possible to identify the winners ahead of time. That is why the majority of stocks in the US are now held in passive portfolios.

(3) Are there one or more good passive Vanguard funds worth looking into?

The nice thing about total market funds, in addition to their being proven good investments, is that you need only one.

DW and my preferred fund (also at Vanguard) is VT, which holds the whole world, 7000 stocks instead of just the 3600 in the US. You will find heated debates here about the right percentage of international vs US. A good video is here: https://famafrench.dimensional.com/videos/home-bias.aspx

The other nice thing is that the fund companies have been slitting each others' throats on price for a couple of years and the fees for total market index funds now vary between zero and negligible.

 

[gwraigty]

The goal is to use the taxable account monies to generate future profits/income after I retire (other than money market payments, which I know I can't avoid in that account).

Thanks very much.

You can use an ETF screener to sort by lowest dividend yield first among growth stock ETFs. VTI is the ETF version of VTSAX. You can compare the results via Portfolio Visualizer using VTI as one of the portfolio options to see if you will get the sort of growth you want with lower taxable income. Let us know if you need a primer on that.

 

[LRDave]

I think what the OP wants to do is to minimize taxable income from their taxable account investments.

If you have international stocks as part of your asset allocation, then it is best to have them in taxable accounts because while some of the dividends are ordinary income, you get a foreign tax credit for foreign taxes paid... and any foreign taxes paid go to waste in a tax-deferred account since you get not tax benefit for them.



You could try to get fancy and buy some individual stocks like BRK.B that don't pay dividends but IMO the downsides of less diversification are not worth the minimal tax drag.

pb4uski: If you had $50K in an international stock fund, $50K of BRK.B (both in tIRAs) and you had cap room to convert $50K to Roth - from those two options, which would convert and why?

EDIT: Emily luttella: Nevermind....

(No tax consequences in Roth.) So what is best to convert from TIRA to Roth?

 

[pb4uski]

^^^^ I'm not sure it matters... in both cases (tIRA or Roth) you lose the foreign tax credit... I guess I would convert the one that I expect to have a higher total return since the total return will be tax-free... I'm assuming that whatever is converted is bought in the Roth so the overall AA is unchanged.

 

[OldShooter]

... I guess I would convert the one that I expect to have a higher total return ...

Here is wisdom. It is far too easy to get focused on tax issues like foreign tax credits, fund distributions, etc. and forget that the goal is to end the game with the maximum amount of money in our pockets.

@stevemac, this is an important thing for you to remember as you consider your fund distribution question. The tax tail should not wag the investment dog.

 

[stevemac]

Here is wisdom. It is far too easy to get focused on tax issues like foreign tax credits, fund distributions, etc. and forget that the goal is to end the game with the maximum amount of money in our pockets.

@stevemac, this is an important thing for you to remember as you consider your fund distribution question. The tax tail should not wag the investment dog.

Everyone here has been extremely helpful, so in additin to quoting OldShooter's message and saying thanks, I want to expressly thank Gumby, pb4uski, bingybear, gwraigty, and LRDave for taking the time to write. There are several questions/comments made, that I believe deserve a response:

1. Why is it ‘phantom income’ if you reinvest divided (Gumby): I use the phrase beczuse as I understand it, one must pay taxes on the dividends in the year they issue, even if you don’t take the money that year. It’s a phrase both my accountant and the accountant expert witnesses I employ use frequently. Hopefully it’s properly used here.

2. “I would go with VTSAX…What tax bracket are you in?” (pb4uski): Highest brackets both federal and state at the moment as I have my own business and it generates enough income to be at the top even with every deduction. This is why pbuski is also correct when he says “I think what [I want to do] is minimize taxable income” from the taxable account.

3. The advice for Munis in the taxable account is a good one, though I also understand that if the Muni is in a state other than your own, you can owe tax on some of those bonds…I’ll have to check.

4. “VTSAX is not a growth fund” (bingybear): That’s exactly what I believe, though Vanguard has this in the description: “Vanguard Total Stock Market Index Fund is designed to provide investors with exposure to the entire U.S. equity market, including small-, mid-, and large-cap growth and value stocks.” And somewhere I saw it listed as a “growth” fund but now (of course) I can’t find it. So I’ll go with you guys.

5. Thanks for the help on “active” versus “passive” funds (various people). Excellent analysis.

6. An Emily Lutella reference (LRDave) – classic.

 

[gwraigty]

1. Why is it ‘phantom income’ if you reinvest divided (Gumby): I use the phrase beczuse as I understand it, one must pay taxes on the dividends in the year they issue, even if you don’t take the money that year. It’s a phrase both my accountant and the accountant expert witnesses I employ use frequently. Hopefully it’s properly used here.

<snip>

3. The advice for Munis in the taxable account is a good one, though I also understand that if the Muni is in a state other than your own, you can owe tax on some of those bonds…I’ll have to check.

1. I believe phantom income might be used more appropriately for something like zero coupon bonds, where you're paying tax annually on the income you're not actually going to receive until the maturity date. In your case, you did receive the income. You just chose to have it reinvested in more shares instead of paid in cash.

3. I just recently spoke with someone else who had a similar understanding, which is wrong the way you've written it. If munis are in one of the other 49 states other than your own, the interest income is probably taxable on your state income tax return, not your federal income tax return. (The exception would be BABs, which I don't think are issued anymore.) This isn't a big concern, unless you're in a particularly high tax state. It adds a bit of complexity to doing your state taxes, but nothing too bad.

 

[pb4uski]

1. I believe phantom income might be used more appropriately for something like zero coupon bonds, where you're paying tax annually on the income you're not actually going to receive until the maturity date. In your case, you did receive the income. You just chose to have it reinvested in more shares instead of paid in cash.

3. I just recently spoke with someone else who had a similar understanding, which is wrong the way you've written it. If munis are in one of the other 49 states other than your own, the interest income is probably taxable on your state income tax return, not your federal income tax return. (The exception would be BABs, which I don't think are issued anymore.) This isn't a big concern, unless you're in a particularly high tax state. It adds a bit of complexity to doing your state taxes, but nothing too bad.

+1 on phantom income... dividends reinvested is not phantom income at all... it is income that the taxpayer has made a conscious decision to reinvest... I would disagree with the OPs experts. I agree with gwraigty... that is novel.

On the second part (or is it the third part... I'm confused...), the OP's profile indicates that he is in California... a very high tax state... but also a state with lots of Ca muni bond funds out there that would be tax free for both federal and state since the OP is in a high tax bracket.

 

[ocean view]

1. Why is it ‘phantom income’ if you reinvest divided (Gumby): I use the phrase beczuse as I understand it, one must pay taxes on the dividends in the year they issue, even if you don’t take the money that year. It’s a phrase both my accountant and the accountant expert witnesses I employ use frequently. Hopefully it’s properly used here.

You need to think about your reinvested dividends differently. What actually is happening is two separate transactions.

Transaction #1: VTSAX distributes a dividend of $1000. For this example let’s assume that cash is deposited into your settlement fund at VG, not reinvested automatically. This is a taxable event.

Transaction #2: Hey, I have $1000 new dollars sitting as cash that I’d like to invest in VTSAX! So you buy some shares.

The difference between my example and dividend reinvestment is simply administrative. The end result is the same. YOU made the choice to reinvest and not take the dividend as cash, so the right of receipt makes it taxable. There is no phantom income.

 

[stevemac]

The difference between my example and dividend reinvestment is simply administrative. The end result is the same. YOU made the choice to reinvest and not take the dividend as cash, so the right of receipt makes it taxable. There is no phantom income.

I'll have to respectfully highlight this summary by the Bogleheads using TIPS as an example: "This problem of paying taxes on income not received until a future date is often referred to as the 'phantom income' problem." (https://www.bogleheads.org/wiki/Treasury_Inflation_Protected_Security#Tax_considerations)

I've seen similar definitions of "phantom income" for decades. You are correct that a decision was made to use the "money" that could otherwise be returned as cash, but it's the paying of taxes on money you haven't yet received which makes it "phantom".

 

[pb4uski]

Disagree all you want, but you're just plain wrong. What you are not seeing is that the criitical element isn't the receipt of cash... it is the RIGHT to receive cash.

The TIPS inflation adjustment is legitimately phantom income, you never receive cash or even have the right to receive cash for the inflation adjustment... yet you are taxed on it.... the inflation adjustment is similar to reinvested dividends in that it is taxable and is added to the investment except the investor doesn't have a choice to receive cash like they do with dividends.... a nuance of a difference that makes it totally different.

With reinvested dividends you have the right to receive cash, you just chose not to.... so it is NOT phantom income.

 

[Gumby]

I'll have to respectfully highlight this summary by the Bogleheads using TIPS as an example: "This problem of paying taxes on income not received until a future date is often referred to as the 'phantom income' problem." (https://www.bogleheads.org/wiki/Treasury_Inflation_Protected_Security#Tax_considerations)

I've seen similar definitions of "phantom income" for decades. You are correct that a decision was made to use the "money" that could otherwise be returned as cash, but it's the paying of taxes on money you haven't yet received which makes it "phantom".

You can call reinvested dividends anything you want, but the economic reality is that it is real, current income. More importantly, the IRS says that it is real, current income. That's why you pay income tax on it.

PS - you don't have to receive cash to receive income. Dividends legally can be paid in shares of company's own stock, physical assets, investment securities, shares of another company (as in a spin-off), warrants, options, real estate or almost anything else of value. All of that is income, whether you reduce it to cash or not.

 

[RobbieB]

Yup, there is no phantom income. Just because you never saw it it's real and pay the tax baby!

Me, I see it every month when all my divi's and interest get transferred to my cash accounts so I can...

Blow That Dough -

 

[stevemac]

Thanks to everyone for the comments, and I see the point. The accounting experts I employ regularly for court testimony refer to the phantom part of the income during the year in which it is "earned" but not distributed, and thus taxes are due. I highlighted this just so people could address the issue of how to allocate funds understanding taxes may be due during a year for which related income is not distributed to them.

 

[pb4uski]

What you need to ask your accounting experts is whether they consider reinvested dividends to be phantom income.... while there are different kinds of phantom income... the inflation adjustment of TIPS being a great example.... reinvested dividends are not in that category (BTW, I'm a retired Big 4 CPA).

Where the taxpayer is entitled to receive the income and choses not to it is not phantom income.

Let us know what they tell you.

With respect to the last part, many/most of us here chose to receive dividends from taxable accounts in cash once we are retired... and reinvest dividends in tax-deferred and tax-free accounts.

 

[ocean view]

I’m going to guess that the tax experts that you employ are speaking about a business that is an accrual basis taxpayer. In this case, yes, accrual basis taxpayers (e.g. corps) would be taxed when the income is earned not paid.

Individuals are generally CASH basis taxpayers, who include payments in income in the year received. Big difference.

 

[OldShooter]

Killjoy, I know, because everyone has been having fun with this but here is a pretty good explanation of the phantom income concept: "Phantom income is money that is never received by a partnership or individual but is still taxable." (https://www.investopedia.com/terms/p/phantom-income.asp)

The taxpayer has constructive receipt: "An individual is considered to be in constructive receipt of income when they have the ability to control or utilize the funds, even if they do not have direct possession of them ..." (https://www.investopedia.com/terms/c/constructive-receipt.asp) So mutual fund capital gains and interest are not "phantom."