Where can the uninformed learn about "tax advantaged" investing?

[dessert]

I keep reading posts where references are made to selling mutual funds to reduce your tax liability. It leaves me wondering how the "do it yourselfers" have learned how to do this.
I guess the bottom line is "I'd like to learn this myself and would like to know where to get this type of information".
Is this terribly complicated or can anyone learn to help themselves this way?

 

[FIREd]

Are you talking about making your portfolio tax efficient, or are you talking about "tax harvesting" (where you sell the losers to compensate for eventual gains elsewhere and therefore reduce your tax bill in a given year)?

 

[Animorph]

morningstar.com should have some educational articles about tax efficiency and tax havesting.

There's nothing too difficult about it if you know how to do your own taxes. The worst part of tax harvesting is buying a fund and watching it go down! Then you can sell it and balance out that loss against your other sales gains. There are simple rules for balancing out short-term and long-term (>1 year) gains and losses. You also have to watch out not to trigger the wash sale rule by buying the same fund within +/-30 days before or after you sell it for a loss (watch out for distributions!). You don't want to mess with that.

Dan

 

[LOL!]

Read "The Bogleheads' Guide to Investing"

There are three parts to this:

1) Purchase only tax efficient funds in your taxable accounts such as the Vanguard Total Stock Market Index fund or the the Vanguard FTSE all-world ex-US index fund.

2) If you taxable funds ever build up a loss, then do tax-loss harvesting. See http://www.early-retirement.org/forums/showpost.php?p=583857&postcount=106 for some thoughts on that.

3) Use your tax qualified accounts (IRAs, 401k) for tax inefficient funds like fixed income funds, REITs, small cap value.

 

[dessert]

Are you talking about making your portfolio tax efficient, or are you talking about "tax harvesting" (where you sell the losers to compensate for eventual gains elsewhere and therefore reduce your tax bill in a given year)?

Thanks. I guess I want to learn about both of your examples.

morningstar.com should have some educational articles about tax efficiency and tax havesting.

Thanks. I will go there to see what I can find.

There's nothing too difficult about it if you know how to do your own taxes. The worst part of tax harvesting is buying a fund and watching it go down! Then you can sell it and balance out that loss against your other sales gains. There are simple rules for balancing out short-term and long-term (>1 year) gains and losses. You also have to watch out not to trigger the wash sale rule by buying the same fund within +/-30 days before or after you sell it for a loss (watch out for distributions!). You don't want to mess with that.

It's the simple rules that I have to learn about. I understand the wash sale but not the other rules, like < one year or > one year ownership.

Read "The Bogleheads' Guide to Investing"

There are three parts to this:

1) Purchase only tax efficient funds in your taxable accounts such as the Vanguard Total Stock Market Index fund or the the Vanguard FTSE all-world ex-US index fund.

2) If you taxable funds ever build up a loss, then do tax-loss harvesting. See http://www.early-retirement.org/forums/showpost.php?p=583857&postcount=106 for some thoughts on that.

3) Use your tax qualified accounts (IRAs, 401k) for tax inefficient funds like fixed income funds, REITs, small cap value.

I am not concerned about the 401K at this point but the non-qualified account is what I'm talking about. I need to learn about what makes a fund "tax efficient" or "tax inefficient".

So let me take a stab at how simple this is....If you see that you will be collecting dividends and capital gains by the end of the year, then you will sell a fund that is losing that much and it ends up even? No taxes owed?
Now let me go do some reading. Thanks for the comments.

 

[FIREd]

I am not concerned about the 401K at this point but the non-qualified account is what I'm talking about. I need to learn about what makes a fund "tax efficient" or "tax inefficient".

Funds are tax inefficient when they make large annual distributions (dividends, capital gains,...) because you have to pay taxes on those distributions annually and therefore you have less money left to compound. So bond funds, REITs, and balanced funds are considered the most tax-inefficient. For equities, value funds, equity income funds and managed funds can also be considered tax-inefficient. What is considered tax efficient then? Equity index funds (blend or growth) are some of the most tax-efficient investments you can find. They tend to have low dividends, and because they don't do a lot of trading (because they track an index), capital gain distributions are minimal. If you must have bonds in your taxable account, then go for municipal bond funds, their dividends are tax-free (though if you are subjected to the AMT, you might not enjoy the tax-free distribution on those unless you choose your fund very carefully).

So in order to maximize your tax efficiency, and if you have both a 401K and a taxable account, you would want to keep all your bond funds, REITs, balanced funds, equity managed funds, value funds and equity income funds in your 401K and keep only equity index funds in your taxable account. So let say you have a 401K with $50K and a taxable account with $50K. If you want a 70% stock / 30% bond allocation overall, you should have $30,000 worth of bonds in your 401K (30% of the total), you should have $20K worth of stocks in your 401K (which can be managed funds, equity income, value stocks or other tax inefficient investments) and $50K worth of stock in your taxable account (which should be tax efficient, like a total market fund).

 

[mathjak107]

to tax efficiant isnt to good either, especially if sold while in a high tax bracket. having just sold a non tax efficiant fund i have held for many years and had distributions taxed all along and the taxes due on the gains were still huge actually bumping me into amt territory. , i can only imagine the hit had i not been paying all along. i do hold quite a few etf's also in my taxable account so those are fairly new.

they havent had enough time yet to rack up huge gains with no taxes paid on them yet when sold.


becareful of the tax torpedo as its called on these low distrubution funds, the big gains when sold can bump you into higher brackets or kill you with the amt. it could work out far worse then just buying conventional funds making normal distributions all along...

 

[Delawaredave5]

Does an ETF have less distributions than an index fund ?

ETF Tax Efficiency

Article has a chart showing a value ETF having distributions of 0.24% and a corresponding Vanguard index fund at 6.53%

Why would it be that different ? Thanks.

 

[dessert]

Funds are tax inefficient when they make large annual distributions (dividends, capital gains,...) because you have to pay taxes on those distributions annually and therefore you have less money left to compound. So bond funds, REITs, and balanced funds are considered the most tax-inefficient. For equities, value funds, equity income funds and managed funds can also be considered tax-inefficient. What is considered tax efficient then? Equity index funds (blend or growth) are some of the most tax-efficient investments you can find. They tend to have low dividends, and because they don't do a lot of trading (because they track an index), capital gain distributions are minimal. If you must have bonds in your taxable account, then go for municipal bond funds, their dividends are tax-free (though if you are subjected to the AMT, you might not enjoy the tax-free distribution on those unless you choose your fund very carefully).

So in order to maximize your tax efficiency, and if you have both a 401K and a taxable account, you would want to keep all your bond funds, REITs, balanced funds, equity managed funds, value funds and equity income funds in your 401K and keep only equity index funds in your taxable account. So let say you have a 401K with $50K and a taxable account with $50K. If you want a 70% stock / 30% bond allocation overall, you should have $30,000 worth of bonds in your 401K (30% of the total), you should have $20K worth of stocks in your 401K (which can be managed funds, equity income, value stocks or other tax inefficient investments) and $50K worth of stock in your taxable account (which should be tax efficient, like a total market fund).

Thanks Firedreamer. That is a good explanation and easy to follow.
My non-qualified account is definitely not set up the way you explain.
I need to keep reading and learning. Meanwhile, it's value is down now and I am not selling but hoping that it rebounds so that I can make allocation improvements at that time.

 

[innova]

i can only imagine the hit had i not been paying all along. i do hold quite a few etf's also in my taxable account so those are fairly new.

they havent had enough time yet to rack up huge gains with no taxes paid on them yet when sold.


becareful of the tax torpedo as its called on these low distrubution funds, the big gains when sold can bump you into higher brackets or kill you with the amt. it could work out far worse then just buying conventional funds making normal distributions all along...

This is a common and easily debunkable fallacy.

Just so I'm sure (I'll get to the debunking shortly), you are stating you would prefer a high-turnover, high-short term cap gain / dividends fund in a taxable account so you can 'pay your way' all along versus deferring those gains as long as possible? If so - that flies completely in the face of logical tax planning.

This is certainly NOT a disadvantage of holding index funds in taxable accounts. After-tax returns are the only returns you can spend. Therefore, taxes are a huge drag on performance and short-term gains and dividends should be avoided whenever possible.

Put it another way, by avoiding paying all those taxes along the way your fund has grown much larger, and the long-term cap gains rates are quite favorable. What is the problem exactly?

 

[mathjak107]

im not saying a high turnover fund or paying taxes is a good thing or a bad thing. each situation is different. but what i am saying is while the joy of deferring taxes looks like a great thing depending on your bracket you can get hit alot harder at the end when you sell it and not just on the funds gains but everything you earn or received..

if it pushes you to amt territory as it did me its an extra tax on every penny you made that year including all your regular income. good bye all deductions hello flat rate from dollar one as the taxable gains get higher and higher .. while the capital gains rate stays at 15% all the income from every other source is penalized and given a flat rate of as much as 33% even if before the amt your were in the 25% bracket, not to mention now the state tax is based on the higher amount too.


dont forget how a fund makes its profits be it never trading or trading alot , hi expenses, low expenses all boils down to the bottom line gains. maybe yes the high turnover fundor hi expense fund is performng better than the index etf so its all about profit.
while compounding is nice it can be overshadowed by the damage done by our stupid amt tax system right now.

its more important then ever that you monitor your funds and the funds tax strategy closely and whether they have the potential to bump you up to amt land.

 

[mathjak107]

of course if you intend to hold the same funds well into retirement odds are when the pay check stops so will your chances of hitting the amt levels so in that case go for the lower distribution funds.

i use both an actively managed portfolio as well as a portfolio based around etf's and even the etf's are swapped out occasionally so its not like im holding one fund for ever even on my etf's

 

[Darryl]

This was offered in another thread, http://fairmark.com/mutual/selling.htmread

 

[saluki9]

Does an ETF have less distributions than an index fund ?

ETF Tax Efficiency

Article has a chart showing a value ETF having distributions of 0.24% and a corresponding Vanguard index fund at 6.53%

Why would it be that different ? Thanks.

Yes, in general ETFs are more tax efficient. This has to do with how the actual shares of an ETF are created (called creation units). In short when you sell an index fund, unless the manager of the fund has daily net inflows they must sell shares to fund your distribution. This creates a capital transaction (gain or loss) which eventually gets passed on to you (gain only) or held by the fund (loss only).

When you sell shares in an ETF they are either sold to another investor or bought by the specialist who covers that ETF. If they need cash they can just deliver out of actual holdings of the ETF and not sell the shares. This means lower taxes for you.

 

[DblDoc]

dessert - I find this general guide helpfull. It is from the Vanguard DIehards site:

Here is a list of securities in approximate order of their tax-efficiency. (Least tax efficient at the top.):
Hi-Yield Bonds
Taxable Bonds
TIPS
REIT Stocks
Stock trading accounts
Balanced Funds
Small-Value stocks
Small-Cap stocks
Large Value stocks
International stocks
Large Growth Stocks
Most stock index funds
Tax-Managed Funds
EE and I-Bonds
Tax-Exempt Bonds


- I would place ETF's next to index funds

DD

 

[dessert]

dessert - I find this general guide helpfull. It is from the Vanguard DIehards site:

Here is a list of securities in approximate order of their tax-efficiency. (Least tax efficient at the top.):
Hi-Yield Bonds
Taxable Bonds
TIPS
REIT Stocks
Stock trading accounts
Balanced Funds
Small-Value stocks
Small-Cap stocks
Large Value stocks
International stocks
Large Growth Stocks
Most stock index funds
Tax-Managed Funds
EE and I-Bonds
Tax-Exempt Bonds


- I would place ETF's next to index funds

DD

Thanks. I am enjoying this thread and learning too! I would have thought that ETF's would be higher up the list simply because of their titles. I'm still not clear about the difference between ETF's and Mutual Funds, and why invest in one over the other?

 

[mathjak107]

etf's trade like stocks, you can buy and sell as many times as you want, and they are priced at every trade thru out the day. mutual funds generally have restrictions on how many times you can go in and out and they are only priced 1x a day at the close. mutual funds generally trade at net value to the assets they hold, etf's can trade at a slight discount or premuim although no where near the span of closed end funds.

i have traded in and out of TLT a long term treasury bond fund 14x since jan 1 this year, my mutual fund company would never allow that on a regular fund

 

[LOL!]

Thanks. I am enjoying this thread and learning too! I would have thought that ETF's would be higher up the list simply because of their titles. I'm still not clear about the difference between ETF's and Mutual Funds, and why invest in one over the other?

Be careful, just because it's called an ETF does not mean it is tax-efficient. You really need to look at the asset class first. So a REIT or bond ETF will be much less tax-efficient than a total stock market ETF.

So DblDoc's list is a really a list of asset classes. But also note that an actively managed LARGE CAP fund with trading and turnover will be less tax efficient than a passively managed index LARGE CAP fund.

 

[DblDoc]

LOL! has some excellent points. That list is from the Diehard site so I suppose implicit in it is you are not using actively managed funds. I only use ETF's in my taxable account to 1) get access to asset classes I cannot in my IRA and 403b and 2) the way I invest the ETF's are cheaper long-term then the corresponding Vanguard MF.

DD