Holding FI in a taxable account for simplicity?

[veremchuka]

I'm teaching my sister how to handle the investments she will inherit one day. She is a right brained person but intelligent enough to do what I think is simple math (percentages for rebalancing her AA) and I am a right brained person. I've told her to use just 3 Vanguard funds – Total Stock Market Index (TSMI), Total International Stock Market Index (TISMI) and Total Bond Market Index (TBMI) and to keep her desired AA whether 50/50 or whatever using these 3 funds in all accounts. But here's the problem (as I see it) - she will have a lot of rebalancing because in addition to her IRA, Roth IRA and taxable accounts (which amount to very little) she will have from my estate an inherited IRA, an inherited Roth IRA and additional taxable money from the sale of my house and any cash I have. So she needs to rebalance all these and by owning all 3 funds in all these places it simplifies things vs holding different funds in different percentages in these 3 accounts.


Now I'm wondering about having her use the Vanguard “Target Risk” funds instead because they always keep their AA and therefore automatically rebalance for her. There are 4 “Life Strategy” (LS) funds - 20/80, 40/60, 60/40 and 80/20 AA (equity/fixed income). As she ages she can switch to a fund with less in equity or change the AA by holding 2 of them for say a 50/50 or 30/70 AA. I think this makes her life much simpler by removing the need to hold 3 mutual funds in all these places and more importantly how to rebalance them.


So here's the question and it is about the taxable account. I know that equities (in this case TSMI and TISMI whether held as an individual funds or held within the LS fund) are very tax efficient but the fixed income (in this case TBMI whether held as an individual fund or TBMI and the Total International Bond Market within the LS fund) being fixed income are not tax efficient and would be better held in the tax privileged accounts. So while I think the LS funds are perfect for her, holding a LS fund in the taxable account is not the most tax efficient thing but maybe that's not the end of the world for the simplicity it gives her. I know a lot of folks use the Wellesley Fund which is 1/3 equity and probably hold it in a taxable account. So how big an issue is this holding a LS fund in a taxable account because of the fixed income component it holds? I'd guess the amount in the taxable account would be in the $200-$300k range.


Thanks.

 

[inky]

What would her income be, including the estimated dividends from the bond fund? As long as it stays in the 15% tax bracket, she will not have to pay federal taxes on the dividends.

 

[veremchuka]

What would her income be, including the estimated dividends from the bond fund? As long as it stays in the 15% tax bracket, she will not have to pay federal taxes on the dividends.

No idea, seriously doubt it'd be very high though. Today it's 15% and she'd have a way to go to get to 25% bracket now but years from now who knows what the brackets will be. Her RMDs from the inherited Roth is tax free, the inherited IRA RMDs could be enough to push her into the 25% today (?) but that would be dependent upon her age at that time.

I'm surprised no one else is commenting. I tend to think it doesn't matter a whole lot but I like to be tax efficient. If it was me I'd figure it out and keep it efficient but I don't want her discouraged and confused with 6 different buckets of money in 3 different accounts.

 

[LOL!]

Bond fund dividends are not qualified, so they do not get the 0% qualified dividend tax rate for folks in the 15% marginal income tax bracket. That is, to be clear: She WILL be paying federal taxes on the non-qualified bond dividends.

But if she is in a low tax bracket like 15%, there is probably no problem with tax efficiency and paying taxes for the sake of simplicity.

As for rebalancing, this is really a red herring. Over the years, I have noticed that one doesn't really need to rebalance unless they want to drastically change their asset allocation.

 

[Ready]

If you want to complicate things slightly, you could add a fourth fund - tax exempt municipal bond fund, for bonds held in a taxable account. But unless she is in a fairly high tax bracket, it may not be worth the trouble. Especially if state taxes are low or non-existent. If she lives in a high tax state, that favors tax free bond funds a bit more.

 

[samclem]

As for rebalancing, this is really a red herring. Over the years, I have noticed that one doesn't really need to rebalance unless they want to drastically change their asset allocation.

Maybe: "One doesn't need to rebalance if they don't mind having their asset allocation change drastically over time." With no rebalancing, the assets with the highest return (and often with the highest volatility) will, over time, become a larger share of the portfolio.

veremchuka,
It probably won't make a huge amount of difference. Unless >you< want to have this discussion with her frequently and hold her hand (or do the figuring for her), just make things as simple as possible so your sister can do this herself. Explain the tax issues to her, but don't expect her to take an interest in it or to grab the torch and start running. Just give her something simple and she'll still be way ahead of most investors. Simple rebalancing is probably all she'll want to handle, adding the tax-optimization is a complexity she probably doesn't need, especially when her RMD's begin.

 

[veremchuka]

Maybe: "One doesn't need to rebalance if they don't mind having their asset allocation change drastically over time." With no rebalancing, the assets with the highest return (and often with the highest volatility) will, over time, become a larger share of the portfolio.

veremchuka,
It probably won't make a huge amount of difference. Unless >you< want to have this discussion with her frequently and hold her hand (or do the figuring for her), just make things as simple as possible so your sister can do this herself. Explain the tax issues to her, but don't expect her to take an interest in it or to grab the torch and start running. Just give her something simple and she'll still be way ahead of most investors. Simple rebalancing is probably all she'll want to handle, adding the tax-optimization is a complexity she probably doesn't need, especially when her RMD's begin.

Thanks but just so everyone is clear this is inherited by her from me upon my death. This is why I am looking for something simple because I can't guide her and she really doesn't care to get involved with this stuff as some of us do.

 

[samclem]

Thanks but just so everyone is clear this is inherited by her from me upon my death. This is why I am looking for something simple because I can't guide her and she really doesn't care to get involved with this stuff as some of us do.

One big challenge is that, after you are gone, she'll be a target for every commission-based advisor, annuity salesman, and for the latest thing a friend read in Money magazine. Without understanding and "buying in" to low-fee, index-based investing, it probably won't "stick" long term.

After she's got the basics, help her set up a portfolio. Best to do this early so she can "run it", rebalance, do her taxes, all while you are here to answer questions. Once she's on the path and understands what she's doing and why she might just stay on it. Then just leave instructions for how she can best merge the new money you'll leave her into her existing investment structure.

 

[veremchuka]

She does not have this money right now I do. She has her IRA, Roth IRA and a taxable account with cds cuz she is risk adverse. Add them all up and it isn't close to $100k.

I have explained to her about AA, risk, rebalancing, general investing basics, market timing but I need to discuss annuities. I don't think she'll fall for any sales pitches, she trusts my judgement and opinion about this and seems to be pretty comfortable about what to do. I've warned her about expenses, loads and she likes Vanguard so she's comfortable with having investments there.

Changing from the 3 funds to the LS fund would be even easier for her. If she feels the LS fund that's 60/40 is too much equity then she can hold the LS fund that's 40/60 and 60/40 in equal amounts in those 6 buckets and you have 50/50. Having to forget rebalancing makes this a winner IMO.

I would worry that having to rebalance across 6 buckets of money each with the 3 mutual funds and worse if the taxable is different for the tax efficiency, now that may well get her confused.

ETA she has a 10 page document from me explaining a lot of things and we've reviewed it twice.

 

[samclem]

She does not have this money right now I do. She has her IRA, Roth IRA and a taxable account with cds cuz she is risk adverse. Add them all up and it isn't close to $100k.

Yes, I understand. I'm not nagging and I'll let this alone after this post. I'm suggesting, if she's willing to accept this, that you work with her to set up her existing accounts as a micro-version of what she'll eventually have. Let her do the taxes, see how it works, see if she panics and sells the mutual funds when the market goes down, and you can answer her questions. If she's too risk averse to accept equities and bonds and instead has everything in CDs with her present money, it's very likely she'll have the same attitude when your money becomes her money.

Good luck.

 

[veremchuka]

You aren't nagging to the contrary I appreciate your comments. Sorry, I misunderstood your post, yes setting up her present accounts and working with them to see how to allocate the money is good practice. Thanks.

 

[pb4uski]

Since you are planning go use VG funds, consider having her develop a relationship now with Vanguard Financial Planning Services, even if she has to pay. You can be part of. the process now and they can guide her once you're gone.

 

[donheff]

I wouldn't worry about a few hundred in extra taxes. That sounds a lot better than 1% to an advisor. Can you leave instructions for the companies (VG for example) to transfer the existing funds into the target funds upon your death? It would be nice to leave her with a properly set up AA. I worry a little about this stuff as well. DW was a partner in a law firm and is a very intelligent but she has an aversion to dealing with numbers. Hopefully, our son will step up to the plate if I kick before her. Hopefully, he will step up to the plate if we start getting foggy in old age.

 

[growing_older]

If there is a reasonable chance that she will have trouble managing a three fund portfolio spread across taxable, Roth and IRA, then the one fund option is ideal for her. There isn't a big difference between 60/40, 40/60 and 50/50, so just pick one. If she can manage the split between two funds to get 50/50 out of their combination, then she can likely manage the three fund portfolio. If ANY of this could be a problem, then just pick one for her. She's so heavily into CDs that 40/60 seems like a better bet than 60/40 (although there really isn't a lot of difference between them). Or even Wellesley. But having picked ONE, then she can stick with the same one everywhere.

The cost of a mistake, or worse, the cost of being sweet talked by some salesman, is much greater than whatever you leave on the table with tax inefficiency or choosing between these middle of the road asset allocation percentage. Make it so simple she's sure to stick with it.

 

[veremchuka]

Thanks all. I think one LS fund (or 2 to create a different AA) is very simple for her, even easier than the 3 fund portfolio. The yield on the fixed income part of the fund within the taxable account is not a lot so the tax inefficiency is pretty small. She knows to avoid the sharks! I think the LS method is better because it is simpler. It rebalances automatically so that's off the table and it's 1 (or 2 at the worst) fund per account.

 

[Tortoise]

I suggest that you tell her (perhaps in your will) that as part of her inheritance from you that she must read "The Bogleheads' Guide to Investing," and "The Bogleheads' Guide to Retirement." They are pretty easy reads and continually show that index investing is straightforward. They also point out that most people do NOT need a financial adviser and why.

 

[easysurfer]

How motivated is she in rebalancing? If not, I'd consider the "Tarket Risk" funds that you mentioned. It's awfully tough to change someone's way of thinking if the person is not motivated.

From personal experience, I had helped out a sister after her divorce and explained the concept indexing, AA and helped her get started with the various index funds.

She was moving along pretty well, but then later got remarried and last I heard, raided the accounts with her hubby.

What's that saying? "No good deed goes unpunished". I tried to be a good brother.

 

[veremchuka]

She is on board with index funds, that's what she is holding in her IRA and Roth IRA, I made sure of that. She just isn't interested in managing money, as I stated she is right brained and has no interest in such stuff. I have her educated to the point I know she'll do OK, it was the BS of rebalancing 3 funds in 6 places that I think would frustrate and maybe get confusing.

She is not interested in reading any BH books. I wrote up a document for her that explains everything I think she needs to know, at 10 pages it covered a lot of territory.