I was recently asked by a reader what a (debt-free) investor should do after maxing out his/her IRA and 401(k) contributions for the year. My suggestions for investing in taxable accounts can be summed up as follows:
- Make intelligent asset location decisions, and
- Choose tax-efficient funds for your taxable accounts.
Index funds and ETFs are already rather tax-efficient due to their low portfolio turnover. But depending upon your circumstances, you may actually be able to reduce your total costs by straying away from purely passive funds in your taxable accounts.
One option is to use “tax-managed” funds–funds that are specifically managed to minimize distributions of capital gains.
Vanguard’s tax-managed funds are generally low-cost in terms of expense ratios. (In fact, many have lower expense ratios than the comparable index funds.) And they do appear to be tax-efficient.
The drawbacks are that they have a $10,000 minimum investment, and they carry a 1% redemption fee if the fund is sold within 5 years. This redemption fee gets in the way of rebalancing and tax-loss harvesting.
As an example, let’s compare three small-cap funds from Vanguard:
|Tax-Cost Ratio||Expense Ratio||Other Costs|
|Tax-Mngd Sm-Cap (VTMSX)||0.17%||0.19%||1% redemption fee|
|Small-Cap Index (NAESX)||0.29%||0.28%||none|
|Small-Cap ETF (VB)||0.46%||0.15%||commission/trade|
Three notes on the data:
- The “tax-cost ratio” is provided by Morningstar. The figure changes from period to period, so while it can be an indicator that one fund is more tax-efficient than another, it’s certainly not set in stone.
- Morningstar’s calculations assume that the investor is in the highest tax bracket.
- I used the 5-year tax-cost ratios. It’s not a perfect comparison because the data for the ETF is for the 5-year period ending 11/30/09, while the data for the other two funds is for the 5-year period ending 12/31/09.
As you can see, the tax-managed fund does appear to be more tax-efficient. If we were to compare it to the small-cap index fund and assume that the tax-cost ratios are constant (which they aren’t), we’d see that the total costs of the tax-managed fund are 0.21% less per year than the costs of the index fund.
Conclusion: If you expect to sell your holdings in the fund every 4-5 years, it’s probably a wash (because of the redemption fee). If you expect to hold for longer than 5 years, the tax-managed fund is very likely better. If you expect to sell in less than 4 years, the regular index fund is probably better.
Tax-Free Bond Funds
If you have to own bond funds in a taxable account, you may earn a higher after-tax return using tax-free bond funds rather than taxable bond funds. To determine whether it’s advantageous to use tax-free bonds, calculate the tax-equivalent yield of a tax-free bond fund by multiplying it by (1 – your marginal tax rate).
For example, as of 12/31/09, the yield on Vanguard’s Intermediate-Term Tax-Exempt Fund was 2.94%. If you’re in the 28% tax bracket, this would be equivalent to a taxable fund yielding 4.083%–calculated as 0.0294 ÷ (1 – 0.28).
Note: If your state exempts its own municipal bonds from state income tax and you have access to a low-cost bond fund that invests exclusively in tax-free bonds from within your state, be sure to add your state income tax rate to your Federal tax rate when determining your tax-equivalent yield.
For example, as of 12/31/09, Vanguard’s New Jersey Long-Term Tax Exempt fund had a yield of 3.27%. If you live in New Jersey and are in the 28% Federal tax bracket and 6.37% state tax bracket (for a total tax rate of 34.37%), your tax-equivalent yield would be 4.98%–calculated as 0.0327 ÷ (1 – 0.3437).
Any Other Suggestions?
Aside from being careful with asset location decisions and tax-efficient fund selection, do you have any tips for an investor who has maxed out his/her IRA and 401(k) contributions for the year?