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Investing in a Taxable Account

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:

  1. Make intelligent asset location decisions, and
  2. 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.

“Tax-Managed” Funds

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:

  1. 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.
  2. Morningstar’s calculations assume that the investor is in the highest tax bracket.
  3. 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?

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Comments

  1. Hi Mike! It’s good to see someone actually talking about what to do with non-retirement money. There’s such an emphasis on tax avoidance that anything outside a retirement account is viewed as a mistake in some quarters.

    I don’t profess to be an investment guy, but it seems that there’s some necessity for holding at least some investments outside a retirement portfolio. Even though investments may grow more freely in a tax sheltered account, accessing those funds comes with stiff costs.

    You never know when you might need to get your hands on your money, and if most or all of it is tied up in tax sheltered plans things can get messy.

  2. I’m confused about tax cost ratio. Why are NAESX and VB so far apart? Am I missing something?

  3. Kevin: Agreed. Having access to liquid funds is essential. (It’s worth noting, however, that withdrawals from a Roth IRA are tax and penalty free up until the point where they exceed your lifetime contributions.)

    Steve: Honestly, that surprised me as well. Your question spurred me to check Morningstar’s data against Vanguard’s data. Vanguard’s info is much closer to what I would have expected:

    VB’s 5-year after-tax returns are 0.37% lower than before-tax.
    NAESX’s 5-year after-tax returns are 0.34% lower than before-tax.

    Interestingly, according to Vanguard, the 5-year after-tax returns of VTMSX are 0.22% less than the 5-year before-tax returns.

    The end result is that the difference in tax-cost ratios between NAESX and VTMSX is 0.12% whether we use Vanguard’s data or Morningstar’s. VB, however, looks a great deal better when we use Vanguard’s data.

    I wonder if any other readers can provide information as to the reason for the discrepancies.

  4. As far as tax-free bonds go, I’ve found that they’re usually only advantageous if you are in the top tax brackets (which excludes most of us). Now of course that’s not always true, you should check it for your own situation. But in general, you’ll end up with a higher return (even after taxes) if you use taxable bonds.

    Another thing to compare would be the relative safety of municipal bonds versus Treasury or a mix of gov’t/credit (corporate?) bonds. This might be a bigger factor going forward if states start to have more budget problems. Or maybe it won’t – what are your thoughts, Mike?

  5. Regular Reader says:

    I asked the question that prompted this post.

    It astounds me that I can ask a question like this and get this professional level and quality of analysis and information in just a couple days’ time–FOR FREE!!!

    And the comments are often as good as the original content. Amazing.

    Thanks Mike.

  6. Paul: You’re quite right to point out the credit risk differences between muni bond funds, total bond market funds, and Treasury bond funds.

    I don’t have any special insight on the matter though. I can’t think of anything that would be more reliable than historical default rate data. It would seem reasonable to expect higher municipal default rates in the next few years due to all the budget crises occurring across the country. That said, your guess is as good as mine as to how much higher default rates will be.

    RR: Thanks for the article suggestion. And I agree: The commenters around here do tend to have some excellent insights. :)

  7. Tyler WebCPA says:

    Hey Mike, great post and great comments. Some investors get so obsessed by the tax nature of investments that they let the tax tail wag the profit dog. As Paul points out, after-tax return on investment is what we are after, not avoiding taxes and some investments are specifically designed for investors in high tax brackets. Another strategy could be to just buy individual stocks and hold them. If you are not actively trading and keep most of your investments for a year you can significantly reduce your tax burden.

  8. Hi Tyler. Thanks for adding your thoughts.

    As much I’m not a fan of trying to pick stocks to beat the market, there’s no debating that buying and holding a diversified portfolio of individual stocks can be an extremely low-cost, tax-efficient way to invest. The trick is the “diversified portfolio” bit!

  9. Mike,

    At risk of sounding self-serving since I am a DFA-approved advisor, I’d like to discuss DFA’s core fund idea.

    Let me use this as an example, an investor allocates some money to a small cap fund, some to a large cap funds. When a stock graduate from small cap to large cap, the investor still own the same stock but it is sold by the small cap fund and bought by the large cap fund, thereby triggering capital gain taxes.

    Now if an investor has 9 funds (corresponding to Moringstar style boxes,) migrations of stocks would trigger many unnecessary capital gain taxes and transaction costs on the fund level. That’s where the core fund comes in. It covers all capitalization and styles, so the aforementioned capital gain tax event would not happen.

    Michael Zhuang

  10. Shouldn’t probably funded cash value life insurance be brought into this conversation? Tax deferred growth with tax free withdrawals plus having a death benefit that when set up properly passes to your heirs directly and tax free. The biggest thing I could stress is properly funded as I see so many people make the mistakes in the design of the policies and the way in which they are funded. It’s too bad that most insurance people are the ones screwing this up for everyone.

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