Tuesday, January 21, 2014

Optimal location for investments - 401k vs Roth vs taxable? / How would you prioritize allocation of these investments (highest priority for taxable vs. Roth vs. 401k)?

Posted on 6:13 AM by Unknown
Over at Bogleheads we read the following discussion: Optimal location for investments - 401k/Roth/taxable?
Postby alphabeta » Mon Jan 20, 2014 1:02 am
Hi,

Thank you very much for your recent help with "part 1" of my portfolio makeover: replacing higher-ER funds with lower-ER options (mostly Vanguard). I haven't fully completed that exercise, but I've made some progress, and I'd like to start "part 2" - figuring out which investments to prioritize for 401k vs. Roth vs. taxable. Here's my current situation and thinking - would very much appreciate your guidance!

Investments
US large-cap growth: VUG (Vanguard Growth ETF)
US healthcare: VGHCX (Vanguard Healthcare fund)
US mid-/small-cap: VXF (Vanguard Extended Market ETF)
International large-cap: FSIVX (Fidelity Spartan International Index fund)
International mid-/small-cap: VSS (Vanguard FTSE All World ex-US Small Cap ETF)
Multisector bond: PIMIX (PIMCO Income Fund institutional class)
CDs: PenFed 5- and 7-year CDs
I-bonds

Current thinking
VUG: ?
VGHCX: ? (currently in 401k - don't plan to buy more (or to sell for now) - would incur transaction fee to move it to taxable but open to doing that if it makes sense)
VXF: ?
FSIVX: 401k (Fidelity is sponsor for spouse's 401k)
VSS: Roth, then 401k
PIMIX: 401k
CDs: Roth (mostly - also hold some in taxable because CD holdings double as very conservative emergency fund - not concerned about withdrawal penalty)

Tax situation
Highest brackets and still working (and will be for next 10-15 years). Most future contributions will be to taxable (already maxing out tax-deferred).

Question
How would you prioritize allocation of these investments (highest priority for taxable vs. Roth vs. 401k)? I'm especially finding it hard to rank VUG, VGHCX, VXF, and VSS for tax-friendliness. I'm just starting non-CD taxable investing and am hoping to get it right (or as right as reasonably possible to foresee).

Thank you very much for your help!
Postby Laura » Mon Jan 20, 2014 9:54 am
This might help you.

4-Step Rule for Tax Efficient Fund Placement:

1. Put your most tax-inefficient funds in 401ks, 403bs, Traditional IRAs and similar retirement accounts. When full..
2. Put your next most tax-inefficient funds in your Roth(s). When your Roth(s) are full-
3. Put what's left into your taxable account.
4. Try to use only tax-efficient funds in taxable accounts.

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

1. Invest as much as possible in your tax-deferred and tax-free accounts.
2. Put the most tax-inefficient funds in your tax-deferred and tax-free accounts.
3. Use only tax-efficient funds in taxable accounts.
4. If all else is equal, put funds with higher expected returns in tax-free (Roth) accounts in preference to tax-deferred (traditional 401(k), 403(b), traditional IRA) accounts.

Laura
Postby 2beachcombers » Mon Jan 20, 2014 11:17 am
This is how I am invested. Note--90% of these investments are for heirs and charity-and hence have a 20yr+ time horrizon. 110% income needs from pensions and SS.

1 Research the international funds for Non Qualified dividends. I originally had some internationals--VSS, VWO, and FSivx(fido international) in Taxable. For the past 2,3 yrs, VSS and VWO were moved to Roths due to 50% non quals. I may move VWO back some day as I monitor the non qual output and the compensating international tax deduction.

2 REITS, large cap value and Bonds in 401/IRA

3 Roths are Small Value both US and international and Int large value

4 Total US, Total int, munis in taxable

jerry
Postby alphabeta » Mon Jan 20, 2014 1:41 pm
Thanks to both of you for the guidance! Based on your comments, it sounds as though a good priority order for the funds might be:
1 [best for taxable]) VXF (Vanguard Extended Market ETF)
2) VUG (Vanguard Growth ETF)
3) FSIVX (Fidelity Spartan International Index fund)
4) VSS (Vanguard FTSE All World ex-US Small Cap ETF)
5) VGHCX (Vanguard Healthcare fund
6) PIMIX (PIMCO Income Fund institutional class)

Thanks again for your help - I appreciate the expert review before I take the plunge into taxable investing.
Last edited by alphabeta on Mon Jan 20, 2014 2:09 pm, edited 1 time in total.
Postby Laura » Mon Jan 20, 2014 1:42 pm
If you could use fund names rather than ticker symbols that would help us out. Most of us don't have them memorized and won't look them up.

By holding international in taxable you also benefit from the foreign tax credit.

Laura
Postby livesoft » Mon Jan 20, 2014 1:57 pm
I can say that in the past VGHCX was terribly tax-inefficient. I sold it years ago and actually had a loss because of all the intervening distributions that made it look like I had a gain. I was paying taxes also on all those distributions every year.
It's all about market timing, uh, I mean rebalancing, uh, I mean opportunistic rebalancing, uh, I mean short-term opportunistic rebalancing due to a short-term change in one's asset allocation.
Postby alphabeta » Mon Jan 20, 2014 2:11 pm
Laura: Thanks for the tip on the foreign tax credit. Also, good callout on naming the funds - I just edited my post to include full names (I'd included them in my original post but understand that it's probably annoying to have to look up-thread).

Livesoft: Yes, I was looking at distributions for VGHCX (Vanguard Healthcare Fund) and was surprised to see the hefty capital gains & dividend distributions! I think I'll keep that one in tax-deferred.
Postby Laura » Mon Jan 20, 2014 2:15 pm
I would be tempted to move up the Fidelity international to taxable but bet that fund is actually available in your 401k plan. That is part of the challenge with taxable investing because you must work around the limited fund choices in employer plans. I wouldn't move an international small cap fund up and would keep that in a tax advantaged account.

Laura
Postby abuss368 » Mon Jan 20, 2014 2:24 pm
We follow the "equal location" rather than "asset location" approach as recommended by Rick Ferri. The tax code is always in a state of change. Tax rates go up and down. Capital gains tax rates change as well. A strategy such as "asset location" may work for a while, then after a tax code change it is not optimal. Over a lifetime of investing "equal location" may be the most tax efficient.

Hopefully Rick Ferri will see this post and provide additional perspective.
John C. Bogle: "You simply do not need to put your money into 8 different mutual funds!" | | Disclosure: Three Fund Portfolio + REITs
Postby 2beachcombers » Mon Jan 20, 2014 2:41 pm
alphabeta wrote:Thanks to both of you for the guidance! Based on your comments, it sounds as though a good priority order for the funds might be:
1 [best for taxable]) VXF (Vanguard Extended Market ETF) = Fido extended mkt has too many non quals--put in deferred
2) VUG (Vanguard Growth ETF)--------------------------------------recommend a SP500 fund for taxable FUSVX has a 0.05% er
3) FSIVX (Fidelity Spartan International Index fund)--taxable--very efficient with Foreign Tax Credit FTC
4) VSS (Vanguard FTSE All World ex-US Small Cap ETF)-----------------deferred
5) VGHCX (Vanguard Healthcare fund-------------------------------------deferred
6) PIMIX (PIMCO Income Fund institutional class)----------------------deferred--402

jerry

Thanks again for your help - I appreciate the expert review before I take the plunge into taxable investing.
Postby dublin » Mon Jan 20, 2014 3:02 pm
Laura wrote:This might help you.

4-Step Rule for Tax Efficient Fund Placement:

1. Put your most tax-inefficient funds in 401ks, 403bs, Traditional IRAs and similar retirement accounts. When full..
2. Put your next most tax-inefficient funds in your Roth(s). When your Roth(s) are full-
3. Put what's left into your taxable account.
4. Try to use only tax-efficient funds in taxable accounts.


I'm probably missing something basic, but why would you want your most tax-inefficient funds in 401ks etc vs Roth IRA and similar (steps 1 and 2, respectively)? Aren't those two slots functionally the same in terms of taxes?
Postby alphabeta » Mon Jan 20, 2014 3:05 pm
Thanks for the comments!


I would be tempted to move up the Fidelity international to taxable but bet that fund is actually available in your 401k plan.


Yes, this is a free option in the 401k plan (managed by Fidelity). Side note on the Fidelity vs. Vanguard choice: With the brokerage account option, I could buy Vanguard MFs or ETFs, but they'd carry commissions and/or other restrictions, and FSIVX seemed like a decent substitute.


We follow the "equal location" rather than "asset location" approach as recommended by Rick Ferri. The tax code is always in a state of change. Tax rates go up and down. Capital gains tax rates change as well. A strategy such as "asset location" may work for a while, then after a tax code change it is not optimal. Over a lifetime of investing "equal location" may be the most tax efficient.


Thanks, this is very true - and vividly illustrated by recent changes in dividend tax rates plus the Medicare investment surtax. Makes it hard to plan (based on status quo rates) strategy: (a) find a nice low(er) tax-bracket strategy for retirement, OR (b) take the hit now - 23.8% + CA state income tax on qualified dividends & LT capital gains. Right now, I'm leaning toward (a) given the added ouch factor from CA tax (since CA taxes all dividends & LT capital gains as ordinary income, as I understand it).

A couple questions/thoughts on Jerry's recommendations:

1 [best for taxable]) VXF (Vanguard Extended Market ETF) = Fido extended mkt has too many non quals--put in deferred
2) VUG (Vanguard Growth ETF)--------------------------------------recommend a SP500 fund for taxable FUSVX has a 0.05% er
3) FSIVX (Fidelity Spartan International Index fund)--taxable--very efficient with Foreign Tax Credit FTC


VXF looked fairly good for distributions as % of NAV - given my tax situation (e.g., high bracket and in CA), would you still recommend tax-deferred for this fund? And either way, would it make a good 2nd choice for taxable once I've hit my target allocation for US large-cap in taxable?

If I'm subject to AMT, do I still qualify for the Foreign Tax Credit? Also, how big of an issue is the Foreign Tax Credit? For example, if I had, say, $10,000 invested in FSIVX (or maybe the Vanguard equivalent), what would've been the approximate size of the credit in 2013 (or a given year)? (Just trying to get a ballpark idea - e.g., are we talking about $10 vs. $500?)
Postby ogd » Mon Jan 20, 2014 3:11 pm
dublin wrote:I'm probably missing something basic, but why would you want your most tax-inefficient funds in 401ks etc vs Roth IRA and similar (steps 1 and 2, respectively)? Aren't those two slots functionally the same in terms of taxes?

You're not missing anything -- the Roth and tax-deferred are functionally the same.

You will often see people claim that putting stocks in Roth nets you more money because you pay no taxes on the higher growth. This rationale forgets to account for the fact that Roth money is effectively worth more, meaning that an allocation with stocks in Roth is riskier than viceversa. The necessary tax-adjustment of the allocation is a multiplicative factor that applies the same before or after growth.

Now you might argue that the tax adjustment is an unknown (future tax rates). This is true, but this merely means that the precise risk of your allocation is an unknown, as long as there are major differences between Roth and Traditional; you still can't make better money for the same risk one way or the other. If you balance Roth and Traditional the same, you eliminate that unknown, which is nice.
Postby dublin » Mon Jan 20, 2014 3:37 pm
ogd wrote:
dublin wrote:I'm probably missing something basic, but why would you want your most tax-inefficient funds in 401ks etc vs Roth IRA and similar (steps 1 and 2, respectively)? Aren't those two slots functionally the same in terms of taxes?

You're not missing anything -- the Roth and tax-deferred are functionally the same.

You will often see people claim that putting stocks in Roth nets you more money because you pay no taxes on the higher growth. This rationale forgets to account for the fact that Roth money is effectively worth more, meaning that an allocation with stocks in Roth is riskier than viceversa. The necessary tax-adjustment of the allocation is a multiplicative factor that applies the same before or after growth.

Now you might argue that the tax adjustment is an unknown (future tax rates). This is true, but this merely means that the precise risk of your allocation is an unknown, as long as there are major differences between Roth and Traditional; you still can't make better money for the same risk one way or the other. If you balance Roth and Traditional the same, you eliminate that unknown, which is nice.


Thanks - I definitely get the rationale you explained in your first sentence, but it seemed like the original post I quoted was saying that purely on the basis of tax-efficiency, one should fill up 401ks before Roths with tax-inefficient investments, even if the two investments in question have identical expected returns. Am I just misreading? I get it on the basis of putting the higher-return assets in Roth, but I don't get putting the more tax-inefficient assets in 401k.
Postby ogd » Mon Jan 20, 2014 6:01 pm
dublin wrote:Thanks - I definitely get the rationale you explained in your first sentence, but it seemed like the original post I quoted was saying that purely on the basis of tax-efficiency, one should fill up 401ks before Roths with tax-inefficient investments, even if the two investments in question have identical expected returns. Am I just misreading? I get it on the basis of putting the higher-return assets in Roth, but I don't get putting the more tax-inefficient assets in 401k.

I don't know of any other reason to prefer tax-efficient funds in Roth, other than the [misleading] rationale that they are usually high-growth assets, i.e. #4 in Laura's first reply.
Postby abuss368 » Mon Jan 20, 2014 6:06 pm
At the end of the day these are all different strategies.

Our investing philosophy is all the same which is low costs, passive index funds, that are diversified, and staying the course.
John C. Bogle: "You simply do not need to put your money into 8 different mutual funds!" | | Disclosure: Three Fund Portfolio + REITs
Postby 2beachcombers » Mon Jan 20, 2014 6:10 pm
dublin wrote:
ogd wrote:
dublin wrote:I'm probably missing something basic, but why would you want your most tax-inefficient funds in 401ks etc vs Roth IRA and similar (steps 1 and 2, respectively)? Aren't those two slots functionally the same in terms of taxes?

You're not missing anything -- the Roth and tax-deferred are functionally the same.

You will often see people claim that putting stocks in Roth nets you more money because you pay no taxes on the higher growth. This rationale forgets to account for the fact that Roth money is effectively worth more, meaning that an allocation with stocks in Roth is riskier than viceversa. The necessary tax-adjustment of the allocation is a multiplicative factor that applies the same before or after growth.

Now you might argue that the tax adjustment is an unknown (future tax rates). This is true, but this merely means that the precise risk of your allocation is an unknown, as long as there are major differences between Roth and Traditional; you still can't make better money for the same risk one way or the other. If you balance Roth and Traditional the same, you eliminate that unknown, which is nice.


Thanks - I definitely get the rationale you explained in your first sentence, but it seemed like the original post I quoted was saying that purely on the basis of tax-efficiency, one should fill up 401ks before Roths with tax-inefficient investments, even if the two investments in question have identical expected returns. Am I just misreading? I get it on the basis of putting the higher-return assets in Roth, but I don't get putting the more tax-inefficient assets in 401k.



That is exactly what I feel is best if you have a long time horizon for the the Roths. I don't want to share my growth with U. SAM. So I have riskier assets in Roths. I also want to manage my IRAs to control the future RMDs in retirement. Lower growth but also lower risk. And as I get closer to RMD time, will reduce the REITS(risky) and add more bonds. Therefore, REITS, bonds, LCV in IRA's. These are also the most tax inefficient of my investments and which reduces growth-- big time over the long run.

Last year 2012 FSEVX(extended mkt) was 29% non qual dividends. 2013 Fssvx(small blend) was 65% non qual--these go in deferred

And there is no free lunch in the 401--you are still paying the expence ratio and some places an additional fee.

And yes AMT will cut into you FTC but probably not eliminate it. Play with turbo tax for an approximation

And get ready for a wild ride in the ROTHS-- I have ridden some wild years--but happy I stayed the course :moneybag

jerry

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Joined: 31 Jul 2010
Location: Savannah
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