Monday, February 17, 2014

If tax rates have gone way up for you - How have you changed your investments?

Over at Bogleheads we came across the following discussion:  If tax rates have gone way up for you... -by wrysys » Sun Feb 16, 2014 12:51 pm


How have you changed your investments? As a two earner couple living in California, our taxes have significantly climbed and my tax preparer pointed out repeatedly that the dividends from small cap value with be subject to the new 3.8 investment tax. Small value has done well for us, we have a large chunk in SCV, but now i wonder if the value premium is really there anymore. The tax adjusted return on m* seems to say that SCV is 23 vs 22.4 (5 yr) but others on the board have argued with their math. Any suggestions/thoughts on this welcome. i don't see any great alternatives other than just paying the tax. Might increase my slice of VG california intermediate term taxexempt , but I don't want to radically alter my allocation. Interested in hearing from other cali folks.
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Re: If tax rates have gone way up for you -by DSInvestor » Sun Feb 16, 2014 1:09 pm

What steps can you take to reduce your AGI/MAGI? Are you maxing out Traditional 401k plans , HSA if eligible?
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Re: If tax rates have gone way up for you -by wrysys » Sun Feb 16, 2014 1:47 pm

just started an hsa this year, max out our 401k's each year. so that's about 40k
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Re: If tax rates have gone way up for you -by neurosphere » Sun Feb 16, 2014 1:56 pm

Do you have access to the asset classes you want (i.e. SCV) within your 401ks? What about doing a backdoor Roth to gain access to that asset class, within tax-advantaged accounts where the investment taxes don't apply?


The problem is not so much your asset allocation, it's that perhaps the location of your asset classes is not optimal. As you note, you need to consider the impact of taxes on your investments. It seems that capital gains might prevent you from moving assets right now, but why not pledge to only add tax-friendly assets in your taxable space to minimize any additional tax hit in the future? You can simply allow your asset allocation to drive from you "ideal" until you can access those asset classes you desire in a tax friendly way.


It's a good thing, overall, that your income has risen such that the impact of taxes is higher. So tweak your strategy, and maximize your after-tax returns. SCV, REITS, and TIPS for example, might be great additions to a portfolio. But not so much if one has to hold these in taxable accounts. Benefits vs. disadvantages and all that.


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Re: If tax rates have gone way up for you -by baw703916 » Sun Feb 16, 2014 1:57 pm

For the record, the dividend yield of Vanguard SV Index is actually less than that of TSM. 1.78% to 1.86%.


You could do away with the value tilt and just own the small cap index (yield 1.28%) or the Tax-managed small cap (yield 1.08%) --although I think the lack of an ETF share class for the tax-managed fund may put it at some risk of distributing capital gains at some point.


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Re: If tax rates have gone way up for you -by DSInvestor » Sun Feb 16, 2014 1:59 pm

wrysys wrote:just started an hsa this year, max out our 401k's each year. so that's about 40k


Are you also maxing out IRA contributions? At your income level and coverage by employer plan, your IRA contributions would not be tax deductible but it would create an extra 11k/yr in tax advantaged space to hold your less tax efficient holdings and improve your asset location. If you don't have pre-tax IRA assets, you could contribute to Traditional IRA and convert to Roth IRA.
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Re: If tax rates have gone way up for you -by manwithnoname » Sun Feb 16, 2014 2:38 pm

wrysys wrote:How have you changed your investments? As a two earner couple living in California, our taxes have significantly climbed and my tax preparer pointed out repeatedly that the dividends from small cap value with be subject to the new 3.8 investment tax. Small value has done well for us, we have a large chunk in SCV, but now i wonder if the value premium is really there anymore. The tax adjusted return on m* seems to say that SCV is 23 vs 22.4 (5 yr) but others on the board have argued with their math. Any suggestions/thoughts on this welcome. i don't see any great alternatives other than just paying the tax. Might increase my slice of VG california intermediate term taxexempt , but I don't want to radically alter my allocation. Interested in hearing from other cali folks.



Only thing you can do is increase deductions, e.g., by taking out a larger mortgage, or by substituting assets which generate income that does not show up on the 1040 such as municipal bonds or MLPs (which many taxpayers will not invest in) for taxable investment income. If your income comes from a business you own you can establish a Defined benefit pension and take additional deductions for contributions to the plan. If you are corporate employee can you participate in a non qualified deferred compensation that will reduce your w-2 income (although the long term tax consequences may not be favorable)?
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Re: If tax rates have gone way up for you -by Watty » Sun Feb 16, 2014 3:10 pm

As a two earner couple living in California, our taxes have significantly climbed and my tax preparer pointed out repeatedly that the dividends from small cap value with be subject to the new 3.8 investment tax.



Look at what that is in dollar terms.


In round numbers a 2% dividend on $100K is $2,000. An additional 3.8% tax on that is $76.


$76 is 0.076% of $100K. That is pretty much at the "noise level" so I would not make major decisions based on that. If the mutual fund was a good choice before it is still a good choice.


The kicker was that if you moved the money around to get it invested more tax efficiently then if you sold that mutual fund it would likely generate a lot of capital gains that would be taxed a lot more than the new dividend tax is costing you.


If it was a mistake to have that mutual fund in your taxable account then about the best you can do now may be to not have the mutual fund dividends and capital gains distributions automatically reinvested in that mutual fund and instead invest that money, and any new money, into more tax efficient choices.


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Re: If tax rates have gone way up for you -by VennData » Sun Feb 16, 2014 7:39 pm

You're married. The thresholds START at $250,000 AFTER deductions.




Don't sweat it.
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Re: If tax rates have gone way up for you -by Langkawi » Sun Feb 16, 2014 8:18 pm

VennData wrote:You're married. The thresholds START at $250,000 AFTER deductions.




Don't sweat it.


I don't see any indication that OP isn't aware of the threshold.
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Re: If tax rates have gone way up for you -by Artsdoctor » Sun Feb 16, 2014 9:17 pm

wrysys wrote:How have you changed your investments? As a two earner couple living in California, our taxes have significantly climbed and my tax preparer pointed out repeatedly that the dividends from small cap value with be subject to the new 3.8 investment tax. Small value has done well for us, we have a large chunk in SCV, but now i wonder if the value premium is really there anymore. The tax adjusted return on m* seems to say that SCV is 23 vs 22.4 (5 yr) but others on the board have argued with their math. Any suggestions/thoughts on this welcome. i don't see any great alternatives other than just paying the tax. Might increase my slice of VG california intermediate term taxexempt , but I don't want to radically alter my allocation. Interested in hearing from other cali folks.



Two income family here in California as well. Yes, our marginal federal and state tax rates have increased significantly--state last year and federal this year.


Regarding equities, I no longer have Emerging Markets in our taxable account. The dividends have been relatively "high," over 3%, and a sizeable chunk of those dividends are non-qualified. I had hoped to use Tax-Managed International more, but Vanguard merged into something which will be less tax-friendly. I still have a very large chunk of Total International but I've been putting new international contributions into tax-sheltered accounts. The foreign tax credit is relatively little and does not make up for the 20% qualified dividend rate, the 39.6% non-qualified dividend rate, the 3.8% investment tax, and the 12.3% state tax.


I do own Tax-Managed Small Cap. I do not own SCV in my taxable account. For you, perhaps you can stop adding to SCV unless you have tax-sheltered place, and use Total Stock Market or Tax-Managed Small Cap instead.


Munis have become far more valuable to me. I have a large chunk in the Vanguard intermediate fund, I buy individual CA state GO bonds, out-of-state AAA/AA GO bonds, and prerefunded CA bonds.


I max out everything I can with tax-deferred accounts, and I contribute the maximum to our HSAs. Just remember that CA does not recognize HSAs and you will not be able to deduct the HSA from your income in CA and you will pay state tax on both capital gains (unless you have losses to balance) and dividends.
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Re: If tax rates have gone way up for you -by wrysys » Sun Feb 16, 2014 9:42 pm

watty; thanks for the math, and I was wondering if I was worrying about it too much. Since I don't have much tax advantaged space but want to tilt to small value, perhaps I just need to accept the added tax. I do not reinvest my dividends but if you want a value tilt the issue still remains. The ideas for a defined benefit plan are good but my job has too many different partners of varying ages. I have been doing the backdoor roth each year also. Or are there other small value ETFs or funds which do not throw off much dividends that others can recommend? when you look at expense ratio and ease i cannot complain about VG's VISVX. thanks
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Re: If tax rates have gone way up for you -by dmcmahon » Sun Feb 16, 2014 10:42 pm

wrysys wrote:watty; thanks for the math, and I was wondering if I was worrying about it too much. Since I don't have much tax advantaged space but want to tilt to small value, perhaps I just need to accept the added tax. I do not reinvest my dividends but if you want a value tilt the issue still remains. The ideas for a defined benefit plan are good but my job has too many different partners of varying ages. I have been doing the backdoor roth each year also. Or are there other small value ETFs or funds which do not throw off much dividends that others can recommend? when you look at expense ratio and ease i cannot complain about VG's VISVX. thanks



The math misses out the bump in the state income tax, as well as the fact that the drag from the tax will compound over a long time period. I've elected to just pay the tax, but I probably have fewer years until retirement. The all-in tax is now about 1/3 on qualified dividends, up from about 1/4. I guess one observation was that you already had a tax drag problem under the old rules. A low-cost deferred variable annuity might be suitable if you have no better way to expand your tax deferred space. A more radical idea would be to tilt the other way, in favour of stocks that don't pay dividends.
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Re: If tax rates have gone way up for you -by SGM » Mon Feb 17, 2014 12:23 am

I have switched higher dividend funds into tax favored accounts. Not expecting my taxes to get lower in retirement, I am converting tIRAs to Roths. The buying power is the same, but I have less in taxable accounts.


I purchased a deferred savings annuity with 4% tax deferred interest. This functions essentially as a tax deferred 7 year CD. These rates are not available now. I am not sure what I will do 4 years down the road. I could annuitize it or take money out of it as needed.

One could purchase variable annuities through Vanguard to postpone taxes. Unfortunately there is an additional layer of expenses on top of the mutual fund ER. A Vanguard CFP advised against this strategy, but the thought had crossed my mind as a way to delay taxes. I agree with the CFP that a VA is not suitable for me. Maybe it would be helpful to someone who is expecting lower tax rates in the future. An extra 1% or more in yearly fees could outweigh any tax benefit. Interested folks could calculate the costs and benefits of lower cost VAs for individual scenarios.

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