Wednesday, December 3, 2014

Creating a More Tax-Efficient Portfolio

Over at, we came across the following discussion:

I posted this question on *M's discussion page but I guess it wasn't sexy enough due to the endless fascination with day trading of CEFs, ETFs, MLPs, etc. 

After getting hit with lots of year-end capital gains once again, I've decided to make a few moves next year to create a more tax efficient portfolio. I've identified a few culprits that belong in tax deferred accounts, such as BERIX, VWENX, FLPSX and FCNTX. I've found a few funds that could take their place in taxable accounts (VTMFX, HDV, SCHM, to name a few). The main issue is that all of the taxable funds have built up very large capital gains, so a sale would trigger capital gains, albeit mostly in the long term category. I was thinking maybe selling one fund each year so I wouldn't get hit badly in one year. Any other suggestions on how to maneuver my portfolio to make it more tax efficient? Thanks. 


  • One obvious suggestion is not to reinvest dividends, but to apply the money toward more tax-efficient funds such as ones you've identified.

    Also, unless you know that dividends are going to be pure long term gain, sell before the distribution rather than after. (That way, you can avoid some ordinary income distributions, though you'll have higher capital gains on the shares you sell.) That's not a suggestion to liquidate a fund, or to sell now, but just if you are planning to sell some shares soon, do it before rather than after the end of year distribution.
  •  edited December 1
    I was a little surprised and disappointed at FCNTX's distribution (about 6%) because it's supposed to be a large cap growth fund and the turnover isn't outrageous. Thanks for the suggestions, MSF.
  • Transition into ETFs from mutual funds. They are inherently more tax efficient.
  • Sometimes ETFs are not more tax efficient.

    Vanguard Admiral class shares and ETF class shares are identical in tax efficiency. Vanguard Investor class shares, which are a poorer choice, are inherently more tax efficient.

    For example, for the Vanguard 500 fund, its admiral share class (VFIAX) and ETF share class (VOO) have 1 year tax cost ratios of 0.83%, and 3 year tax cost ratios of 0.57%. (VOO doesn't go out five years.)

    VFINX, the investor share class, has corresponding tax cost ratios of 0.78% and 0.53%.

    The reasons are twofold:

    1) These are different share classes of the same (not merely identical) portfolio, so they share equally in the realized gains.

    2) Interest and dividends of the underlying stocks are used to pay the ERs. So the higher the ER of a share class, the less that is distributed in the way of income dividends. That means that the higher the ER, the higher the tax efficiency (lower dividends).

    It's the same idea as hoping a fund will have small distributions because it made little money. Not something to be hoped for.

    Admiral shares and ETF shares currently have the same ERs, so they'll have the same tax efficiency. All else being equal, the ETF will lose a little bit on a round trip, because of the bid/ask spread that is absent from the other share classes.
  •  edited December 2
    Nice post msf. It looks like neither the Vanguard 500 Index fund VFIAX nor the Vanguard Total Stock Market Index Fund VTSAX have had any capital gains distributions in the past 10 years

    And the tax cost ratio and tax adjusted returns for VTI (Vanguard Total Stock Market Index ETF) and VTSAX (Admiral shares, Total Stock Market Index Fund) were just about identical over 1, 3, 5 and 10 years, per Morningstar.


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