Over at Bogleheads we came across the following discussion:
by boggler » Sat Jan 24, 2015 5:38 pm
I'm trying to understand the concepts of tax efficiency and tax aware asset allocation, and I have a question so that I can make the best decisions for my portfolio: are tax efficiency benefits and recommendations, such as putting bonds in IRAs and international stocks in taxable accounts primarily due to capital gains benefits?
In other words, what tax efficiencies can be achieved if you plan to sell everything you own and buy it back at the end of every year or two? Assuming any gains would be taxed at the long term rate, would it then make sense to put bonds in the taxable account instead since the expected returns are lower?
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What if you are in the 15% marginal income tax bracket and long-term capital gains are taxed at 0%? Wouldn't you want to do tax-gain harvesting whenever you could? That would mean stocks in taxable.
I always treat tax-efficiency as the "the way to invest for my situation such that I have to pay the least taxes for the mostest gains." And my situation involves conversions to Roth IRAs and future RMDs and current tax-loss harvesting and being in the 33% tax bracket years ago and the 15% tax bracket this year and for the foreseeable future.
Sometimes rules of thumb do not apply or do not really make a difference.
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Tax efficiency depends both on avoiding taxable gains and on paying the lowest taxes you can on the gains which are taxed. Funds which pay non-qualified dividends or short-term capital gains are less tax-efficient than funds which pay only qualified divdends and long-term capital gains. Dividends on international funds are taxed at a lower effective rate because of the foreign tax credit. (However, international funds are less tax-efficient than domestic funds when international yields are much higher, as they have been since 2008; paying a lower tax rate on a higher dividend yield is not necessarily a benefit.) Treasury bond funds are more tax-efficient than corporate bond funds with the same yield if you pay state income tax.
David Grabiner
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Capital gains benefits (a lower rate on long term capital gains) is one part of the puzzle. There are other parts. As mentioned already, qualified dividends vs non-qualified dividends. Bond dividends are always non-qualified (not taxed at the lower rate).
Another aspect of tax efficiency is control over when money is taxed. If you hold bonds in taxable, the dividends will be taxed at your marginal rate every year whether you reinvest the dividends or spend the money. Since you have no control over when the dividends get taxed, your dividends are getting taxed at a high rate in your high income years. But if the bonds are in a tax-deferred account, you can control when that income gets taxed - you might not withdraw it until you are retired and in a lower tax bracket.
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boggler wrote:I'm trying to understand the concepts of tax efficiency and tax aware asset allocation, and I have a question so that I can make the best decisions for my portfolio: are tax efficiency benefits and recommendations, such as putting bonds in IRAs and international stocks in taxable accounts primarily due to capital gains benefits?
In other words, what tax efficiencies can be achieved if you plan to sell everything you own and buy it back at the end of every year or two? Assuming any gains would be taxed at the long term rate, would it then make sense to put bonds in the taxable account instead since the expected returns are lower?
No.
First understand there are different types of investment income, and each is taxed differently:
-Ordinary income---highest tax rate applies.
-Short-term capital gains---highest tax rate applies.
-Qualified dividend income---preferential tax treatment applies.
-Long-term capital gains---preferential tax treatment applies.
-Treasury dividends---state tax exempt, but federally taxed.
-Tax-exempt/municipal bond dividends---federally tax exempt, but state taxes may apply.
Assets producing least tax efficient returns should go in tax-advantaged space. Assets producing more tax-efficient returns can be placed in taxable space. As tax-advantaged space is limited, find the Wiki topic on "Principles of tax-efficient fund placement". Topic explains what should go where to minimize your tax bite.
Add to above, the understanding that...
-Foreign tax credit. Increases yield on foreign asset ~10%, but only if asset held in a taxable account.
-Tax-loss harvesting. Only applies to assets in taxable accounts. Execution restrictions apply.
-Tax-gain harvesting. No execution restrictions. State taxes may apply.
-Tax-advantaged space (Roth excepted) converts returns into ordinary income upon withdrawal. Meaning: LTCG, QDI, and tax-exempt income lose their tax-advantaged treatment. This is the reason people do a Roth conversion: pay the tax now (out of channel) to tax-shelter LT growth. That, and to stop required minimum distributions (RMD) later.
Your example of selling assets every couple of years to generate LTCG is less tax-efficient than just holding the assets. No need to pay taxes if they can be postponed. (Unless you are doing a Roth conversion.)
Putting bonds in taxable, stocks in tax-advantaged is a recognized option called "shoot for the moon in tax-advantaged". If in a higher tax bracket, would implement it with muni bonds.
I may have forgotten something.
d.r.a, not dr.a.
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by boggler » Mon Jan 26, 2015 1:41 am
dratkinson wrote:Your example of selling assets every couple of years to generate LTCG is less tax-efficient than just holding the assets. No need to pay taxes if they can be postponed. (Unless you are doing a Roth conversion.)
What if you're going to sell the assets at some point anyway, say for retirement or to buy a house? If you're guaranteed to sell the assets eventually, what implications does this have for tax efficiency?
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boggler wrote:
dratkinson wrote:Your example of selling assets every couple of years to generate LTCG is less tax-efficient than just holding the assets. No need to pay taxes if they can be postponed. (Unless you are doing a Roth conversion.)
What if you're going to sell the assets at some point anyway, say for retirement or to buy a house? If you're guaranteed to sell the assets eventually, what implications does this have for tax efficiency?
If the 15% LTCG tax rate always applies, nothing would seem to be gained by paying taxes early, as tax rates now/then would be the same.
On the other hand, selling in a low tax bracket now, taking smaller LTCGs to remain within low bracket, would slowly raise cost basis, so later large LTCG withdrawal should be taxed less.
