Target Date Funds and Tax Efficient Asset Placement   Leave a comment

Back in my post on what funds I invest in, I said that you should not just blindly follow my fund selection, one of the reasons being you should take into consideration retirement accounts. Certain assets should, generally speaking, be held in a retirement account instead of a taxable account. I think I’ll motivate this with a discussion of target date funds.

Target Date Funds

I haven’t mentioned target date funds at all even though they’re a common investment of choice for a significant number of people. And part of my neglect is because I don’t use them, for reasons I will expand on. But, they are a good choice for some people.

A target date fund is one that is typically implemented as a fund of funds—ie, Vanguard’s target retirement funds are composed of four funds: total (US) stock market index, total international stock market index, total bond market index, and total international bond index. These funds have a target retirement date in the name – Vanguard has them for 2010 – 2060 in 5 year increments. The key feature of any target retirement fund is that they are self-rebalancing – so if the stock market has a particularly bad year, they sell some of the bond fund shares to buy some of the stock fund shares, and vice versa. A retirement date fund of 2060 will have virtually all, if not all of the assets in stocks. As retirement approaches, the fund follows a glide path towards more bonds.

But, remember that income from bonds is always taxed at normal income rates, while some (and depending on the fund choice, virtually all) of the dividends from stocks can be qualified dividends, which are taxed at the long term capital gains rate, which is always lower than your normal income tax rate. If you hold a target date fund in a taxable account, you will always have some of your investment returns taxed at normal income rates.

So what’s the alternative? Hold your bond funds in a tax advantaged account like an IRA or a 401k (where no investment returns contained within the account will be subject to tax). And let your stock funds fill up the rest of your tax advantaged accounts, and spill over into a taxable account if you have one.

Additionally, splitting your funds out like this, and having some funds in a taxable account, let you engage in tax loss harvesting. Tax loss harvesting is not possible for funds held in a retirement account. But at the same time, the purchase of a fund in a retirement account can trigger a wash sale for a potential tax loss harvest in a taxable account.

Now before I get into some more of the details of tax efficient asset placement, I do want to list out for what type of people and/or situations I would advocate a target date fund

  • When you cannot meet the investment minimum of holding a couple funds (ie a US stock, intl stock, and bond fund) but you can meet the investment minimum for a target date fund, and this fund would be held in a retirement account. I add the last clause in there because eventually, I would recommend you switch to using 3 funds (US stock, International stock, US bonds). When you sell funds in a retirement account, that is not a taxable event, and hence, you can switch funds at no tax cost.
  • If you truly just do not want to have to manage three funds and you just want a one stop shopping experience. I would argue that the benefits of holding 3 funds outweigh the costs, but if the overhead of managing 3 funds is preventing you from investing at all, then certainly, using a target date fund to invest is better than not investing at all
  • If you are the type of person who is inclined to tinker with things – follow the latest “news” on marketwatch or whatever and make investment decisions based on that. Low cost index investing doesn’t work that well if you want to do frequent trading. With a target date fund, there’s no tinkering involved – just buy this one fund, set and forget.

Tax Efficient Asset Placement

As I mentioned above, bond interest income (whether it’s from an individual bond, or from a mutual fund that holds bonds) is always taxed at your normal income tax rate. Hence, you should hold it in a retirement account, where the income it generates won’t be taxed. You will of course, owe taxes on the withdrawals. But this way, your bond investments aren’t taxed along the way at a high rate.

US Stock funds tend to give off a large portion of their dividends as qualified dividends. Qualified dividends are taxed at the favorable long term capital gains rates. In the case of Vanguard’s total stock market index fund, 100% of their dividends have been qualified for the past 11 years, except in 2013 where it was 94.35% (the site as of today has not been updated for 2014, but I received the tax information from Vanguard for it, and it was 100% qualified dividends). This makes US stock funds tax efficient, and hence, can be held in a taxable or retirement account without large tax consequences.

So far, it’s been pretty clear – bonds and bond funds in retirement accounts, US stocks and US stock funds in either.

With International stock funds, it’s less clear cut. In the case of Vanguard’s VTIAX (total international stock index),  around 70% of dividends are qualified, depending on the year. If you hold the fund in a retirement account, you don’t have to concern yourself with the fact that 30% of the dividends aren’t qualified. But, when you hold the fund in a retirement account, you are ineligible for the foreign tax credit.

The foreign tax credit can get complicated, but the idea is that if you have foreign income that is taxed by a foreign government, the IRS doesn’t want to tax you again on the same income. So, they give you a tax credit equal to the foreign tax withheld. Now if you have less than $300 of foreign tax withheld, you will get every dollar of that foreign tax back from the IRS. If you have more than $300 of foreign tax withheld, you will have to fill out the form associated with the foreign tax credit, and you may not get a credit equal to foreign taxes withheld. If you only have foreign income from your investments though, this isn’t that big a concern, as typically the foreign taxes are about 0.2% for VTIAX.

Hence, you’ve got two competing forces – holding international funds in a taxable account means some of your dividends will get taxed at normal income rates and give you a foreign tax credit, but holding international funds in a retirement account means your dividends won’t get taxed (at least, not until eventual withdrawal – but that should be at a lower rate than your current marginal rate), while you don’t get the tax credit.

I remember seeing a thread on the Bogleheads forum with the math behind it, but somebody sat down and calculated the effect. Essentially, the key is that the foreign tax credit is a dollar for dollar credit and doesn’t depend on your tax rate. However, your marginal tax rate is used for calculating the tax on non qualified dividends. My recollection is at the 25% bracket, it’s more or less a wash. Above that, you should hold the funds in a retirement account, and below that, you should hold the funds in a taxable account. If I can find the thread, I will update this section.

What if you don’t have enough space in your retirement accounts?

Let’s look at hypothetical Jane. Jane doesn’t have a 401k from work—she only has an IRA and a taxable account. Her IRA only accounts for 5% of her total portfolio. However, she wants 10% of her portfolio to be in bonds. She can fill her IRA with bonds, but she’s still short 5%. Should she just buy some bonds in her taxable account?

Yes, but not the typical US bond fund. I’d recommend she buy municipal bonds (bonds issued by states). This is because income from such bonds are not taxable by the US government (and conversely, interest from federal government bonds are not taxable by state governments). These bonds do have slightly more risk, but it’s not that big, and in my opinion, worth the risk for the lower taxes.

If you don’t have enough space for the international fund in a retirement account, I’d just buy it in the taxable account and pay the taxes.

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Posted January 21, 2015 by Fiby in Uncategorized

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