Hey everyone, it’s Finance Fridays again and I was going to continue with my series outside of the normal “Stick to Index Funds” Philosophy. However, after talking last week about Taxable Accounts, I think it was a good idea to talk about Being Tax Efficient, at least a little bit.

What is “Being Tax Efficient”?

Well, I alluded to this in my prior post, but because of how different securities are taxed, where you put your money matters.

This isn’t a huge deal if all you have is a 401k/403b/457 since those are all tax-advantaged accounts (deferred). Even if you throw in a Backdoor Roth IRA, it doesn’t really matter too much since that is also a tax-advantaged account (post-tax). However, once you have any significant amount of money into a taxable investment account, then you should probably start paying attention to how to be tax efficient.

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Ok, so what do I need to know?

In general

Put tax inefficient items into a tax-deferred account.

Put tax efficient items into a taxable account.

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What taxes should I be aware of?

The important one to understand is capital gains tax.

Basically, when you sell a security you are taxed on it either:

At the normal rate, which is based on the investor’s marginal tax rate (as high as 39.6%) – when security held less than 1 year

At the long term rate,  which is typically between 15-20%.

Note: Dividends are also taxed at 0%, 15%, or 20%, depending on your income.

So, it’s really not cut and dry. Everything about tax-efficient is a general statement based on your marginal tax rate and alternative minimum tax.

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I see, so what are the “generalizations” then?

Once again, in general:

Taxable accounts (investment account):

• Stocks, held longer than 1 year
• Low turn-over funds (Index funds)
• Stocks or Funds that pay dividends
• High Yield Corporate Bonds (aka Junk Bonds)

Tax-advantaged accounts (401k/403b/457/IRA/Roth/etc):

• Stocks, held less than one year
• High turn-over funds (Actively Managed Funds)
• Taxable Bond Funds, Treasury Inflation Protected Securities (TIPS)
• Real Estate Investment Trusts (REITS)

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Wait a second, how do I do that if I’m a Boglehead?

Well, as you can see above as a Boglehead, who would only use Index Funds and Bonds, you don’t have many options to be tax-efficient. Ideally, as a Boglehead, you would want the majority of your money in a Taxable Account since your primary focus will be Index Funds and Bonds. However, more than likely, your tax-advantaged accounts will have more money in them than your Investment Account. In which case it would be difficult to allocate money well.

For example:

Let’s say you have $90,000 in your tax-advantaged account (a 401k). More than likely you have around only around 10% in a separate investment account, so let’s say another $10000.

Now let’s say you want to do a 70/30 split of Stocks/Bonds and you only want to use Index Funds and Bonds, as a true Boglehead.

That means you should probably have the full $10000 of your Investment Account into whichever Index Fund you like, and then allocate the other $90000 in your tax-advantaged account accordingly, which would be something like this:

Vanguard Total Stock Market (ETF):
$10000 in Investment Account

Vanguard Total Stock Market (Admiral Shares or ETF):
$60000 in 401k

Vanguard Total Bond (Admiral Shares or ETF):
$30000 in 401k

As I discussed before, in general, the ETF variant of a fund is more more tax efficient in a taxable account.

If you wanted to do a Global Portfolio and include International Stocks, then you would just divide things up a little differently. Either 50/50 US/International or some tilt.

Obviously, as you add in different securities, like TIPS, REITs, and individual stocks and such, this can get very complicated very quickly.

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What about my Backdoor Roth IRA?

I left out the Backdoor Roth IRA for simplicity. However, you can treat your Backdoor Roth IRA as a separate entity. Since it’s not just tax-advantaged, it’s tax-free. So if possible, you will want to place the items that have the potential for greatest growth in there.

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Ok, now let’s say you’re just starting out and are a high saver:

Great! I’m going to assume you didn’t make The Biggest Mistake of Your Life, right?

So that first half year as an attending is over. Your paycheck is a little higher every 2 weeks now and since you’re living like a college student still, you have some extra income every month… where do you put it…. in order to be efficient?

Well, it’s still pretty similar to the above:

Let’s say you have $30000 in your 401k ($18k + some employer match). At the end of this year you will put away another $18k (with a more complete match of $16k). So the assumption is that by the end of your 1st full year as an attending you will have $30000 + $34000 = $64000. Then because you’re have been living frugally, you were able to save an extra $1000 a month, and put an extra $12000 into an investment account.

So how do you approach this 1st full year as an attending?

It’s kind of tough because you are going off of a lot of assumptions, but the general idea still holds true. You still want your investment account to be predominantly the index fund. Let’s assume you want a 80/20 stock/bond split. So here is the plan

In total, you are expecting ~$64000 in 401k and ~$12000 in Investment Account for a total of $76000 by year’s end.

80% of $76000 = $60,800 (stock)
20% of $76000 = $15,200 (bonds)

So then:

Vanguard Total Stock Market (ETF):
Start with $0
End with $12000 in Investment Account ($1000/month)

Vanguard Total Stock Market (Admiral Shares or ETF):
Start with $24000 in 401k (80%)
End with $48800 in 401k

Vanguard Total Bond (Admiral Shares or ETF):
Start with $6000 in 401k (20%)
End with $15200 in 401k

Is this a perfect way to do it? No. However, it gives you a general direction to shoot for.

Or if you want to be even more simplistic, just keep your 401k contribution allocation at 80/20 and rebalance at some point, taking into account whatever is in your investment account at the time.

Of course, this doesn’t take into account your spouse’s retirement/investment accounts, or potentially a Spousal IRA. However, you can pretty much figure that out from here.

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What if I want to use TIPS and REITs?

Well, as a Boglehead, it doesn’t change what you do too much. You want to keep your TIPS and REITs in your tax-advantaged accounts, if at all possible.

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What if I want to invest in individual stocks or dividends?

Well, now it gets more complex because it depends on how long you plan to keep the stocks.

Like I said above, if you plan to keep the stocks longer than a year, then you will want them in a taxable account. If you are only keeping them less than a year, then you will want them in a tax-advantaged account.

However, that is not that easy. In my experience, not many 401k/403b/457 allow you to buy individual stocks. So then, you’re left with either your Backdoor Roth IRA or Taxable Account to buy individual stocks. So then:

Put stocks you will hold for less than 1 year in your Backdoor Roth IRA.

Put stocks you plan to hold longer than one year in your Taxable Account.

If you want to buy dividend stocks, which I will talk about more next week, then those should go in your Taxable Account.

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Wait… shouldn’t I use an Actively Managed Fund in my 401k/403b/457 to be tax efficient then?

It’s true that using an actively managed fund in tax-advantaged account is tax efficient. However, being tax efficient just for the sake of being efficient is losing the forest in the trees.

If you say it’s good idea to use an actively managed fund, you’re saying it’s better to be tax efficient over being a Boglehead, which is not what I advise.

Remember the Philosophy. Keep your eye on the ball and stay the course.

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TL;DR

Being tax efficient isn’t all that hard for Bogleheads.

Once you start gambling (picking individual stocks, etc), it becomes more complex.

Remember, these are just general guidelines. I’ve done my best to give reasonable advice for common scenarios.

If you anyone disagrees with me, please let me know why.

-Sensei

Agree? Disagree? Questions, Comments and Suggestions are welcome.

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