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Learning, Sharing, and Teaching => Ask a Mustachian => Topic started by: Its All About Value !!! on September 29, 2012, 12:57:36 AM

Title: Tax Minimization Strategy
Post by: Its All About Value !!! on September 29, 2012, 12:57:36 AM
1. Do you agree with the tax strategy outlined in rule #8 on this page?
http://www.bogleheads.org/wiki/Video:Bogleheads%C2%AE_investment_philosophy

2. A more detailed related question... I currently have my 401k and IRA at Fidelity.  I wanted to by VBTLX in my IRA, but I don't want to pay the transaction fee that Fidelity would charge.  So I could by the BND ETF for a $7.95 commission or I could buy iShares AGG which would be commission free. I know this is nit picky... but what do you all think I should do?  There an element of mutual fund vs ETF... and an element of duplicate funds offered by other providers that may have slightly higher expense rations.
Title: Re: Tax Minimization Strategy
Post by: ShavinItForLater on September 29, 2012, 08:05:27 AM
For those not wanting to watch a long video, Rule #8 is advising to keep bonds in tax-deferred or tax-free (e.g., Roth) accounts, and to keep stocks in taxable accounts as a way of minimizing taxes.

My response--that advice I believe is based on several assumptions that may or may not hold true for you:
 

Walking through those assumptions, first, if you will need the money you're investing to be fully accessible before age 59 1/2, you won't want it in a traditional IRA or a 401(k).  Roth IRAs would be more flexible since after 5 years you can withdraw the *contribution* portion without penalty.  Any money you need sooner would be better off in taxable accounts to avoid withdrawal penalties and rule 72(t) restrictions.

Assuming we are talking about 100% retirement funds (passing assumption #1), if you can put it all in tax-advantaged accounts, then there is no reason to worry about this--all the money will be completely tax-advantaged, stocks or bonds.  It's only when you have surplus funds to save that this might apply. 

Also note that Roth IRA/401(k)s will never have any tax on the income or dividends or appreciation (with the tradeoff being that you have already paid taxes on the money you are using to invest).  That might actually be the ideal place to stash retirement bonds.

Next, if your income is low enough, your marginal tax bracket might be zero or 15%--in that case, your capital gains tax rate will actually be zero, but you can't just consider this point in time.  You have to project what your income will look like in retirement when you have your full 'stash, and you also have to project what tax rates might be at that time.  A lot of people think the current tax rates are much lower than historical norms, and too low to be sustainable over the long term--therefore likely to rise by the time a young'un might be retiring. 

If you have a big 'stash and are withdrawing enough to get beyond that magical 15% bracket point later on, then based on today's "low low" rates your capital gains tax rate later on would be...15%.  So in these early years if you are in the 15% bracket, you're not losing anything by paying 15% tax on your investment income today.

Now, many budding Mustachians will have much, much higher income than the 15% bracket allows, so in that case, and if you believe your tax bracket may be a lot lower after FIRE due to your Mustachian spending levels, then you very well might save something by having your bonds in tax-advantaged accounts and your stocks in taxable (with all the previous assumptions still applying).

Finally, if your investment portfolio is small, and your investment income is also therefore very small, we are talking very little difference here.  If you have $10,000 invested in bonds, and it is paying you 5% per year in bond interest, that is $500.  If you were in the 25% tax bracket, you'd be paying $125 in taxes.  If it was in a tax-advantaged account, you'd eventually be paying some tax on that anyway, so you can't even count the full $125 as "savings".  So, you're jumping through a bunch of hoops for what, $50-75 per year maybe?  If your bond portfolio were $100,000 or $500,000, then we're talking some real money here, but when the numbers are small, you'd get a lot more from your time figuring out how to spend less, and how to make more, increasing your savings rate--for most people, probably not to hard to find $100 per year that way...

I've rambled on long enough, so I'll leave your Fidelity vs. Vanguard question to others in terms of a detailed answer.  I'll just say that in your shoes I'd open a Vanguard IRA account and buy the Vanguard fund/ETF there.
Title: Re: Tax Minimization Strategy
Post by: Its All About Value !!! on September 30, 2012, 01:32:59 AM
Thanks for the reply!  I should have mentioned that the video I linked is about keeping bonds in tax-deferred or tax-free (e.g., Roth) accounts, and to keep stocks in taxable accounts as a way of minimizing taxes.

Does anyone have anything to say about my second question?
Title: Re: Tax Minimization Strategy
Post by: Zaga on September 30, 2012, 07:42:12 AM
Thanks for the reply!  I should have mentioned that the video I linked is about keeping bonds in tax-deferred or tax-free (e.g., Roth) accounts, and to keep stocks in taxable accounts as a way of minimizing taxes.

Does anyone have anything to say about my second question?
What's wrong with using the Spartan funds at Fidelity?  They are great, low fee index funds.  Most of our accounts are in these and I have been happy with them.
Title: Re: Tax Minimization Strategy
Post by: grantmeaname on September 30, 2012, 09:53:18 AM
Shavin, there are a couple of rules you're not mentioning that make accounts more flexible than I think you realize. Namely:
Walking through those assumptions, first, if you will need the money you're investing to be fully accessible before age 59 1/2, you won't want it in a traditional IRA or a 401(k).
I guess that would depend on your definition of 'fully'. As long as you're planning on a reasonably long time scale, like five years out, you can simply convert a year's worth of expenses from a traditional account to a Roth. Then wait five years and you're good. This is the "Roth rollover pipeline" that I and a handful of others are posting about all the time, and it's a much, much better method than Rule 72(t) in many circumstances (such as today's low-interest climate).

Quote
Roth IRAs would be more flexible since after 5 years you can withdraw the *contribution* portion without penalty.  Any money you need sooner would be better off in taxable accounts to avoid withdrawal penalties and rule 72(t) restrictions.
Five years? Pssh. You can withdraw Roth contributions mere seconds later than you contributed them if you want to. There's no penalty for withdrawing Roth contributions at any time. (Obligatory wikipedia link (http://en.wikipedia.org/wiki/Comparison_of_401(k)_and_IRA_accounts): "At any point, the owner may withdraw the total contributed into the IRA, without tax or penalty"). Your five year figure applies only to conversions, which is why the pipeline mentioned above needs to exist.