Active Management and Taxes

[AdrianC]

Preaching to the choir with this one, but just in case anyone still needs convincing:

Actively Managed Mutual Funds and the Negative Alpha of Taxes
http://mutualfunds.com/education/active-managed-mutual-funds-and-the-negative-alpha-of-taxes/?preview=2639dba4-99ec-4ebf-9e9f-c8dc17f2484c

I've only just managed to extricate myself from some actively managed funds bought in taxable accounts before my Bogle-inspired epiphany. That was a relief.

[COEE]

So I started looking at this yesterday (independent of seeing this thread).  I looked at the following large blend actively managed funds, YAFFX, PRILX, POGSX in comparison with the two "best" S&P500 index funds, SWPPX and VFINX.  All three of these funds have significantly outperformed the market over the last 10, 5, and 3 years and theoretically would have been better investments for any of those time periods, but you do make a good point about taxes and active vs passively managed funds.

A few questions as I am somewhat new to this.

• Is there a metric the shows how much tax liability there would be for this time period?
• Wouldn't these be significantly better funds in a tax advantaged Roth where you don't have to pay taxes when you withdraw?
• How are the taxes calculated?  I imagine that it's partially your tax bracket and partially the buying and selling of stocks within the fund and their capital gains/losses.  It's a bit complicated for a average joe to figure out.
• Any good reading on the tax implications of actively vs. passively managed funds that isn't biased and have loads of advertisements on their website?
• The problem with the figures in the previous website (and everywhere else) is that it doesn't explain where the figures came from... it's simply "believe me" type of numbers where someone else has done a bunch of excel type work, but doesn't make it available for others to see.

For the record - I did read the first few chapters of John Bogle's book when I first started investing, and it made a lot of sense to me at the time.  Most of my investments still sit in good index funds with <0.1% expense ratios.  My current employer only has one index fund with a better than 0.1% expense ratio, VBAIX (0.08%)... most are actively managed or shitty index funds at 0.25% to 1.5%.  I am currently trying to decide if I should change my strategy to just use VBAIX or keep my investments in other actively managed funds that have performed better than VBAIX over the last 10, 5, and 3 year periods.  The 401k at my new job is currently about 10% of my investment portfolio.

I am currently using a traditional 401k, but I do have a Roth option for long-run tax sheltering purposes.  However, I do plan to FIRE in about 10 years so my strategy to date has been to keep it traditional since I expect my income to go down significantly in 10 years, getting the tax advantage now and later.

I can use a self-directed brokerage account through TD Ameritrade for a $100 yearly fee, and can have no more than 50% of my 401k there.

[seattlecyclone]

Yes, those funds did outperform the index. This is due either to exceptional skill on the part of the managers or plain dumb luck. It's impossible to know which. On average you should expect an actively managed fund to match the performance of an index in that asset class before management fees are taken out. The few funds managed by truly skilled (as opposed to lucky) managers might do better than this. Once again, you have no way of knowing whether the fund outperformed due to luck or skill.

An index fund won't let you beat the market. Instead you are guaranteed to exactly match the market, which has historically been pretty good!

[COEE]

Yes, thanks for reiterating the logic behind the index investment strategy.  Logic that I'm very familiar with and have been implementing in my own portfolio for the last 4 years.  However, you did not answer any of the questions that I do have, which are reasonable questions based on my lack of good investment funds at my new company.

[seattlecyclone]

I wouldn't say you have a lack of good investment funds at your new company. Since your 401(k) is only 10% of your investments, VBAIX is a great fund to put that money in as long as your asset allocation has at least 5% for bonds. A 0.25% index fund isn't great by any means, but it also isn't terrible.

As to your specific questions, I'll take a stab at a couple of them.

1. Is there a metric the shows how much tax liability there would be for this time period?

I don't know of a metric off hand, but you can look at the history of distributions at various mutual fund research sites. For example, Fidelity's site shows that YAFFX had a $4.58 capital gains distribution last year when the fund value was $19.86. That's 23%. Ouch!

Wouldn't these be significantly better funds in a tax advantaged Roth where you don't have to pay taxes when you withdraw?

Sure, these funds would be better in a tax-advantaged account because you don't have to pay taxes on any dividends or capital gains that happen within the account every year. You just have to pay tax on the final sum when you withdraw (for traditional accounts) or never (for Roth accounts)

How are the taxes calculated?  I imagine that it's partially your tax bracket and partially the buying and selling of stocks within the fund and their capital gains/losses.  It's a bit complicated for a average joe to figure out.

Taxes on capital gains and dividends are based on your tax bracket. Short-term gains and bond interest are taxed at your regular marginal rate. Long-term gains and qualified dividends are taxed at a lower rate (0% for this income when you're in the 10-15% bracket, 15% in the 25-35% bracket, 20% in the 39.6% bracket). There's also an additional 3.8% added on to these rates for any investment income that pushes your total income past $200k (single) or $250k (married). When a fund makes a distribution the 1099 you get at the end of the year should have a breakdown of how much of the income is short-term gains, long-term gains, dividends, etc.

[Ursus Major]

1. morningstar.com has some tax info on funds, e.g. here for MPGFX: http://performance.morningstar.com/fund/tax-analysis.action?t=MPGFX&region=usa&culture=en_US

On the tab Portfolio -> Holdings you can also see some info on annual turnover.

2. Yes, funds with a high annual turnover might be best held in a Roth.

3. Mutual funds pay out (distribute) their capital gains, say once or perhaps twice a year. Most people reinvest those back into the fund. You'll pay taxes on those capital gains based I ttyl8r personal federal and state tax rate for capital Gains.

4. See the morningstar info above, which let's you compare funds.

5. You should be able to find the actual historical distributions for a fund on their website, so you can get a sense of how their tax efficiency was in the past.

While I don't necessarily agree with the posters who tell you to only stick with index funds (though it's decent enough advice), buying into a fund just based on recent performance without regards to people or process of the fund strikes me as not so smart. To give you an example look at the Fairholme Fund (FAIRX). The manager was Morningstar's "Fund Manager of the Decade" in 2010. And the fund hasn't performed up to par since then.

You don't mention what the other funds in your employer's plan are, but you might consider 50% VBAIX and the other 50% in your brokerage account in cheap index funds.

[COEE]

seattlecyclone, Thanks for taking the time to answer my questions.

1. Is there a metric the shows how much tax liability there would be for this time period?

I don't know of a metric off hand, but you can look at the history of distributions at various mutual fund research sites. For example, Fidelity's site shows that YAFFX had a $4.58 capital gains distribution last year when the fund value was $19.86. That's 23%. Ouch!

So let me make sure I get this right.  If I had a brokerage account and I had 100 shares of YAFFX ($19.86+$4.58=$24.71) when they initialize a capital gains distribution 12/28/15.  So now my shares are valued at $19.86 and I have 23 additional shares (if I reinvest).  But I also have a $458 tax liability for that year.  And I'm in the $25% tax bracket, so I would owe $114.50 in taxes that year.  Does that sound right?  Do I understand this correctly?

Wouldn't these be significantly better funds in a tax advantaged Roth where you don't have to pay taxes when you withdraw?

Sure, these funds would be better in a tax-advantaged account because you don't have to pay taxes on any dividends or capital gains that happen within the account every year. You just have to pay tax on the final sum when you withdraw (for traditional accounts) or never (for Roth accounts)

So if I use the same scenario as I outline above in a traditional 401k/IRA account at the same time I'd still be responsible for the $114.50 tax, but I wouldn't be responsible for that amount until I pull the funds out.  If 10 years pass when I pull the funds and I'm in the 15% tax bracket that year, then I pay no taxes on that $114.50, right?  Essentially making my tax rate 0%.

If I take that same scenario in a Roth 401k/IRA then the only tax I pay is the tax on the income I used to buy my initial 100 shares... and that's really no different than the brokerage account, except future earnings are not taxed regardless of tax bracket.

If I have this right, if I have to have actively managed funds, then having actively managed funds in a traditional 401k is the best way to go because these funds will see minimal taxes applied to them.  This makes it easier to beat the market because their isn't much of a tax hit - meaning the OP's post is pretty much not true - at least in my scenario.

Please let me know if I'm missing something.

[Ursus Major]

seattlecyclone, Thanks for taking the time to answer my questions.

1. Is there a metric the shows how much tax liability there would be for this time period?

I don't know of a metric off hand, but you can look at the history of distributions at various mutual fund research sites. For example, Fidelity's site shows that YAFFX had a $4.58 capital gains distribution last year when the fund value was $19.86. That's 23%. Ouch!

So let me make sure I get this right.  If I had a brokerage account and I had 100 shares of YAFFX ($19.86+$4.58=$24.71) when they initialize a capital gains distribution 12/28/15.  So now my shares are valued at $19.86 and I have 23 additional shares (if I reinvest).  But I also have a $485 tax liability for that year.  And I'm in the $25% tax bracket, so I would owe $114.50 in taxes that year.  Does that sound right?  Do I understand this correctly?

Distributions from funds are usually long-term capital gains, so if you are in the 25% tax bracket, your federal tax rate on those will be 15%. So your capital gains will be $485, but your tax liability is $72.75. Furthermore - assuming reinvestment of shares - your cost basis on the entire position has just gone up by $485. BTW your math seems slightly off. When you reinvest $485 at $19.86 a share you get 24.421 additional shares by my calculation.

[COEE]

Ursus Major - thank you for taking the time to answer my questions.

While I don't necessarily agree with the posters who tell you to only stick with index funds (though it's decent enough advice), buying into a fund just based on recent performance without regards to people or process of the fund strikes me as not so smart. To give you an example look at the Fairholme Fund (FAIRX). The manager was Morningstar's "Fund Manager of the Decade" in 2010. And the fund hasn't performed up to par since then.

I have been looking at FOCPX today.  They have incredible performance 10-year, 11.75%; 5-year, 12.58%; 3-year 16.01%.  All of this I'd usually chalk up to luck (at least at those returns), but with a 32 year track record at 13.11% (inception in 1984) they've survived some tough periods and still made good money.  They are doing something right.  Of course, I'd read up a bit more before actually investing in this fund - not that I'm going to... just playing devil's advocate in the 'only index funds' mentality that is so popular lately.

You don't mention what the other funds in your employer's plan are, but you might consider 50% VBAIX and the other 50% in your brokerage account in cheap index funds.

I was hoping someone would make this suggestion.  That is exactly what I've been considering doing.  I also don't get a company match so I've also been considering contributing to an IRA with more options first rather than the 401k.  VBAIX is a weak fund.  I think it's only there so that we have a Vanguard option.  It tries to track two different index funds and ends up trailing the S&P usually.  I'm more inclined to use the BlackRock Russell 3000 Index, but I get your point about spliting things up into two accounts and not worrying too much about the small percentage of my portfolio in any of these accounts.  I just really hate BlackRock.  They usually don't perform as well as Vanguard and Schwab Index funds and perform worse.  It's like pissing away money.

Below is a list of all of my available funds, (expense ratio), ticker, and my current distribution amounts.  I'm 34 and my wife is 35 this is the only account account we are currently contributing to.  I like to have a 20% bond, 20% Large Cap, 40% Mid/Small, and 20% Int'l  At least that's been a pretty good mix for me so far - I just wish I had true index funds for these distributions.


Voya Target Solution 20XX        (0.81%)
Stable Value Fund                      (0.78%)
BlackRock US Debt Index          (0.32%)
 Fidelity Total Bond                     (0.45%)  FTBFX    20%
Vanguard Balanced Index          (0.08%)   VBAIX
 Voya Large Cap Value Port       (0.75%)   IPEIX     10%
BlackRock Russell 3000 Index   (0.28%)
 Voya Large Cap Growth Port     (0.67%)  IEOHX    10%
JHancock Dspl Val Mid Cap        (0.87%)  JVMIX
 T.Rowe Mid Cap Growth            (1.03%)  PAMCX   40%
Federated Clover Sm Cap Val       (1.13%)  VSFIX
T. Rowe Price New Horizons       (0.79%) PRNHX
BlackRock Global Equity Ex US  (0.38%)
 American Funds EuroPacific       (0.84%) REREX  20%

[COEE]

Distributions from funds are usually long-term capital gains, so if you are in the 25% tax bracket, your federal tax rate on those will be 15%. So your capital gains will be $485, but your tax liability is $72.75. Furthermore - assuming reinvestment of shares - your cost basis on the entire position has just gone up by $485. BTW your math seems slightly off. When you reinvest $485 at $19.86 a share you get 24.421 additional shares by my calculation.

Sorry for the confusion... the capital gain distribution was $4.58.  I had a dyslexia moment this morning.  I updated the original post.

Yes, if they were long-term gains then I'd be on the hook for $68.70 ($458*15%) - only if I had the funds in a brokerage account.

However, I wouldn't owe any tax immediately if they were in a traditional IRA (I only pay when I pull).  Further, if I waited to pull the assets 10 years later from the traditional IRA, and I was in a 15% tax bracket, it wouldn't cost me anything because then I've held the gains for at least one year, I think.

[Ursus Major]

Distributions from funds are usually long-term capital gains, so if you are in the 25% tax bracket, your federal tax rate on those will be 15%. So your capital gains will be $485, but your tax liability is $72.75. Furthermore - assuming reinvestment of shares - your cost basis on the entire position has just gone up by $485. BTW your math seems slightly off. When you reinvest $485 at $19.86 a share you get 24.421 additional shares by my calculation.

Sorry for the confusion... the capital gain distribution was $4.58.  I had a dyslexia moment this morning.  I updated the original post.

Yes, if they were long-term gains then I'd be on the hook for $68.70 ($458*15%) - only if I had the funds in a brokerage account.

However, I wouldn't owe any tax immediately if they were in a traditional IRA (I only pay when I pull).  Further, if I waited to pull the assets 10 years later from the traditional IRA, and I was in a 15% tax bracket, it wouldn't cost me anything because then I've held the gains for at least one year, I think.

You are still a bit confused. If you hold that fund in a tIRA, capital gains distributions are tax neutral. But any withdrawal from the account is taxed at your ordinary tax rate, not at the capital gains tax rate.

[COEE]

Distributions from funds are usually long-term capital gains, so if you are in the 25% tax bracket, your federal tax rate on those will be 15%. So your capital gains will be $485, but your tax liability is $72.75. Furthermore - assuming reinvestment of shares - your cost basis on the entire position has just gone up by $485. BTW your math seems slightly off. When you reinvest $485 at $19.86 a share you get 24.421 additional shares by my calculation.

Sorry for the confusion... the capital gain distribution was $4.58.  I had a dyslexia moment this morning.  I updated the original post.

Yes, if they were long-term gains then I'd be on the hook for $68.70 ($458*15%) - only if I had the funds in a brokerage account.

However, I wouldn't owe any tax immediately if they were in a traditional IRA (I only pay when I pull).  Further, if I waited to pull the assets 10 years later from the traditional IRA, and I was in a 15% tax bracket, it wouldn't cost me anything because then I've held the gains for at least one year, I think.

You are still a bit confused. If you hold that fund in a tIRA, capital gains distributions are tax neutral. But any withdrawal from the account is taxed at your ordinary tax rate, not at the capital gains tax rate.

Ah yes... so there ends up being NO capital gain tax.  You essentially get a stock split without any tax penalty other than your regular income tax when you eventually sell the shares. 

So the taxes that reduce the rate of return of an actively managed fund that the OP linked is true... but usually only a real hit to the bottom line if held in a brokerage account.

[Ursus Major]

Ah yes... so there ends up being NO capital gain tax.  You essentially get a stock split without any tax penalty other than your regular income tax when you eventually sell the shares. 

So the taxes that reduce the rate of return of an actively managed fund that the OP linked is true... but usually only a real hit to the bottom line if held in a brokerage account.

That's not quite correct, You don't pay taxes, when you eventually sell the shares. You pay taxes, when you pull money out of the account. So you could sell the shares in the account (and buy something else, or just leave the money in cash) and that has no tax consequences whatsoever. Only when you actually take a distribution from the account, you pay taxes (at your ordinary tax rate).

[COEE]

Ah yes... so there ends up being NO capital gain tax.  You essentially get a stock split without any tax penalty other than your regular income tax when you eventually sell the shares. 

So the taxes that reduce the rate of return of an actively managed fund that the OP linked is true... but usually only a real hit to the bottom line if held in a brokerage account.

That's not quite correct, You don't pay taxes, when you eventually sell the shares. You pay taxes, when you pull money out of the account. So you could sell the shares in the account (and buy something else, or just leave the money in cash) and that has no tax consequences whatsoever. Only when you actually take a distribution from the account, you pay taxes (at your ordinary tax rate).

Got it - I think I'm getting confused in semantics after looking at this half the day - but I have the general idea of how using a tax advantaged account can help shelter very steep taxes.

[seattlecyclone]

VBAIX is a weak fund.  I think it's only there so that we have a Vanguard option.  It tries to track two different index funds and ends up trailing the S&P usually.

Yes, it usually trails the S&P 500 because it's invested 60% in stocks and 40% in bonds. Bonds tend to provide a lower return than stocks, therefore an index fund that includes bonds will likely underperform a pure stock index fund. It's not that the fund is "weak," it's that it's investing in a different asset class that doesn't usually perform as well.

What does your investment policy statement say? What percentage of your investments do you want to have in bonds? If that number is more than zero, VBAIX is a fine place to meet that allocation.

[PhysicianOnFIRE]

Tax Drag can eat away at your returns in a taxable / brokerage account. It's a non-issue in tax-deferred and Roth accounts.

It's best to keep only passive index funds in the taxable account. In addition to capital gains and dividend taxes, most of us pay state income tax on those dividends and gains. The high earners get hit with the ACA surtax and for some, a 20% rather than 15% capital gains tax.

[COEE]

VBAIX is a weak fund.  I think it's only there so that we have a Vanguard option.  It tries to track two different index funds and ends up trailing the S&P usually.

Yes, it usually trails the S&P 500 because it's invested 60% in stocks and 40% in bonds. Bonds tend to provide a lower return than stocks, therefore an index fund that includes bonds will likely underperform a pure stock index fund. It's not that the fund is "weak," it's that it's investing in a different asset class that doesn't usually perform as well.

What does your investment policy statement say? What percentage of your investments do you want to have in bonds? If that number is more than zero, VBAIX is a fine place to meet that allocation.

Meh... I realize that it's split between the two indexes... it's too bond heavy for my tastes, and weak for my investment strategy.

[seattlecyclone]

Yeah, I guess if your investment policy statement says you should have less than 4% of your portfolio in bonds, then you wouldn't want to consider investing the 10% of your money that's in your 401(k) in a 60/40 stock/bond index fund.

[COEE]

Tax Drag can eat away at your returns in a taxable / brokerage account. It's a non-issue in tax-deferred and Roth accounts.

It's best to keep only passive index funds in the taxable account. In addition to capital gains and dividend taxes, most of us pay state income tax on those dividends and gains. The high earners get hit with the ACA surtax and for some, a 20% rather than 15% capital gains tax.

Yeah - I had that epiphany today as well.  If I'm going to do any highly taxed actively managed funds I better do it in tax-deferred accounts.  In fact this is probably a good strategy considering the reinvested tax disbursements essentially is a stock split of sorts.  Then keep the index funds in brokerage accounts where you see more tax liability, but the indexes aren't too tax heavy.  I have a while until I max out all of my tax-deferred accounts, but it's coming soon enough that maybe I'll do a little bit of that at some point.

Investing more in a IRA is more appealing than my 401k after being involved in this thread as well - just for the lower fees in better funds.  I'll probably start working that soon.

[COEE]

Yeah, I guess if your investment policy statement says you should have less than 4% of your portfolio in bonds, then you wouldn't want to consider investing the 10% of your money that's in your 401(k) in a 60/40 stock/bond index fund.

Hmm... I can't tell if you're being snarky or not... but I thought about this a while.  Of the roughly 10% I have in that account... only 20% of that should go to bonds - 2% of my total assets.  Now if I do end up investing in VBAIX we're talking only +2% too much to that asset class.  Not a big deal I suppose.  As this account grows and becomes a higher percentage of my assets I might need to rethink things.  Also, I suppose it's easy enough to rebalance my other account to go -2% there to balance things out.  This would eliminate all of my expense ratio concerns and make it easier investing.

Hmmm - you've given me something to think about whether you meant to or not.

[Roots&Wings]

Tax Drag can eat away at your returns in a taxable / brokerage account. It's a non-issue in tax-deferred and Roth accounts.

It's best to keep only passive index funds in the taxable account. In addition to capital gains and dividend taxes, most of us pay state income tax on those dividends and gains. The high earners get hit with the ACA surtax and for some, a 20% rather than 15% capital gains tax.

I've been meaning to try the Bogleheads Tax Efficiency fund comparison spreadsheet (https://docs.google.com/spreadsheets/d/12okbyUlGIsz5nLi3I9R7QdkfNx9XX8GGp0-cwikG0Ts/edit). PoF, yours seems to be missing QDI and I'm unclear how it can compare different funds (maybe it doesn't).

If anyone knows of a more user-friendly, less technical spreadsheet or online calculator for comparing total after tax returns for taxable account holdings, would love to know.

I thought Morningstar used the highest tax rate for distributions in their after tax/total return comparisons, but from what I heard on Bogleheads, that's not the case.

[seattlecyclone]

Yeah, I guess if your investment policy statement says you should have less than 4% of your portfolio in bonds, then you wouldn't want to consider investing the 10% of your money that's in your 401(k) in a 60/40 stock/bond index fund.

Hmm... I can't tell if you're being snarky or not... but I thought about this a while.  Of the roughly 10% I have in that account... only 20% of that should go to bonds - 2% of my total assets.  Now if I do end up investing in VBAIX we're talking only +2% too much to that asset class.  Not a big deal I suppose.  As this account grows and becomes a higher percentage of my assets I might need to rethink things.  Also, I suppose it's easy enough to rebalance my other account to go -2% there to balance things out.  This would eliminate all of my expense ratio concerns and make it easier investing.

Hmmm - you've given me something to think about whether you meant to or not.

Apologies for the snark. I sometimes make the mistake of assuming that people know more than they actually do. In this case I assumed you were aware that you don't need to have each investment account match your overall asset allocation, that you can have one account be more bond-heavy than another account as long as the total across all of your accounts adds up the way you want. Glad I could help, I guess.