Author Topic: Adjusting Investments due to State Taxes  (Read 3931 times)

climber1

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Adjusting Investments due to State Taxes
« on: July 20, 2015, 11:10:17 PM »
I currently live in California. Given my career, this is an excellent choice to maximize earnings and career growth, but not so great for taxes. In particular, California taxes capital gains (no distinction between short-term and long-term) at my marginal income tax rate (9.3% and likely to stay there due to a very wide tax bracket). So there is a significant advantage to choosing investments which will be very long-term so I can hold them until some time in the future when I no longer live in California at which point I will recognize the gains. Ideally, at that point, I would have no earned income and so the federal tax rate would also be zero.

However, this only solves the issue of capital gains. There is no corresponding way to delay receiving dividends. Since I pay a higher tax rate on these dividends than other investors in lower tax regimes, this makes them a worse choice for me. So I am thinking if I should tilt my taxable portfolio towards stock likely to grow through capital appreciation rather than dividends with my tax-advantaged accounts tilted in the opposite direction. Does this make sense to others? Can anyone recommend good Vanguard funds which together are close to a total stock market fund, but one is focused on dividend stocks and the other on growth stocks?

forummm

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Re: Adjusting Investments due to State Taxes
« Reply #1 on: July 21, 2015, 06:55:34 AM »
If you just buy and hold Vanguard funds like VTSAX and VTIAX, you never need to sell them until you're retired (i.e. lower income and lower taxes).

VTSAX doesn't have a high dividend rate (<2%). I think that's a reasonable amount to pay some tax on. But if you want to eliminate dividends, you could buy a lot of BRK.B. It's not as diversified as VTSAX of course, so you're taking on some more concentrated risk.

MDM

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Re: Adjusting Investments due to State Taxes
« Reply #2 on: July 21, 2015, 07:09:40 AM »
So there is a significant advantage to choosing investments which will be very long-term so I can hold them until some time in the future when I no longer live in California at which point I will recognize the gains. Ideally, at that point, I would have no earned income and so the federal tax rate would also be zero.

You probably are already, but just checking: do you take full advantage of all your tax-deferred (e.g., 401k, HSA) space now?  Expecting both federal and state brackets to drop significantly makes that choice all the more valuable.

innerscorecard

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Re: Adjusting Investments due to State Taxes
« Reply #3 on: July 21, 2015, 07:31:47 AM »
If you just buy and hold Vanguard funds like VTSAX and VTIAX, you never need to sell them until you're retired (i.e. lower income and lower taxes).

VTSAX doesn't have a high dividend rate (<2%). I think that's a reasonable amount to pay some tax on. But if you want to eliminate dividends, you could buy a lot of BRK.B. It's not as diversified as VTSAX of course, so you're taking on some more concentrated risk.

If you absolutely don't want to pay dividends, there are a lot of holding companies run by owner-operators besides Berkshire Hathaway as well, that don't pay dividends because they believe they can reinvest the money better.

MKL is the obvious other one, but there are more (most more complex and with odd issues that might make you uncomfortable holding them - for example, some may require you to participate in various rights offerings from time to time - not very passive). I won't name them here, as any one of them could be criticized for various reasons.

NorCal

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Re: Adjusting Investments due to State Taxes
« Reply #4 on: July 21, 2015, 07:43:55 AM »
You should also put some of your taxable Fixed Income holdings in CA Muni bonds.  Not too much, due to the risks involved, but an allocation there helps.  I have ~12% of my bond allocation in CA MUNI's.

There's not much you can do about dividends other than putting your biggest payers in tax advantaged accounts and your lowest payers in taxable accounts. 

I would not change your allocations based on taxes.

climber1

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Re: Adjusting Investments due to State Taxes
« Reply #5 on: July 21, 2015, 10:15:54 AM »
Yes, I will max out all tax-advantaged accounts before making any investments in taxable accounts. I am saving more than 401k limit (53k), IRA limit, and HSA limit per year, so it is necessary to look at taxable accounts. I don't think CA muni bonds are a good idea for me for two reasons. First, I am not in the very highest brackets. My marginal tax rate is 28%+9.3%=37.3%. The top bracket is 39.6%+13.3%+3.8%=56.7%. Additionally, I don't plan to stay in California forever or even necessarily for a long time. So if I move out of state in 5 years, I am no longer getting the state tax benefit.

Focusing on stocks (since at my age, that is where the bulk of my portfolio is), I don't want to change my overall allocation, just place different pieces of it where is most tax advantageous. For this reason, I would like to avoid individual stocks like Berkshire or Markel. The ideal thing would be that someone at Vanguard looks at all the companies in VTSAX and decides that some of those companies are more likely to pay dividends while others are instead likely to grow in market cap (like Berkshire and Markel) or use share buybacks to return capital. And then created two index funds which match this divide. Does this not exist? Or perhaps there are some other Vanguard funds which would approximate this even if it wasn't their design goal.

innerscorecard

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Re: Adjusting Investments due to State Taxes
« Reply #6 on: July 21, 2015, 10:22:45 AM »
Yes, I will max out all tax-advantaged accounts before making any investments in taxable accounts. I am saving more than 401k limit (53k), IRA limit, and HSA limit per year, so it is necessary to look at taxable accounts. I don't think CA muni bonds are a good idea for me for two reasons. First, I am not in the very highest brackets. My marginal tax rate is 28%+9.3%=37.3%. The top bracket is 39.6%+13.3%+3.8%=56.7%. Additionally, I don't plan to stay in California forever or even necessarily for a long time. So if I move out of state in 5 years, I am no longer getting the state tax benefit.

Focusing on stocks (since at my age, that is where the bulk of my portfolio is), I don't want to change my overall allocation, just place different pieces of it where is most tax advantageous. For this reason, I would like to avoid individual stocks like Berkshire or Markel. The ideal thing would be that someone at Vanguard looks at all the companies in VTSAX and decides that some of those companies are more likely to pay dividends while others are instead likely to grow in market cap (like Berkshire and Markel) or use share buybacks to return capital. And then created two index funds which match this divide. Does this not exist? Or perhaps there are some other Vanguard funds which would approximate this even if it wasn't their design goal.

Sounds like a business idea. You know - you really are giving me the idea of creating an ETF exclusively composed of companies that don't pay dividends (but instead reinvest their earnings into the business). I would call it REIN or NODV.

I think the challenge is whether to give this kind of portfolio a growth or value tilt. The portfolios would look VERY different either way.

It would be BRK.B, MKL and others versus BABA, FB and the like I suppose some AMZN and GOOG could be defensible in either portfolio.

Aphalite

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Re: Adjusting Investments due to State Taxes
« Reply #7 on: July 21, 2015, 10:24:37 AM »
Focusing on stocks (since at my age, that is where the bulk of my portfolio is), I don't want to change my overall allocation, just place different pieces of it where is most tax advantageous. For this reason, I would like to avoid individual stocks like Berkshire or Markel. The ideal thing would be that someone at Vanguard looks at all the companies in VTSAX and decides that some of those companies are more likely to pay dividends while others are instead likely to grow in market cap (like Berkshire and Markel) or use share buybacks to return capital. And then created two index funds which match this divide. Does this not exist? Or perhaps there are some other Vanguard funds which would approximate this even if it wasn't their design goal.

You mean something like https://personal.vanguard.com/us/FundsSnapshot?FundId=5102&FundIntExt=INT ?

Growth index funds also tend to not pay dividends, but the tradeoff is you have less diversification (dividend stocks are traditionally considered a bit more defensive due to the value component): https://personal.vanguard.com/us/funds/snapshot?FundId=0509&FundIntExt=INT

NorCal

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Re: Adjusting Investments due to State Taxes
« Reply #8 on: July 21, 2015, 10:37:55 AM »
I'd still do the math on whether CA MUNI's make sense in your personal situation.  VBTLX currently yields 2.48% pre-tax and CXA yields 2.42% non-taxable.  You'd absolutely be better off from a pure yield standpoint by having a little bit there.  Of course, CA MUNI's do have specific risks.

You can also sell them when you move out of CA.  You shouldn't have much in the way of capital gains on bond funds.

I wouldn't worry about changing allocations on stocks with higher or lower dividends.  The loss of diversification would more than offset any tax benefits.

climber1

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Re: Adjusting Investments due to State Taxes
« Reply #9 on: July 21, 2015, 06:45:14 PM »
Focusing on stocks (since at my age, that is where the bulk of my portfolio is), I don't want to change my overall allocation, just place different pieces of it where is most tax advantageous. For this reason, I would like to avoid individual stocks like Berkshire or Markel. The ideal thing would be that someone at Vanguard looks at all the companies in VTSAX and decides that some of those companies are more likely to pay dividends while others are instead likely to grow in market cap (like Berkshire and Markel) or use share buybacks to return capital. And then created two index funds which match this divide. Does this not exist? Or perhaps there are some other Vanguard funds which would approximate this even if it wasn't their design goal.

You mean something like https://personal.vanguard.com/us/FundsSnapshot?FundId=5102&FundIntExt=INT ?

Growth index funds also tend to not pay dividends, but the tradeoff is you have less diversification (dividend stocks are traditionally considered a bit more defensive due to the value component): https://personal.vanguard.com/us/funds/snapshot?FundId=0509&FundIntExt=INT

Thanks for the information about VTCLX. This sounds like what I would be looking for. Unfortunately, the facts don't bear it out. For the past 10 years, the average dividend for VTSAX is 1.97%. For VTCLX, it is still 1.65%. So this still has 84% of the dividends of VTSAX. For this small an improvement, it isn't worth the extra effort. Also, there doesn't appear to be the opposite fund which chooses companies with higher dividends so I could hold those companies in my tax-advantaged accounts.

Some days I really want to set up an ETF that has exactly the desired properties.

Scandium

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Re: Adjusting Investments due to State Taxes
« Reply #10 on: July 21, 2015, 07:06:35 PM »
Vanguard has at least two dividend focused (large cap) funds. No saying  this would work out great, but they do have them.

So guess you could do LC growth, and a SC growth (if it exists?) in taxable and SCV and dividend fund in tax advantages. No idea if this would give you total market, or how much it would save you.

climber1

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Re: Adjusting Investments due to State Taxes
« Reply #11 on: July 21, 2015, 08:16:26 PM »
Vanguard has at least two dividend focused (large cap) funds. No saying  this would work out great, but they do have them.

So guess you could do LC growth, and a SC growth (if it exists?) in taxable and SCV and dividend fund in tax advantages. No idea if this would give you total market, or how much it would save you.

Thanks for the suggestion Scandium. I spent some more time looking through the list of Vanguard funds and it turns out that Vanguard has value and growth funds for each of Large-Cap, Medium-Cap and Small-Cap. I also pulled up the dividends of these funds for the last 10 years (9 for Medium-Cap as that is back to founding) on Bogleheads, http://www.bogleheads.org/wiki/Category:Vanguard_funds:_distributions, and averaged them over that period. I used Admiral shares for Large-Cap and ETF for the other two due to availability for the full term of interest. The results are below:

Large-Cap Value: 2.73%
Large-Cap Growth: 1.20%
Medium-Cap Value: 2.32%
Medium-Cap Growth: 0.71%
Small-Cap Value: 2.23%
Small-Cap Growth: 0.66%

So the value funds definitely pay a much higher average dividend. And based on the indexes that these track, it looks like the combination of them in the right ratio should have equivalent performance to VTSAX. Also, I like that they are broken up by size. Having more distinct funds will make tax loss harvesting easier in the future.

So my plan is that in my taxable accounts, I will stick to the growth funds for my domestic stocks. Since I still will be savings more in my retirement accounts than taxable accounts, they will have a combination of growth and value funds.

Scandium

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Re: Adjusting Investments due to State Taxes
« Reply #12 on: July 21, 2015, 08:34:01 PM »
Interesting. So on $100k you'd save about 1.5% on your large cap dividends. That's $150 in state taxes per year. Plus you'd save $225 in fed taxes too. Not nothing.. Up to you whether the hassle it worth it.

maizeman

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Re: Adjusting Investments due to State Taxes
« Reply #13 on: July 21, 2015, 09:43:00 PM »
Interesting. So on $100k you'd save about 1.5% on your large cap dividends. That's $150 in state taxes per year. Plus you'd save $225 in fed taxes too. Not nothing.. Up to you whether the hassle it worth it.

Also need to factor in the increased expense ratios. Looking at Admiral shares the difference between a total stock market index and growth/value indexes is 0.04% so that eats up $40/year, or about 10% of the total tax savings. If you tried it without Admiral shares or with index funds from another provider, it's possible differences in expense ratio would consume the majority of your tax savings.

Not a reason not to do it, but another issue to run the numbers on when you're deciding if the strategy will make financial sense for you.

climber1

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Re: Adjusting Investments due to State Taxes
« Reply #14 on: July 21, 2015, 09:50:46 PM »
The value is actually about half of that because the correct comparison is not the growth index against the value index, but against the market-capitalization weighted average of the two and the market caps are about equal. So a savings of $180/yr per $100k invested. Doesn't sound like much, but is comparable to a 0.18% expense ratio. maizeman, thanks for the reminder about the difference in expense ratio.

Maybe I am overthinking this, but I plan to hold the investments in my taxable portfolio as long as practicable to avoid paying capital gains tax each time I move between investments. So I need to make my investment choices correctly the first time.

Another risk I need to consider if investing in more specific funds is the higher risk of future closure. If Vanguard chooses to cease operation of the fund and closes it rather than merge it into another fund, this would cause an unexpected tax implications. Anyone have historial data on what Vanguard has done when they decided to stop operating a fund?
« Last Edit: July 21, 2015, 09:59:23 PM by climber1 »

Aphalite

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Re: Adjusting Investments due to State Taxes
« Reply #15 on: July 22, 2015, 07:06:07 AM »
climber1, I will say that you shouldn't make taxes your top investment priority. It should be a part of your overall strategy, but if you prioritize growth funds over total stock market, there will be periods throughout the future where you underperform the total market (growth funds are TYPICALLY more volatile but not always). If that is an acceptable risk, then go for it, just make sure you understand the risks.