Author Topic: How to collect profits from Index Funds  (Read 13495 times)

nnhubbard

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How to collect profits from Index Funds
« on: November 04, 2013, 10:40:17 AM »
I am new to the investing game. I took MMM advice and bought some index funds from Vanguard, VTSMX. They have already made a small profit, but my questions are:

  • Once a profit is made, should I take that out of the account, and possibly buy more shares when the stock is lower?
  • Just leave the profits there?

My goal was to invest about $1k/month into VTSMX index funds. Any other advice?

Thanks guys!

Watchmaker

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Re: How to collect profits from Index Funds
« Reply #1 on: November 04, 2013, 10:46:01 AM »
I take it by profit you mean that the share price has gone up.  You shouldn't do anything with those shares--leave them alone so over the next several decades they will have time to grow more and more.  It's even more important that in the years that go badly (and there will be some) that you don't panic and sell.

If you meant that the fund had paid out dividends, the best thing to do would be set the account up so the dividends are automatically reinvested in the fund.

nnhubbard

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Re: How to collect profits from Index Funds
« Reply #2 on: November 04, 2013, 10:48:05 AM »
Got it. Will just leave it alone and continue to invest in that fund.

Can you explain more about "set the account up so that the dividends are automatically reinvested"? How would I set this up?

iamlindoro

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Re: How to collect profits from Index Funds
« Reply #3 on: November 04, 2013, 11:10:38 AM »
If you invest directly through Vanguard, you can change your reinvestment elections in My Accounts->Dividends and Capital Gains->Change elections.  You were asked about these elections when setting up the account, too.

Another reason you don't take anything out with Vanguard is that when you sell, you have a 60 day (IIRC) window in which you cannot buy back into the fund again.  This is to discourage people from treating the ETF/Index fund as a stock and from trying to do what you describe in your first message.  It's a pretty bad idea to try to frequently trade these funds anyway-- your strategy if you're following MMM's advice is buy early, buy often, and HOLD.

nnhubbard

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Re: How to collect profits from Index Funds
« Reply #4 on: November 04, 2013, 11:18:00 AM »
Thanks. Love the "buy early, buy often, and HOLD" quote.

When buying often, should I even worry about what the price of VTSMX currently is?

Watchmaker

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Re: How to collect profits from Index Funds
« Reply #5 on: November 04, 2013, 11:21:27 AM »
Generally speaking, no, don't worry about the current price when buying.  Search these forums for the phrase 'timing the market' for more conversation on this.

It is a good idea to spread you purchases out so you dn't happen to put 10,000 in on a bad day (called dollar cost averaging)--sounds like you're already planning that iwith a month purchase cycle.

iamlindoro

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Re: How to collect profits from Index Funds
« Reply #6 on: November 04, 2013, 11:24:19 AM »
Thanks. Love the "buy early, buy often, and HOLD" quote.

When buying often, should I even worry about what the price of VTSMX currently is?

Nope-- Because by investing regularly, you're essentially dollar-cost-averaging.  Sometimes it will be up, sometimes it will be down, but the general trend is towards perpetually higher.  So if you catch the market on a "buy day" (let's just arbitrarily call that every other Friday) and it's down a half a percent, in the long run it's smoothed out by being up .5 two fridays from now, and the general trend over years (which is the only timeline we really care about) is up, up, up. 

http://en.wikipedia.org/wiki/Dollar_cost_averaging

It's very easy to be caught in the trap of caring about minute changes to the market when you're starting out.  You can watch your precious $1000 investment go up or down by $100 and feel a sense of excitement or desparation.  But if you get stuck worrying about these micro-changes, then you end up making mistakes that harm your performance over the long run (like selling your position).  The (very successful) approach espoused by MMM and other ER sites is to learn to ignore the minor changes.  As soon as you stop looking and start regularly contributing, you will have won half the battle.  Then you can just set a threshold where your investments produce in a given (average) year the amount you need to pay your expenses... and retire when you hit it :)  (this is a simplified explanation, but more or less the jist)

nnhubbard

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Re: How to collect profits from Index Funds
« Reply #7 on: November 04, 2013, 11:28:36 AM »
Got it.

Quote
Then you can just set a threshold where your investments produce in a given (average) year the amount you need to pay your expenses... and retire when you hit it :)  (this is a simplified explanation, but more or less the jist)

So, at that point, say 10 years down the road, would I just start taking $$ out of that fund to pay my expenses? Is that how it works?

lizfish

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Re: How to collect profits from Index Funds
« Reply #8 on: November 04, 2013, 11:35:24 AM »
Really grateful that you've asked these questions. Never touched investing in my life and you are asking the questions I would ask!

I love the fact that people are supportive of newbies round here too. There's plenty of us! Once I work out how to start investing in an vanguard fund in the uk via an ISA. Just trying wade through the maze of charges at the moment, then we'll be all set.

iamlindoro

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Re: How to collect profits from Index Funds
« Reply #9 on: November 04, 2013, 11:35:47 AM »
Sort of, kind of, yes.  This is the correct high level understanding.  Once you've locked in these concepts, then you start exploring taxable versus tax-advantaged accounts, and how to leverage them pre and post age of eligibility.  Many people here would put the first 17,500 per year into a 401k as that comes out before taxes, and improves your tax bill.  Then they might fund a Roth IRA up to $5500 per year, because that has advantages for early retirement such as being tax-free on withdrawal.  Only then would the remaining savings go to a taxable account as it's the least advantageous to you taxwise.

The above is a very simplified explanation of what SOME people might do, it is by no means a one size fits all sort of thing.  But generally speaking, you want to fund the accounts which have the most tax advantage first to their maximum amounts, then spill over into the next most advantaged, etc.  YMMV.

A good article on the concepts:

http://www.bogleheads.org/wiki/Principles_of_tax-efficient_fund_placement

nnhubbard

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Re: How to collect profits from Index Funds
« Reply #10 on: November 04, 2013, 11:45:25 AM »
But what if we are using the MMM concept of retiring early? If I have all this $$ into investments that I can only take out when I am actual retirement age, wouldn't that be a problem?

Nothlit

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Re: How to collect profits from Index Funds
« Reply #11 on: November 04, 2013, 11:54:44 AM »
There are ways to get money out of retirement accounts before retirement age. You have to be careful to avoid triggering certain penalties, but it is possible. Search for the terms "72t", "SEPP", and "Roth pipeline" to find out more.

iamlindoro

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Re: How to collect profits from Index Funds
« Reply #12 on: November 04, 2013, 11:55:27 AM »
But what if we are using the MMM concept of retiring early? If I have all this $$ into investments that I can only take out when I am actual retirement age, wouldn't that be a problem?

This is what I meant by it starts to get complicated (though it's not once you wrap your head around it all).  There are a number of ways to get your 401k money out before 401k eligibility.  The most commonly mentioned here is the 401k-Roth IRA pipeline. 

Let's assume you have a 401k with most of your retirement savings, and a Roth IRA.  The law allows for you to retire (getting yourself into a very low tax bracket), then roll 401k funds into your Roth IRA paying only normal income taxes rather than penalties + taxes.  Since you're retired (and not paying your "full time worker tax rate"), your income taxes on the rollover are negligible.  Now, when the amount you rolled in "ages" and hits 5 years, you can take it out of the Roth with NO PENALTY.  It's also earning money in that Roth all along as part of your investments.  So basically every year during the first 5 years of your retirement, you would roll the amount you need for a year into the Roth IRA.  Once the first year's has "matured," you have a full five year pipeline that you keep filling once a year and pulling out the five year old rollover.  You just keep doing this all the way until you can pull out the 401k money directly.  It sounds complicated, but really it's not.  All you need to start is enough to cover your expenses for the five years you "fill the pipeline," then the rest is coming form the 401k.

Look at strategy 2 in this article:

http://www.mrmoneymustache.com/2011/11/11/how-much-is-too-much-in-your-401k/

There are other way to get at this money (some discussed in the article above) but the 401k-Roth pipeline seems the most popular.

iamlindoro

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Re: How to collect profits from Index Funds
« Reply #13 on: November 04, 2013, 12:03:08 PM »
The 401k-Roth pipeline is probably best illustrated with a hand-wavy example.  Here's one that drastically oversimplifies things (by ignoring gains from investments and using totally made up tax numbers, etc) but should get the point across.

My COL for a year is $25K.  I have $800K in my 401k. I have $25K in my Roth IRA.  I have $125K in my taxable accounts, which I can take out with no penalty.

I retire. 

YEAR ONE!

I pay for my COL with 25K from my taxable account.  I roll $30K from my 401k into my Roth IRA, paying $5K in income taxes on it.
At the end of the year, I have $50K in my Roth IRA, $25K is "one year old."  I have $100K in my taxable accounts, which I can take out with no penalty.

YEAR TWO!

I pay for my COL with 25K from my taxable account.  I roll $30K from my 401k into my Roth IRA, paying $5K in income taxes on it.
At the end of the year, I have $75K in my Roth IRA, $25K is "one year old", $25K is "two years old."  I have $75K in my taxable accounts, which I can take out with no penalty.

YEAR THREE!

I pay for my COL with 25K from my taxable account.  I roll $30K from my 401k into my Roth IRA, paying $5K in income taxes on it.
At the end of the year, I have $100K in my Roth IRA, $25K is "one year old", $25K is "two years old," $25K is "three years old."  I have $50K in my taxable accounts, which I can take out with no penalty.

YEAR FOUR!

I pay for my COL with 25K from my taxable account.  I roll $30K from my 401k into my Roth IRA, paying $5K in income taxes on it.
At the end of the year, I have $125K in my Roth IRA, $25K is "one year old", $25K is "two years old," $25K is "three years old," $25K is "four years old."  I have $25K in my taxable accounts, which I can take out with no penalty.

YEAR FIVE!

I pay for my COL with 25K from my taxable account.  I roll $30K from my 401k into my Roth IRA, paying $5K in income taxes on it.
At the end of the year, I have $150K in my Roth IRA, $25K is "one year old", $25K is "two years old," $25K is "three years old," $25K is "four years old," and $25K is finally five years old.  I have $0K in my taxable accounts.

At this point, I can take out $25K from the Roth with no penalties of any kind, and I have a consistent pipeline of money coming out yearly from my 401k.  I can increase this amount as necessary to cover changes to COL, etc.  This whole example ignores gains, compound interest, etc. and isn't meant to do anything but explain the pipeline in case the previous example didn't make sense.

Hope this helps.

« Last Edit: November 04, 2013, 12:13:53 PM by iamlindoro »

ichangedmyname

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Re: How to collect profits from Index Funds
« Reply #14 on: November 04, 2013, 02:39:55 PM »
The 401k-Roth pipeline is probably best illustrated with a hand-wavy example.  Here's one that drastically oversimplifies things (by ignoring gains from investments and using totally made up tax numbers, etc) but should get the point across.

My COL for a year is $25K.  I have $800K in my 401k. I have $25K in my Roth IRA.  I have $125K in my taxable accounts, which I can take out with no penalty.

I retire. 

YEAR ONE!

I pay for my COL with 25K from my taxable account.  I roll $30K from my 401k into my Roth IRA, paying $5K in income taxes on it.
At the end of the year, I have $50K in my Roth IRA, $25K is "one year old."  I have $100K in my taxable accounts, which I can take out with no penalty.

YEAR TWO!

I pay for my COL with 25K from my taxable account.  I roll $30K from my 401k into my Roth IRA, paying $5K in income taxes on it.
At the end of the year, I have $75K in my Roth IRA, $25K is "one year old", $25K is "two years old."  I have $75K in my taxable accounts, which I can take out with no penalty.

YEAR THREE!

I pay for my COL with 25K from my taxable account.  I roll $30K from my 401k into my Roth IRA, paying $5K in income taxes on it.
At the end of the year, I have $100K in my Roth IRA, $25K is "one year old", $25K is "two years old," $25K is "three years old."  I have $50K in my taxable accounts, which I can take out with no penalty.

YEAR FOUR!

I pay for my COL with 25K from my taxable account.  I roll $30K from my 401k into my Roth IRA, paying $5K in income taxes on it.
At the end of the year, I have $125K in my Roth IRA, $25K is "one year old", $25K is "two years old," $25K is "three years old," $25K is "four years old."  I have $25K in my taxable accounts, which I can take out with no penalty.

YEAR FIVE!

I pay for my COL with 25K from my taxable account.  I roll $30K from my 401k into my Roth IRA, paying $5K in income taxes on it.
At the end of the year, I have $150K in my Roth IRA, $25K is "one year old", $25K is "two years old," $25K is "three years old," $25K is "four years old," and $25K is finally five years old.  I have $0K in my taxable accounts.

At this point, I can take out $25K from the Roth with no penalties of any kind, and I have a consistent pipeline of money coming out yearly from my 401k.  I can increase this amount as necessary to cover changes to COL, etc.  This whole example ignores gains, compound interest, etc. and isn't meant to do anything but explain the pipeline in case the previous example didn't make sense.

Hope this helps.

Oh thank you for this! Will this still work if I just have a traditional IRA instead of Roth? I want the contributions to minimize my taxed income. And I don't earn enough to do 17,500 in my 401k but I'm planning on contributing the max 15% next year.

iamlindoro

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Re: How to collect profits from Index Funds
« Reply #15 on: November 04, 2013, 03:04:24 PM »
I know you can roll over a 401k to a traditional IRA, but the traditional IRA has the same limitation of not allowing you to take the money out without penalty before age 59 1/2.  The Roth allows you to withdraw the contributions without penalty, and the rollovers without penalty after 5 years, all at any age, making it the ideal vehicle for early retirement.  So the Roth IRA is what you want to use for this. 
« Last Edit: November 04, 2013, 04:22:07 PM by iamlindoro »

Eric

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Re: How to collect profits from Index Funds
« Reply #16 on: November 04, 2013, 03:07:18 PM »
Oh thank you for this! Will this still work if I just have a traditional IRA instead of Roth? I want the contributions to minimize my taxed income. And I don't earn enough to do 17,500 in my 401k but I'm planning on contributing the max 15% next year.

You would still convert your traditional IRA to a Roth IRA, as above.  Just replace 401k with traditional IRA, rolling over $30k yearly from traditional IRA to Roth IRA.  If you don't have a Roth IRA when it's time to start the pipeline withdrawals, you can just open one at that time.

Eric

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Re: How to collect profits from Index Funds
« Reply #17 on: November 04, 2013, 03:13:39 PM »
At this point, I can take out $25K from the Roth with no penalties of any kind, and I have a consistent pipeline of money coming out yearly from my 401k.  I can increase this amount as necessary to cover changes to COL, etc.  This whole example ignores gains, compound interest, etc. and isn't meant to do anything but explain the pipeline in case the previous example didn't make sense.

Do you know how the Roth IRA's growth is handled?  For example, if your $25K conversion grows to $30K because of stock market gains after 5 years, you can still only touch the $25K, right?  And the capital gains aren't available for penalty free withdrawal until age 59.5.  Is that correct?

iamlindoro

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Re: How to collect profits from Index Funds
« Reply #18 on: November 04, 2013, 03:15:39 PM »
At this point, I can take out $25K from the Roth with no penalties of any kind, and I have a consistent pipeline of money coming out yearly from my 401k.  I can increase this amount as necessary to cover changes to COL, etc.  This whole example ignores gains, compound interest, etc. and isn't meant to do anything but explain the pipeline in case the previous example didn't make sense.

Do you know how the Roth IRA's growth is handled?  For example, if your $25K conversion grows to $30K because of stock market gains after 5 years, you can still only touch the $25K, right?  And the capital gains aren't available for penalty free withdrawal until age 59.5.  Is that correct?

Yeah, that's my understanding too (and the advantage of having the growth in the 401k, which then becomes all "contribution" on rollover into the pipeline).

nawhite

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Re: How to collect profits from Index Funds
« Reply #19 on: November 04, 2013, 03:49:15 PM »
Another reason you don't take anything out with Vanguard is that when you sell, you have a 60 day (IIRC) window in which you cannot buy back into the fund again.  This is to discourage people from treating the ETF/Index fund as a stock and from trying to do what you describe in your first message.  It's a pretty bad idea to try to frequently trade these funds anyway-- your strategy if you're following MMM's advice is buy early, buy often, and HOLD.

There is one exception to this rule when discussing taxable accounts. Tax Gain Harvesting. Mad Fientist is much better at explaining it than me, so take at look at his explanation: http://www.madfientist.com/tax-gain-harvesting/ . Basically, if you (1) are in the 0% long term capital gains tax bracket and (2) you can sell and then re-buy your assets (something that is hard to do at Vanguard), you can raise the base price of your investments which will maximize the amount of a financial loss that you can claim as a tax break in the future.

nottoolatetostart

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Re: How to collect profits from Index Funds
« Reply #20 on: November 29, 2013, 06:17:17 AM »
Thanks for laying this out. It's incredibly helpful as an idea of how to harvest the money in ER.

tj

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Re: How to collect profits from Index Funds
« Reply #21 on: November 30, 2013, 01:42:56 PM »
I disagree with the recommendation to reinvest dividends in a taxable account. The dividends from Total Stock Market are not all that much. It will complicate your taxes when you do sell. Just have the dividends sent to your checking account and increase your contributions if you want more invested.

Undecided

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Re: How to collect profits from Index Funds
« Reply #22 on: November 30, 2013, 06:41:36 PM »
I disagree with the recommendation to reinvest dividends in a taxable account. The dividends from Total Stock Market are not all that much. It will complicate your taxes when you do sell. Just have the dividends sent to your checking account and increase your contributions if you want more invested.

I suppose it depends on where one invests or how one otherwise tracks basis, but it's pretty simple when investing directly with Vanguard.

Khan

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Re: How to collect profits from Index Funds
« Reply #23 on: November 30, 2013, 09:44:21 PM »
I disagree with the recommendation to reinvest dividends in a taxable account. The dividends from Total Stock Market are not all that much. It will complicate your taxes when you do sell. Just have the dividends sent to your checking account and increase your contributions if you want more invested.

And I disagree with this, because tax issues are amazingly simple and handled on the back end by Ameritrade(and I'm sure Vanguard is just as simple).

iamlindoro

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Re: How to collect profits from Index Funds
« Reply #24 on: November 30, 2013, 10:10:16 PM »
And I disagree with this, because tax issues are amazingly simple and handled on the back end by Ameritrade(and I'm sure Vanguard is just as simple).

Indeed, just as simple.  In fact, I struggle to come up with a single way in which reinvesting dividends complicates anything.

tj

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Re: How to collect profits from Index Funds
« Reply #25 on: November 30, 2013, 11:08:44 PM »
Well, you are going to have more varying cost basises, so you'll have to do more analysis when deciding what to sell. You also also might accidentally cause a wash sale if you sell after a dividend posts. I think Vanguard's 1099's are a bit hard to read, though that wouldn't stop me if I otherwise wanted to. Fidelity 1099's are much clearer, but even there I have always just invested in lump sums. I've never felt the need to DCA or reinvest the dividends, though I know why people do it.

Undecided

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Re: How to collect profits from Index Funds
« Reply #26 on: December 01, 2013, 10:25:48 AM »
Since Vanguard made specific lot ID an easier option when making a sale, I don't think dividend reinvestment creates any meaningful difficulty or complexity at tax time.