Hey hey, and welcome back to lesson 4 of The Minimal Investor!
Lesson 3 Review
The last lesson focused on the analytical side of investing. Understanding how to evaluate and select a fund is an incredibly important skill!
Here’s a recap of what we did:
- Choose a US Stock Market fund, an International Fund, and a Bond Fund.
- Filtered for funds that have the lowest fees (index funds).
- Looked at the importance of market cap in narrowing down funds.
- Looked at the number of companies or bonds within a fund to understand diversification.
By going through this process in your brokerage, you should now have 3 funds that you want to invest in. If you’re using Vanguard, you can use the 3 funds that we talked about last week:
- Vanguard Total Stock Market Index Fund Admiral or Investor Shares ($VTSAX)
- Vanguard Total International Stock Index Fund Admiral Shares ($VTIAX)
- Vanguard Total Bond Market Index Fund Admiral Shares ($VBTLX)
If you’re investing within a 401(k), Roth IRA or IRA these are the three funds you’ll use most of the time. How you allocate these funds between different accounts – and bring in a taxable account – is the focus of this lesson.
Lesson 4 – Tax-Efficient Fund Placement
There have been 4 moments while learning about how to invest when I did the math and was completely floored. Those 4 times were:
- Compound Interest – Understanding how compound interest meant I could earn more from my investments than I could be working.
- Diversification – How diversification means being solidly in the middle of the investing curve – performing as good or better than average.
- Fees – How fees were eating HALF of my potential investment gains.
- Account Choice – How choosing the wrong account for my investments can eat up to HALF my potential investment gains.
The last one is the focus for today. By the end of this lesson, you should understand what the last item means, and how you can plan accordingly to grow your investments in a tax-optimized way.
Here’s how we’ll get there in lesson 4:
- What types of accounts are there?
- Why is this a problem?
- What are dividends?
- Which funds should go into which account? And Why?
The good news is that this will be a little shorter lesson than previous ones!
1) What types of accounts are there?
Here in the US, there are 4 major types of accounts:
401(k)
Only offered by a job. You put pre-tax money in a 401k, which lowers your taxes while you’re depositing money. Since you’re putting in pre-tax money, you’ll be able to put in a little more than if this was after-tax. When you take money out of a 401k you’ll be taxed as though this were income from a job – which means the rate will depend on how much you take out.
The good: Often come with a company match, allowing you to pay fewer taxes while working (earning more), interest grows tax-free, dividends grow tax-free.
The bad: You’ll still pay a bunch of taxes when you withdraw. Depending on your company, there might be a 401k management fee, no control over funds to choose from.
Traditional IRA
Anyone can open up an IRA at most financial services companies. I prefer Vanguard for this (if you haven’t figured that out by now). You can deposit up to $6,000 (2020 limit) in an IRA ($7,000 if you’re 50 or older) each year. Depending on your income, you may be able to deduct this investment from your taxes like a 401k. The rule is a little weird: if you don’t have a 401k from your work, you can deduct your IRA contribution. Otherwise, you can only do it if your income is in a specific range.
The good: For people without a 401k, or with income below a threshold, this allows you to lower your taxes. You can choose where this account is – allowing you to pick somewhere like Vanguard with lower fees. You can roll a 401k over to an IRA.
The bad: You’ll still pay taxes when you withdraw from this later on just like a 401(k). The $6k limit is split between your IRA and your Roth IRA – so you’ll want to pick one to invest in each year.
Roth IRA
Like an IRA, anyone can open up a Roth IRA – usually at the same place (e.g. Vanguard). Often, this will be offered with your 401k. I’d strongly recommend not using the same company as your 401k for this though, and instead, opening an account on your own at Vanguard (for The bad reasons above for 401ks). Roth IRAs are unique, because you put money into them after-tax, and get money out tax-free. These are my favorite account type since you don’t pay taxes while the money is growing, or when you take money out when you retire.
The $6,000 limit for IRAs (2020 limit) is for traditional + Roth, so if you put $6,000 in a Roth IRA for a year, you can’t put anything in a Traditional IRA.
The good: You’ve already paid taxes, so no need to pay anymore! Best account type for overall growth. Won’t pay capital gains taxes. Once the money is in, that’s 100% vested, taxed, and yours (once you hit age 59.5). You can withdraw your contributions at any time without paying an early withdrawal penalty.
The bad: Low limits, you’ve already paid taxes on it. Income limits mean you can’t use this if your income is above about $110,000. Can’t access until you’re 59½.
Brokerage Account
After you’ve invested the max in the above accounts, then a brokerage account may be your last choice. Brokerage accounts are a general all-purpose account (like a savings or checking account), but instead of holding cash, they hold investments (stocks, bonds, mutual funds, and ETFs).
The good: You can put money in or take money out at any time. No limits. Not age restrictions.
The bad: You pay taxes for the year you sell funds at a gain, which means you need to be careful what you choose. Dividends also will result in taxes.
In lesson 1 we looked at which accounts you use, but let’s look at this visualization again.
Which accounts should you be investing in?
Takeaways:
- Look at the order of accounts and figure out where you’ll be investing.
2) Why is this a problem?
Choosing the wrong account can eat into half of your total investment gains. To see that in action, let’s look at an example by comparing two people.
Both GoodSaver and BadSaver both have a tax-deferred account (a 401k) and a taxable account (a brokerage). They invest $50,000 in each account split 50/50 between a US Stock Market fund and a bond fund. The only difference is which mutual funds are in which account.
GoodSaver: Invests in stocks in their brokerage account and bonds in their 401k.
BadSaver: Invests in bonds in their brokerage account and stocks in their 401k.
This is a small different – just swapping bonds and stocks. For both of these accounts here’s the flow they’ll follow:
- Invest $50,000 in their brokerage and $50,000 in their tax-deferred account.
- Wait 30 years for growth.
- Cash it out and pay taxes.
- Using the same tax and growth projections for each account.
GoodSavers Investments
Here’s what their account might look like after 30 years.
| GoodSaver | Stocks in Taxable | Bonds in Tax-Deferred | Total |
|---|---|---|---|
| Beginning Value | $50,000 | $50,000 | $100,000 |
| Value after 30 Years | $820,490 | $380,613 | $1,201,103 |
| Taxes due on withdrawal | $100,499 | $95,153 | $195,652 |
| After-tax value | $719,991 | $285,460 | $1,005,451 |
You can see that GoodSaver would pay $195,652 in taxes when they withdraw — no small amount! Their total after-tax value at the end will still be over $1 million though. In the end, GoodSaver paid about 16% in taxes.
BadSaver’s Investments
Their investments were slightly switched up – with bonds in a taxable account and stocks in a tax-deferred account.
| BadSaver | Bonds in Taxable | Stocks in Tax-Deferred | Total |
|---|---|---|---|
| Beginning Value | $50,000 | $50,000 | $100,000 |
| Value after 30 Years | $232,078 | $872,470 | $1,104,548 |
| Taxes due on withdrawal | $0 | $218,118 | $218,118 |
| After-tax value | $232,078 | $654,352 | $886,430 |
The big thing that stands out immediately is that the “after-tax value” of BadSavers investments are $120,000 less! They also paid more taxes. So they paid more taxes upon withdrawal and the value of their account was lower? Why did GoodSaver end up with $120k more?
Reason 1: Paying Taxes Every Year
The bond value of GoodSaver was higher ($380k vs $232k). This is because each year the bond was giving off dividends – money back into the account that would be reinvested in the bond. For the tax-deferred account, this money was tax-free. For BadSaver, this was in a brokerage account, and they needed to pay taxes on those dividends EACH YEAR.
Taxes are a hidden killer for bonds. Bonds and other funds that give off dividends are best when placed in a tax-deferred account. In this example above, the value of the bond didn’t increase, so no taxes were due on the withdrawal. However they did have a pay a ton in taxes for the dividends, and that was all money that didn’t compound into growth.
When I started learning about investing I thought dividends were this magical free money that would help my accounts grow. In a way that’s still true for both GoodSaver and BadSaver. The difference is that your dividends will grow a LOT more if they’re in a tax-deferred account.
Side note: Once you retire and need spending money each year, receiving dividends in your taxable account isn’t such a bad thing! You can use that money to pay your bills. It’s when you pay taxes and reinvest dividends where you get into trouble.
Reason 2: Favoring growth in tax-deferred
BadSaver did something else wrong – they grew their funds extremely high in their 401k rather than their brokerage. This is why their taxes were so much higher. Remember, when you cash out funds from a 401k, you pay taxes based on how much you cash out. The more you cash out, the higher the taxes!
The taxes due on the taxable account are considerably less since they’re charged at the capital gains tax rate (something we’ll dig more into in lesson 8).
Reason 3: You Probably Won’t Sell All At Once
Both accounts did something. For me personally, I can’t think of a situation where I’d sell all at once. Neither GoodSaver nor BadSaver needed all of their cash at once, and it’s unlikely you will either.
If instead, you withdrew only enough to cover your yearly expenses each year, the tax implications would be less skewed towards GoodSaver. BadSaver would still pay about this much more in taxes, but it’d be it’d over their entire lifetime.
If you want to dig more into this topic, read my article on How to Choose Between 401k, Taxable, and Roth IRA Accounts to Optimize Taxes.
Takeaways:
- Putting funds in the wrong account could eat into as much as half of your entire investment earnings!
3) What Are Dividends?
Let’s look at three funds to see how they differ from a dividend/yield perspective — Vanguard Total Bond Market Index Adm (VBTLX), Vanguard Total Stock Mkt Idx Adm (VTSAX) and Vanguard REIT Index Admiral (VGSLX). Here are three quotes from Morningstar.
The key things to look for here when it comes to taxes are the “TTM Yield” and the “Turnover“. The TTM Yield is the “trailing twelve-month yield” — the amount returned to investors over the previous 12 months. This “amount returned” is different than growth in the fund price. This amount is flat out money back in a cash account of the owner of the fund.
TTM Yield
If you invested $100,000 in each of these over the last year, you’d have received $1,920, $2,450 and $3,290 in dividends. This money would be deposited into your account as cash, and (optionally) reinvested back into this fund or another one.
Within these dividends, there are “qualified dividends” and “unqualified dividends” which are taxed at different rates. “Unqualified dividends” are taxed at your ordinary-income rate just like your paycheck or withdrawals from your 401(k) or IRA. Qualified dividends are taxed at the capital gains rate (again more in week 8 on this).
Turnover
The Turnover is a representation of how long the underlying assets in the fund stick around. A high turnover means that funds are bought and sold often within the fund. Generally, index funds that are matching an index will have a very low turnover, since the index isn’t changing. “Actively managed funds” (where a human intervenes) generally have a MUCH higher turnover.
If a fund has a high turnover, it may have a high dividend as well. This is because the underlying assets from the fund are sold, and the gains are distributed in the form of dividends.
These dividends are then taxed, potentially at your normal tax rate! The only times I’ve found where it makes sense to be making a high amount of dividends are in a tax-deferred account, or if you spend the dividends immediately and don’t reinvest them. No matter what fund you choose you’ll receive some dividends – even in your taxable accounts. The taxes between 3% unqualified dividends (like with a bond or a REIT fund) compared to a 2% qualified dividends (like with a US Total Market index fund) can be thousands of dollars in taxes each year.
Takeaways:
- The higher the dividends and turnover, the more taxes you will pay.
4) Which funds should go into which account? And Why?
The reason GoodSaver made a lot more money was that they put their dividend-generating assets and growth assets into the correct accounts. The higher the yield and the higher the turnover, the more important it is to put that fund in a tax-deferred account. If you want to minimize your taxes, this is your path to it.
I’ll be honest, when I was working with a financial advisor they never mentioned this to me. Taxes seemed like something way down the line when I retire. Surprisingly few financial advisors will take that into account today.
If you are working with a financial advisor, have a chat about taxes. That discussion may be just as important as a similar discussion about diversification and fees.
You can even skip that discussion with your financial advisor and chat directly with a CPA (certified public accountant) who knows more about this subject than a financial advisor would.
In the case above, the Bond fund generated a bunch of dividends each year for BadSaver. That caused them to pay taxes on those dividends each year – resulting in a much lower account balance.
GoodSaver didn’t pay taxes on dividends from their bond fund each year since those were in a tax-deferred account. This isn’t only a rule for bond funds though. Here are some of the different fund types and which accounts they would be most beneficial in.
| Efficient | Moderately inefficient | Very inefficient |
|---|---|---|
| • Low-yield money market • Cash • Short-term bond funds • Tax-managed stock funds • Large-cap or total-market stock index funds • Balanced index funds • Small-cap or mid-cap index funds • Value index funds | • Moderate-yield money market • Bond funds • Total-market bond funds • Active stock funds | • Real estate or REIT funds • High-turnover active funds • High-yield corporate bonds |
| Taxable Account | Tax-Deferred, 401k, IRA | Tax-Deferred, 401k, IRA |
Aside from the REIT funds, I’d personally avoid anything in the “very inefficient” category as an investment altogether.
These are broad strokes from the Bogleheads article on Tax-efficient fund placement, but help gives a starting point. This only looks at taxable vs tax-deferred. The other main account type, tax-free, is a difficult one to pin down on assets. Roth IRAs (tax-free accounts) are great for all types of assets.
Takeaways:
- Put your highest dividend assets into tax-deferred or tax-free accounts.
- Delay taxes whenever possible.
Unanswered Questions
Here are a few questions I haven’t found a good place to answer elsewhere. If you have a question about anything in this post, feel free to reply to this lesson. If you have a question a bunch of others probably do too!
I only have 1 account – what should I do?
Use it! Especially if it’s a tax-deferred account. The beauty of these accounts is that you won’t have to worry about taxes until you start taking distributions. These are an excellent place to learn how to invest without paying taxes each year.
Try planning what a diversified portfolio would look like in just that one account. How much in a bond fund? How much in an international fund? How much in a US Stock fund?
I only have a brokerage account. Won’t that mean paying a ton of taxes?
If you need to put a tax-inefficient fund in a non-tax advantaged account, try finding a substitute fund that pays fewer taxes for the bond fund. For example, instead of investing in “Vanguard Total Bond Market Index Fund Admiral Shares”, pick “Vanguard Intermediate-Term Tax-Exempt Fund Investor Shares”. It’ll be less diversified but more tax-efficient.
This is the bond fund that I hold in my brokerage account. It’s mostly tax-advantaged, meaning you won’t pay federal taxes on the dividends (but you may still need to pay state taxes). It says “tax-exempt” but that doesn’t mean you won’t pay any taxes though – so be aware of that. I had around $70,000 in this fund last year and ended up paying around $500 in taxes on the dividends from this fund for the year. Keep that 1% in mind for budgeting.
Lesson 4 in Review
We may have got way more deeply into taxes than you ever wanted to go in this lesson. They’re not the sexiest subject, but knowing how to control taxes efficiently can be an amazing superpower. There’s no trickery here. No evasion tactics for getting out of paying taxes – just an understanding of how taxes work and using that to make smart choices.
The key points are simple: put your highest dividend (yield) funds in your most tax-advantaged accounts. With that, you’ll pay fewer taxes.
There’s a balance between diversification, taxes, and fees, and finding the ratio that works for your available accounts is what matters. It won’t always mean selecting the most diverse portfolio, or the lowest in fees. Sometimes taxes might be the biggest cost.
An intelligent investor takes into account fees, diversification, and taxes to make investment decisions.
Next Lesson
An intelligent investor takes into account fees, diversification, and taxes to make investment decisions. Once you have a solid handle on all three of those areas, you’re ready to invest! In the next lesson, we’ll walk through the buying process and show how to purchase mutual funds within your investment account.