TranscriptEmily Farrell: Hello, I’m Emily Farrell. Welcome to our webcast on Tax-Efficient Investing. Tonight we’ll talk about tax strategies that could help you keep more of your returns. Now most investors know that by including tax-efficient investments in their portfolio, they can potentially reduce their tax bill. But tax efficiency goes well beyond that step. So what else can you do to become a more tax-efficient investor? With us today to discuss that very question are two of Vanguard’s experts, Joel Dickson, a principal in our Investment Strategy Group, and Tony Giordano, a senior financial advisor for Vanguard Personal Advisor Services®. Thank you both for being here tonight.
Tony Giordano: Thanks for having us.
Joel Dickson: Great to be here.
Emily Farrell: We’ll spend most of our broadcast answering your questions, both those you submitted in advance, as well as those you can submit during the show. Two quick items I’d like to point out. There are a few widgets at the bottom of your screen. For technical help, use the yellow button on the left. And if you’d like to read some of Vanguard’s thought leadership materials on tonight’s topic or view replays of past webcasts, click on the green resource list widget on the far right. Now, does that sound good?
Joel Dickson and Tony Giordano: Sounds good.
Emily Farrell: All right. To kick off our discussion, I’d like to ask you and our audience a question. On your screen right now, you’ll see our first poll question, which is, “Rate your tax-efficient investing knowledge: good, fair, or poor.” So take a second, respond, and we’ll share answers in just a few minutes. Now, Joel, Tony, while we’re waiting for those responses, I thought we’d kick off with one of our pre-submitted questions. So talking about tax-efficient investing. And Matt from Cary, Illinois, Joel, asks us, “How do you balance attaining portfolio growth with tax efficiency?” That’s a good starting point.
Joel Dickson: Yes, I think sometimes people think too much about their investments and the tax impacts of that being separate. But, really, what we’re talking about with tax efficiency is not so much about minimizing taxes, though that may be one strategy, but it’s about maximizing your overall return. I like to think of it in sort of two ways. Yes, we need to talk and think about tax-efficient investments, but you also need to be a tax-efficient investor. And being a tax-efficient investor means doing things like maximizing tax-deferred investment accounts like IRAs and 401(k)s. It means locating assets in the appropriate place where you can take advantage of differences in, say, tax efficiency. And I’m sure we’ll talk about that as we go on. And then it’s also about what types of individual investments might work best in each of those accounts.
Emily Farrell: Yes, so that’s a good point. Now we’re touching on a vehicle versus product a little bit in that.
Joel Dickson: Yes.
Emily Farrell: And Al from Frisco has a great follow-up question. He asks, “Can you ignore tax efficiency in tax-favored accounts?” So I guess the answer is no. So perhaps you could delve into that a little bit.
Joel Dickson: Yes, to a certain extent, yes, what do we mean by tax efficiency, right? And it is, it’s exactly that, Emily. It’s the product versus the portfolio. So if you think about your total investment plan or portfolio, many people, most people have a combination of tax-favored accounts like IRAs or 401(k)s and taxable accounts. And while it’s true that for a product within an IRA, for example, you don’t need to necessarily worry about the tax impact in terms of things like your trading activity, realizing gains, or capital gain or dividend distributions from that on an ongoing basis, it’s still the case that maximizing your overall after-tax return is enhanced by being smart about how much you contribute to tax-favored investment vehicles. And, generally, you’re going to want to maximize the amount that you can sort of shelter from year-to-year taxes. And one way to do that is to use tax-favored investment vehicles like IRAs and 401(k)s to build your wealth.
Emily Farrell: So we’re going to dive a little bit into tax vehicle or tax-efficient vehicles in just a second. But our results are in and, if you remember, the question was “Rate your tax-efficient investing knowledge: good, fair, or poor.” Now interesting enough, and perhaps not so surprisingly, over 50% of our viewers said fair, 20% said good, and 27% said poor. So I’d say that probably is in line with what we’d expect with our general Vanguard investor.
Joel Dickson: Yes, I agree with that, yes.
Emily Farrell: So, Tony, just to switch to you for a second. We talked a little bit about, you know, with Joel about vehicles, products. I have a great question from Steven from Plano, Texas. Now we talk a lot about I think in the idea of building from scratch, but he asks, “Assuming your portfolio has some tax inefficiencies, the wrong type of fund, the wrong type of account, how do you begin to look at it and fix it?”
Tony Giordano: Yes, so, unfortunately, we see that quite a bit. So when we’re working with our clients, there’s, you know, several things that we could actually be doing to fix that problem. The first one is pretty simple, and it’s probably not going to move the dial all that much. But any future dividends, any future capital gain distributions on that particular fund, you know, we would suggest that you redirect that into a more tax-efficient investment within that account. So that’s one thing you can do. You know, a couple of other examples, there’s probably three or four things we talk to our clients about. One is you could take that tax-inefficient mutual fund, you could gift that particular security to charity. That would be a good way to get it out of your portfolio and no longer distributing capital gains on that particular account or that portfolio. The other thing, you know, one of our clients did this a couple of years ago. It just tied in perfectly. The client was looking to make gifts to their grandchildren. They had ten grandchildren. They wanted to gift $10,000 to each of their grandchildren. So they had a very tax-inefficient, very good, actively managed fund at Vanguard, and we decided that we were going to take $10,000 and transfer it over to each of the grandchildren. So that got that $10,000 out of their account and we did it right before the December distributions. So that’s a good time, you know, to do that in November. We’re sitting here at November 17 today. So perfect time to do that so that that client was not actually exposed to the capital gain distributions. On the flip side, I think one of the more underutilized strategies today is the grandchildren. Most of them were actually either not working, had no income, or very little income. So they were in the lowest 15% marginal tax bracket. They can turn around and sell those investments at a 0% capital gain rate in the 15% marginal tax bracket. So you don’t see that. Joel, I don’t think you see that too much, but that gets, I think, overlooked. And then the last, I think, strategy that we would talk to our clients about, which is a very popular strategy, especially this time of year, is tax-loss harvesting. And that’s essentially a process where you’re matching your gains to your losses trying to really, as a tax reduction strategy, trying to mitigate your taxes for the given current year and possibly even in future years.
Emily Farrell: Well, we definitely covered quite a bit there in terms of strategies. And I think we’re going to delve into some of those a little bit more. In the meantime, I actually have another poll for our audience. And that should be up on your screen right now. And the question is, “How will you use what you learn today: to make my retirement assets last, to reduce my heirs’ tax burden, to keep more of what I’m saving for retirement, or other?” So that’ll be interesting to see what our audience says. So now, you know, switching back to strategies, I have a couple more questions that I’d like to get to that our audience has submitted in advance. And we talked a little bit about tax-loss harvesting. Do you want to dive into that a little bit more, Tony?
Tony Giordano: Sure. Sure. Like I said, really, it’s a very popular strategy, especially this time of year when you get into November and December, it’s a tax reduction strategy. And the transactional piece of doing tax-loss harvesting is actually pretty straightforward. I’ll use an example. It’s probably the best way to go through it. Let’s assume an investor today, November 17, has $100,000 capital gain. They’ve already got that booked. Tax-loss harvesting is basically the process of going through their taxable accounts and looking for securities. It doesn’t matter whether it’s securities or ETFs, mutual funds, individual securities. They’re looking for securities that have unrealized losses, and they’re looking to actually sell them and recognize those losses. And dollar for dollar those losses can go to offset that particular capital gain. So in this situation where an investor has about $100,000 capital gain, they’re going to at least pay, Joel, at least $15,000 for federal taxes in April of 2017. So to the extent that they’re able to take some losses and offset that $100,000 gain, that’s a significant savings. That’s cutting $15,000 next tax season and inherently, all things equal, that’s going to better their after-tax returns in a given year. And then I’ll just add one additional point is that if you harvest enough losses that are in excess of your current year gains, that tax loss carried forward can carry forward into future tax years and help offset a client’s future capital gains.
Joel Dickson: Well, and you can also deduct up to $3,000 of any losses and excessive gains to offsetting ordinary income. So for folks that are in higher income tax brackets, that’s even an additional potential benefit because that’ll be at your total marginal income tax rate, which is almost always higher than what your capital gains tax rate is.
Emily Farrell: Obviously a good point and something to keep in mind. The results from our second poll are in, and if we recall, the question is, “How will you use what you learn today?” And interestingly enough, about 40, more than 40%: “To keep more of what I’m saving for retirement,” and 40-something percent: “To make my retirement assets last.” So retirement definitely top of mind, and I think we have a lot more to cover on that topic. And about just under 8%: “To reduce my heirs’ tax burden.” And then 7% in that other bucket, which I’m sure there are plenty of other things on people’s minds when they’re thinking about their overall portfolio.” Now, Tony, something you had said, I think, Joel, might be a good time to kind of level-set. We got a lot of questions about cap gains, distributions. Perhaps we should just kind of step back and talk about how should one think about distributions from a mutual fund?
Joel Dickson: So, at a basic level, mutual funds and ETFs, which are almost always structured in the same legal entity as mutual funds, are required effectively to distribute the income that they receive from the portfolio of the securities that they hold. And they distribute that to investors on a regular basis. Oftentimes dividends, for example, on an equity investment may be distributed quarterly, or once a year typically you have a capital gains distribution if there are realized gains at the fund level that then get distributed to all of the shareholders in the fund. And, usually, the capital gains distributions and often dividend distributions, there’s a lot of them that occur towards the end of the year, usually in December of each year if they are going to occur, especially with the capital gains. And so people start talking about, “Oh, I may be getting some capital gain distribution. How should I think about it? Should I sell my fund to avoid the distribution?” which is almost always a bad idea because think about what you’re doing. You’re going to sell the fund and realize the gain to avoid a gain because you probably have a gain on your own investment. And instead of getting a little bit of gain through the capital gain distribution, you instead realize all of your gain by selling the portfolio. So oftentimes you kind of just have to grin and bear it in some respects with respect to the distributions. That said, and Tony really talked about it a little bit earlier, there are ways that you might be able to get rid of what might otherwise be a tax-inefficient fund. One is the sort of general concept of asset location, which is, if you have an investment that isn’t particularly tax-efficient—pays a lot of ordinary income, for example, a taxable bond fund usually would fall into that type of category—you might try to put that type of investment in a tax-favored account where the year-to-year tax liability is not really affecting you. So in an IRA or in a 401(k). You know, in a taxable account, some of the strategies that Tony mentioned earlier about gifting, whether to charity, getting it to somebody who might be in a lower tax rate like grandkids and so forth is a good strategy. But I think too often people just have sort of a knee-jerk reaction about oh, I have a capital gain, therefore, I’m going to sell my portfolio in advance of that, somehow thinking that they’re avoiding it and they’re not.
Emily Farrell: That’s a good point, and it was certainly a nice story in terms of the, at least from the grandchildren’s perspective. But it sounds like a happy family all around.
Tony Giordano: Yes, absolutely.
Emily Farrell: We have one of our first live questions I’d love to get to. And Wanda asks, “Is tax-efficient investing just for people with a large portfolio?” So I think that’s a good level-set in terms of does it matter what your financial portfolio looks like in terms of do you need to think about this regardless?
Tony Giordano: Yes, I would say absolutely not. I mean, I think tax-efficient investing is appropriate for any investor, whether you’ve got $1,000, whether you’ve got $100,000, or you’ve got $1,000,000, tax-efficient investing is going to benefit any investor at any level.
Emily Farrell: And as we talked about before, and in whatever account that you do invest in, whatever type of account.
Joel Dickson: Yes, and actually, I’d share a story here that, you know, this happened probably about 15 years ago when I was talking on the phone to some clients. And it really highlights this effect that you need to think, again, about what is the approach to maximize your after-tax return. And, again, to Tony’s point, that goes across the board regardless of your income, your wealth, and so forth. I was talking with a client who called in and she was worried about the income in her portfolio. And after just a few questions, I figured out this was an 85-year-old woman living in the state of New Jersey who had basically $30,000 to her name and her Social Security that she was getting. That entire $30,000 was in a tax-exempt muni bond fund. And when I inquired about why that investment, “Well, I don’t want to pay taxes.” Well, the fact of the matter is, given her financial situation, she wouldn’t have paid taxes on a higher taxable bond fund and yet would have had more after-tax return. So sometimes, even for that person, low wealth, really no income other than Social Security and some investment income off of this portfolio, it still makes a big difference. And she would have been, in that case, much better off having been in a more, what we might think of as, tax-inefficient vehicle, but in her tax situation, that would have led to more wealth and more income.
Emily Farrell: That’s really interesting. So you touched a little bit on the type of investment she had. In that case munis. And we have another live question from Eva, who asks, “What type of funds are considered tax-efficient and what types are not?” And we also got a similar question, I should say pre-submitted, asking about which is more efficient, mutual funds or ETFs? So, Joel, perhaps you can kind of start us at the high level here in terms of what are some things you should think about in terms of evaluating the type of investment?
Joel Dickson: Yes, so we could probably spend the rest of the entire hour on just this question, which we don’t want to do.
Emily Farrell: So we’re going to start at the high level.
Joel Dickson: But, yes. When thinking about individual products and their tax efficiency, again, there are lots of different things. I could probably name 30 different things that between two investments, all else equal, any of those 30 things could make a difference in terms of tax efficiency. So if you think about it at the highest level, what is your after-tax return, it’s the pre-tax return on the investment minus whatever taxes you pay. So you want things that have sort of a balance of good pre-tax return and that don’t cost too much in terms of the tax burden. For somebody in a high tax bracket, a muni bond fund that can have tax-exempt interest income may be beneficial where somebody in a lower tax bracket may find they have more after-tax income from a taxable bond fund like corporate or government bonds. Mutual funds and ETFs is a discussion that often comes up. Really, what we’re talking about with mutual funds and ETFs are different investment wrappers, not necessarily different investment strategies. That is, if you think about an investment strategy of, say, a broad market indexed equity fund, that could be in a mutual fund form, it could be in an ETF form. And usually the main driver of tax efficiency is the underlying investment strategy—index, active, muni, taxable—those types of issues, and not as much the vehicle that it’s in, mutual fund versus ETF. Now sometimes the ETF can seem, they have a different way of operating where—we don’t want to get too far into this—but it basically can pay out some shareholders in stocks or securities rather than cash, and that can have some potential benefits for the ETF portfolio. But it’s really kind of, at best, maybe a tiebreaker. It’s the investment strategy that drives the approach. One other thing that I would mention, and again, this is the maximizing after-tax return versus minimizing taxes. One of the important components that’s very tax-efficient is actually low cost. And what’s counterintuitive about this is that the lower-cost your investment is, the more tax you’re going to pay, but yet the more return you will keep. And the idea here is if you have a lower cost, that means there’s more income that the portfolio distributes to you because it’s the income minus the expense ratio that gets distributed to investors. So you have lower cost, you have more income, which means you have more taxes but you keep more because instead of paying 100% in higher cost, you pay just what the tax rate is on the higher income and you keep the rest for yourself.
Emily Farrell: So what do they say about things are certain, death, taxes, but also costs and their erosion on a portfolio.
Joel Dickson: Well, we could start talking about estate tax planning because I think Ben Franklin only had it half right. It’s either death or taxes in many cases.
Emily Farrell: Well, it sounds like we have a debate ahead of us.
Joel Dickson: Yes.
Tony Giordano: And I was just going to add, you know, I think one of the underutilized areas of our website is the after-tax returns. Joel, I don’t know what year we started posting that after-tax returns.
Joel Dickson: About 2000, 2001.
Tony Giordano: Was about 2000, but I don’t really hear any of my clients talking about after-tax returns on the website. But you can go see it and it’s very— The parallels that Joel described when you look at like a broad-based index fund, you’ll see the pre-tax return, you’ll see the net return and they’re very, very close to one another. When you start getting into some tax-inefficient investments, like a taxable bond fund or an actively managed fund, the spread starts to widen quite significantly.
Emily Farrell: That’s a really good takeaway for our audience. Now if I could just pivot for a second. So we’re coming up on year-end. We talked a little bit about, you know, year-end I think popped up in some of the strategies you both were talking about. Now, one of our audience asked about what’s coming up in year-end or like next tax season, things that we should be looking ahead to. Now, I think this or similar questions are going to be on peoples’ minds. We just came out of the presidential election. We have a new administration ahead of us. Tony, is there anything that people should be thinking about, obviously, keeping in mind that nothing is guaranteed?
Tony Giordano: Yes. So I think there’s really two things that I would think of right now. One is, and my clients really appreciated this, was that they made permanent a piece of the tax code called the qualified charitable distribution. It’s been in and out of the tax code over the last several years. And when it’s been in, it’s typically been in in December and clients had to scramble to take advantage of it. But that’s one thing that’s become permanent. It became permanent towards the end of last year. And if you’re sitting today, November 17, and you’re over 70-1/2 and you need to take your required minimum distribution this year, this qualified charitable distribution would allow you to take out up to $100,000, send that money directly to your favorite charity or charities, and not count that 100,000 as income. So people who are looking for a great strategy going into year-end on how to reduce their tax liability, that one comes to mind. That’s front and center. And then the second thing that I would think of there’s been a lot of proposals. We’ve seen the Trump tax plan and what it could look like. And, obviously, everybody knows that the top rate is currently 39.6 today and that’s potentially, potentially coming down to 33%. We don’t know. Nothing’s been enacted at this particular time. So the only other thing that I would say there is a lot of clients’ strategies, some strategies I should say, clients are looking to accelerate income in the current year in 2016. So that may give that client some reservation to think, “Well, we may have lower tax, may have lower tax rates in the future. Maybe I’ll think about that decision and think about taking that into 2017 where I may pay a lower tax bite.”
Joel Dickson: Yes, when you get these periods where there might be a change, and as Tony said, there’s nothing that’s ever guaranteed.
Emily Farrell: Absolutely.
Joel Dickson: And trying to guess on tax policy can be fraught with peril. But if you think that there’s a good chance that taxes—and this is across the board in many ways—taxes won’t go up and may go down, which I think is not an unreasonable thought post-election, then the types of strategies that Tony was talking about can be very beneficial Maybe what you want to do is defer income and accelerate deductions. So you can get the deductions at higher tax rates, more beneficial; defer income at lower tax rates if that income is realized in a lower tax regime going forward.
Emily Farrell: Absolutely.
Joel Dickson: So lot of different things that are being talked about there.
Emily Farrell: Yes, I think it’s something similar that we told our investors. You know, in leading up to any potential volatility directly after, you kind of tune out the noise, ignore the headlines, and think about what you can control. And in this case, I think that that’s a reasonable kind of assessment of the current situation. And then you’ve got to look at your portfolio, right?
Tony Giordano: Right.
Emily Farrell: So, Tony, a little bit earlier you just talked about required minimum distributions, or RMDs, and qualified charitable distributions. Now one of our viewers asked, and it was Sim, asked, “Are there ways to minimize taxes on RMDs that you don’t need to spend?” So you mentioned the qualified charitable distributions.
Tony Giordano: Yes.
Emily Farrell: Anything else along those lines?
Tony Giordano: No, I mean that’s really it. If a client’s RMD is, for example, $70,000, they can satisfy all of that required minimum distribution. That distribution to charity satisfies the required minimum distribution. So that client does not have to take out any more money out of their IRA for that particular year. So that’s a great, great strategy that, like I said, if somebody is looking to reduce their tax liability going into the end of 2016, that would be something to strongly consider.
Joel Dickson: And there are some strategies, and Tony’s exactly right that there’s not much you can do about an RMD that is this year. So, yes, you’ve got to take the RMD, otherwise there’s significant penalties. There may be a way with the QCD, or qualified charitable distribution, to mitigate that in the current year. But there are some strategies to think about smoothing tax liability and future RMDs. So one of those is that there may be a strategic use of converting traditional IRA proceeds into Roth IRAs because Roth IRAs are not subject to required minimum distributions, at least right now. There’s been some proposals to change that, but at least right now, after age 70-1/2. And so to the extent that you’ve maybe done some conversions prior to 70-1/2, those monies are no longer in traditional IRAs and, therefore, not subject to the traditional IRAs that you get the required minimum distributions. That said, doing the conversion itself will give you a tax liability when you do it. But it’s just a little bit more about potentially smoothing that tax liability that in certain instances can be beneficial.
Emily Farrell: Absolutely. So, Joel, that’s a really good transition point. We got a lot of questions about spending down from a portfolio. So we talked about RMDs; obviously, required. But is there other things that are tax-efficient about your spend-down strategy? And now we got a question about that from Scott and he asks, “Taxable first, regular IRA?” So, obviously, again, he’s getting into the accounts there, right?
Joel Dickson: Yes. So tax-efficient withdrawals can make a huge difference in retirement, and I think about back to that second poll question about why am I thinking about tax-efficient investing? It’s because of trying to lengthen the value of my portfolio through time. And so drawing down efficiently can add considerable safety, length, whatever it may be, to an existing investment portfolio. Now there are some general rules of thumb. The problem with general rules of thumb, and especially when it comes to taxes, is they don’t apply to everyone and you’ve got to take your own situation into account. But the general rule of thumb, if you were going to spend or plan to spend all of your income during retirement; I call that the bounce-the-check-at-the-funeral strategy. If that’s your strategy, then generally you would want to think about spending taxable account assets first and then thinking about tax-favored accounts probably starting with, it depends a little bit on your tax situation, but the Roth or the traditional IRA and how you would do that. But basically start with taxable and then go to tax-favored. The thing is, though, if you have an estate wealth transfer plan, you want to give some money away to your heirs—
Emily Farrell: So the not bounce-the-check-at-the-funeral.
Joel Dickson: The not bounce-the-check-at-the-funeral piece.
Emily Farrell: Okay. All right, the other side of the coin.
Joel Dickson: Yes, have your heirs pay the funeral bill out of the proceeds, then you kind of flip that on your head because most of the time you don’t want a traditional IRA passing through an estate. There are many better tax-efficient ways than to have a traditional IRA go through an estate.
Tony Giordano: Yes. I was just going to add that, you know, as you go upmarket and you get into higher-net-worth families, that is exactly right because the focus, it’s not necessarily around, “Do I have enough money to live off of?” It’s not “Am I going to make it? Do I have enough to live off of?” That’s most people’s concern in retirement. But you go upmarket and people are wondering, “How can I best transfer what I’ve accumulated during my lifetime and get it to the next generation as tax efficiently as possible?
Emily Farrell: So let’s delve into that a little bit. Andrea from Maryland asks us just that: “What’s the best way to avoid huge tax bills for my heirs?” So we’re not bouncing the check at the funeral. We’re perhaps passing on the bill to our heirs. Perhaps we could just delve a little bit there.
Tony Giordano: Well, if I was her heirs, I would want to receive 100% Roth IRA money because that money is already, the taxes have been paid and it’s growing on a tax-deferred basis. Yes, her heirs would receive those dollars. They would have a required minimum distribution based on their life expectancy, but the required minimum distribution is tax-free, so you pay no taxes on it. And you could let that Roth IRA grow over that individual’s life expectancy. So that’s the asset I want first. The second asset under current tax law is I would want taxable accounts. There’s a feature called the step-up in cost basis. So if I were to receive, for example, a $100,000 taxable account and the person who owned that account had, say they put $20,000 into it and had $80,000 capital gain, well, what happens at death I receive that as an heir, I get $100,000 and I get to reset the basis now at $100,000. So if I want to take that $100,000 and spend it, I can do it. Would not pay any taxes. Or I can take it and have it invested in my investment portfolio and kind of start from scratch with a new cost basis.
Emily Farrell: So we’re going to switch back a little bit to the beginning part of our conversation. Jeff asks us, “Can we discuss asset allocation a bit? We haven’t yet talked any specifics about what kind of funds are appropriate for different types of accounts.” So, Joel, do you want to kick us off there?
Joel Dickson: Yes, so again, we can talk about rules of thumb and where this all fits in, but—
Emily Farrell: And I have to stop you for a second. I actually read it wrong. So that probably makes it a little bit less confusing, asset location.
Joel Dickson: It said “location.”
Emily Farrell: There you go.
Joel Dickson: That’s where we were going to pivot with it, so.
Emily Farrell: Yes, exactly.
Joel Dickson: So the general idea with asset location, and where asset location really has the most benefit, is when you have a blend of taxable and tax-advantaged accounts, and you have an asset allocation that has a blend between, say, equities and bonds. Because where it makes the biggest difference is when you can shelter otherwise tax-inefficient assets in different types of accounts. So, for example, in an IRA where you’re not going to have an ongoing year-to-year tax burden from it as long as it remains in the IRA, tax-inefficient vehicles like taxable bond funds, really high-turnover actively managed equity funds, maybe tax-inefficient strategies like commodities, real estate to a certain extent, those you sort of want to think first, put those investments of that part of my asset allocation into or locate them in the tax-favored vehicles. In the taxable vehicle, save that for your tax-efficient holdings—broad-based equity, mutual fund or ETF, low turnover, low capital gain distributions, muni bonds if they are appropriate for your approach or in a taxable account. So it’s basically saying if there’s not a lot of tax burden thrown off, put it in a taxable account if you can. If there is a lot of year-to-year tax burden that otherwise would be thrown off, try to put it in the tax-favored account and balance it. But that’s where, you know, for somebody that— You know, as I mentioned, it makes the biggest difference when you have a balance of those types of accounts and investments. For a lot of really high-net-worth clients, a large part of their assets are in taxable accounts.
Tony Giordano: That’s right.
Joel Dickson: Asset location isn’t as valuable there. For a lot of folks, more mass affluent, day-to-day, I think about retirement plan participants, the vast majority of their money tends to be in tax-favored accounts. And, again, asset location doesn’t really matter that much there. It’s more about then your overall asset allocation and trying to meet your overall goal to the long term.
Tony Giordano: And, Joel, I would just add there in terms of asset location, the other thing too is there’s kind of an easy pickup there in yield. When you talk about going into a taxable bond portfolio in a tax-sheltered account, you’re investing in taxable bonds, which historically, I know the yields, obviously, fluctuate, but historically they’re about a point or percentage point higher than municipal bonds.
Joel Dickson: That’s right.
Tony Giordano: So to the extent that we could put them in the tax-sheltered accounts, we’re picking up some extra return in the portfolio.
Joel Dickson: Yes, thinking about shelf space and where do you put things first as you’re filling up the shelves.
Tony Giordano: Exactly.
Joel Dickson: Right, and taxable bonds or your bond allocation, you do it with taxable bonds and put it in the tax-favored vehicles first and then fill up the other buckets typically.
Tony Giordano: Exactly.
Emily Farrell: So, I have another live question about investment type. And Jackson asks, “If we were to listen to the talking heads on television and constantly be buying and selling individual stocks, would our taxes cancel out our gains?” So I’m going to assume that Jackson doesn’t mean that we’re the talking heads. We’re thinking about something else back at home, right? So we’re on the computer screen, not on the television. Joel, do you want to kick that off?
Joel Dickson: So, I actually think Jackson’s point is a good one and you need to think about, in many ways, that trading activity. You normally think of transaction costs, what’s the commission if I’m trading individual stocks? What’s the bid-ask spread? How much is it going to cost me to trade this individual security? Well, taxes, in many ways, is another form of a transaction cost.
Emily Farrell: It’s a good point.
Joel Dickson: Right? So you certainly would want to incorporate that into your thinking about, “Should I trade this security or not?” Now if it’s in an IRA, the fact that I might realize taxes doesn’t really matter. But if it’s in a taxable account, if it’s a gain and it’s been held less than a year, you’re going to get taxed at your ordinary income tax rate. If it’s more than a year, it’s going to be taxed at almost always lower capital gains tax rate. But it’s still a large transaction cost. I actually have said a lot of times that the federal government in its tax policy kind of looked at the hedge fund industry for figuring out what to charge because, hey, it’s 20% of the profits. And for a lot of people on the capital gains side, that’s what it is. Now to be fair, though, and one caveat to that, a lot of times what we’re talking about, you realize that gain. You may have realized that gain eventually anyway. So it’s not like you’re completely avoiding tax by not realizing the gain because you may sell it five years from now or ten years from now so it’s kind of a time value of money or a deferral strategy. If you don’t realize the gain now, you may realize it later. But that’s valuable in and of itself because then you get that growth over that time before you have to pay that transaction cost or, to some of the strategies that Tony mentioned before, you might, in the future, give that security away to a charity or to others where you might be able to forego the gain that would otherwise be realized.
Emily Farrell: So, Tony, you talked a little bit about those families who are planning for transfer of wealth across generations. And one of the resounding terms in all of the questions that I saw before this, and even coming in now is Roth. So we’ll start off with a live question. And Ryan asks, “So are you saying that, if possible, you should always do Roth IRA or 401(k) even though it means higher tax bill now?” So, Tony, what do you think?
Tony Giordano: Well, a little bit misleading, I guess, in terms of my response before. I was talking in the other question as a beneficiary. I would want to receive Roth assets because they’re completely paid for in terms of the tax liability. But if you’re on the accumulation side, you have to really evaluate that decision on whether you’re going to put money into a traditional IRA or a 401(k) plan where you’re going to put the money pre-tax. You’ve got to look at things like where current tax rates are today, where are you in the tax brackets versus what future tax rates may be. In most cases, most people—and this is most, this is not everybody, but most cases, putting money into pre-tax is going to make sense. We’re deferring at a known tax rate today, and we’re going to take it out at some unknown tax rate. So on the accumulation side, we would tend to defer to pre-tax money going in. And then there’s other concepts we can talk about today as well where we talk about hedging, tax diversification where maybe you put some of your money into a pre-tax 401(k) and maybe you put some into Roths because you were just hedging. We just don’t know what future tax rates are going to be when you’re in retirement, which could be 20, 30, 40 years down the road.
Joel Dickson: Just like we don’t know what investment returns are going to be on different asset classes. And so what do you do when you don’t know that? You diversify.
Tony Giordano: Exactly.
Joel Dickson: And a Roth and a traditional, you can diversify the tax outcome potentially. But to the point, if it is pretty certain that your tax rate will be lower in the future, then you’re going to want to deduct at a higher tax rate and be pre-tax. But if tax rates are going to be the same or maybe higher in the future, then you would like the Roth. And if you don’t know, maybe you want some of both. But I think the accumulator versus the beneficiary distinction is extremely important.
Emily Farrell: Important distinction.
Tony Giordano: Very important. There was an article out there today talking about that the Roth could be the biggest beneficiary. I don’t know if you saw that today. I think it was in Forbes, but that the Roth could be the biggest beneficiary. If tax rates do go down next year, which is a big if, then it’s possible that people put more money into Roth thinking that at some point down the road, tax rates will actually go up again. So it’s a game. It’s really something that we talk to our clients about all the time. You really have to plan for both scenarios. But it’s good to work through that with your clients.
Joel Dickson: But I will say that this is also one where you sometimes, and if we get to think of wealth transfer, we actually just put out a research piece or using Roth to transfer wealth that I think is in one of the widgets on the screen. And one of those points then is you’re thinking about what is the tax difference between, say, the retirement and their heir? And this is one where I give the example of my mother all the time. To Tony’s point, I would want to inherit a Roth IRA.
Emily Farrell: We’ll tell her.
Joel Dickson: And I have.
Emily Farrell: Well, I’ll pass it on to her.
Joel Dickson: I would appreciate that. And I’ve even offered to pay the tax burden of the conversion from traditional to Roth in order to get the Roth IRA.
Emily Farrell: Wouldn’t you love for Sunday dinners at Joel’s house? I mean—
Joel Dickson: Hey, I mean, it’s fun stuff, but that’s the point is that— But for her own situation looking at her lifetime, she’s hesitant to do it. And for good reason.
Tony Giordano: Sure.
Joel Dickson: And so that’s one of those discussion that you have about, are we talking about spending down in retirement, or are we talking about a legacy that will continue, and then how you allocate with that in mind?
Emily Farrell: Absolutely. And, Tony, I imagine that this is something or a question that you deal with with your clients all the time, the how do you decide whether or not to do a conversion? And we got a question in advance from Mark who asked us to address the benefits, procedures, and downsides of a Roth conversion. Now, I could imagine that is a very long list. So why don’t we start with a couple rules of thumb.
Tony Giordano: Yes, so I think we’ve talked about it a little bit already, which is when you’re going to consider a Roth conversion, you’re going to pay a known tax liability. So you should know that upfront. You should have those dollars. You need to have those dollars set aside to pay the tax liability. You can’t necessarily convert from a traditional into Roth and then you don’t want to necessarily pull out of the Roth that you just converted.
Emily Farrell: So that’s an immediate tax bill is what you’re saying.
Tony Giordano: It’s an immediate tax bill. So that’s kind of one consideration that we think about for our clients is do we have the money set aside and, then, what we want to do is we want to tie that in. For our clients, we want to tie that in and say, “What does that look like in terms of the longevity of their portfolio? Like how does that impact their financial plan? Like does that mean that their— We use success rates. So when we look at a client’s portfolio and we look at their money and we take a look at their spending, we break it down in terms of success rates. Like is their success rate 80%? Is it 100%? Meaning like are they going to be able to live off of a certain income and be able to do that to their planning horizon? So those are things that we look at. Like, will a Roth conversion actually reduce their success rate or will it actually increase their success rate? So those are a couple of things that we look at with our clients.
Emily Farrell: So, yes, Cheryl from New Jersey asked us, just kind of piggybacking off that, she gets confused about whether or not doing it is worth all of the hassle when it comes to filing taxes? So I guess there are some procedures that you need to go through, and I guess that paper does go into it a little bit more. Anything else to add, Joel?
Joel Dickson: Well, there are lots of different things and it’s not just IRAs. And I think that question was about doing what’s called a backdoor Roth conversion, which is, if you’re not otherwise eligible to make a contribution directly to a Roth IRA—
Emily Farrell: And that’s due to income.
Joel Dickson: —due to income limits, that there’s a backdoor way of doing it by basically contributing to a nondeductible traditional IRA, which doesn’t have income limits, and then converting that to a Roth IRA. But that’s fraught with complication as well because there still may be a portion of it that’s taxable due to certain IRA rules. There might be some consideration about whether there needs to be some amount of time between the time that you make the contribution and the time that you make the conversion. It gets to be a little bit complicated. But there are certainly situations where backdoors and conversions and so forth can be beneficial. But I do think just all of this talk gets us— There are all sorts of different tax treatments of all sorts of different types of accounts. I mean, you think about the different types of tax-favored accounts, right? You’ve got 529 plans, and you have health savings accounts now, and you have IRAs of different types.
Tony Giordano: 529 plans.
Joel Dickson: Yes, exactly. You have then trust when you’re thinking about estate plans that have different tax considerations. And it can all be sort of kind of very scary and, yes, having professional knowledge to help with that. I think about how many types of different dinosaurs there are. You start thinking about different types of accounts. You’ve got stegosaurus and triceratops and so forth and you end up, you know, thinking about— Yes, you have these nightmares about where do I allocate everything and what’s behind the door that could cause some trouble?
Emily Farrell: Yes, and some of these tax rules just seem just as archaic as those dinosaurs, right?
Tony Giordano: That’s right, and I would just add there with the backdoor Roth IRA, because we get that a lot. Our clients want to get money in there and their incomes exceed the limit so they can’t get the money in there so they put the money into a nondeductible traditional IRA and then they’ll convert it over. And, Joel, to our point, we’ve had this discussion, debate. I’ve had it with many accountants across the country, in fact, about when do you actually take the traditional IRA and convert it over to the Roth IRA? When do you do that? How long do you wait? Do you wait till the next tax year? But I’ll tell you the one takeaway with doing the backdoor is it’s important that a client doesn’t have any other traditional IRA assets. And you were talking about the calculation there. Because if you have other traditional IRA assets, what can really trip up an investor on that situation is you do the nondeductible contribution, then you do the conversion, you think I can specifically identify that either $5,500 or $6,500, and I can specifically identify that and then convert it over and pay zero taxes. And that’s not the way it works. You have to look at all of your traditional IRA assets and it’s a pro rata formula which gets a little bit in the weeds, a little complicated.
Joel Dickson: Yes, but if 50% of our traditional IRAs were taxable, then 50% of any amount that you convert is taxable.
Tony Giordano: Exactly.
Emily Farrell: There’s definitely a lot of steps. And I know sometimes even sitting here, I work with you all the time, it can be a little overwhelming, a little confusing. And Lisa at home asks us, “How do I find a financial advisor to manage my portfolios at Vanguard?” So, Tony, you work in that division.
Tony Giordano: I’m going to say I’m a little bit jaded, like, obviously, a little biased, but, yes. I mean, Personal Advisor Services is, obviously, a wonderful department. We launched that service a couple years ago. We’ve got hundreds of financial advisors at Vanguard waiting to work with our investing, our shareholders at Vanguard. Evaluate your portfolios, determine if we’re a good fit to partner with you and work with you on an ongoing basis, but you can certainly contact Vanguard. You can ask your representative to make an appointment with a financial advisor. We’d be happy to speak with any of our shareholders. Anybody who wants to review any of these particular questions, get some advice. And then, in terms of whether they want to become a client of ours, that’s a different story. And we can certainly, if they want to proceed with that, then we would certainly walk them through that process. But it’s a partnership with the financial advisor. It’s a top-down approach. We look at their goals first and then once we figure out and define what a client’s goals are, we’re going to set up an investment strategy. And all these things that we’re talking about today, all these confusing topics, this all gets tied into the experience that a client gets in Personal Advisor Services. We really do all of that for the client so, really, at that point, it’s just the client saying, “Why do you do that, Tony? What’s the reason for you to do it?” And then all the things that we’re talking about today, we just kind of tie it together, but these are things we look at.
Emily Farrell: Right. And, of course, Lisa and everyone else at home who might have any questions, at the green resource widget at the bottom of our screen, there’s some more information about Vanguard Personal Advisor Services. So I have a few more questions I’d love to get to and one of these was submitted in advance. And we talked a little about, I heard you both say 529 plans, which we know are college savings plans. And Larry asked us, “What are some tax-advantaged ways for grandparents to pay for college?” So that’s certainly one of them, right? I guess we kind of answered it. But do you want to walk through that, maybe a grandparent. And, Larry, if you’re paying your grandkids’ college tuition, that’s great.
Tony Giordano: Yes. No, I’d love to talk through that. So one of the things that you can do with the 529 plans, which is unique, is you can frontload a 529 plan. And the beauty of frontloading a 529 plan— I’ll talk about how and the amounts and the dollars. But the beauty of that is you can get more money working. So if you have a grandchild born in 2016, you can put a lot more money into it. And what I mean by that is I’m referring to the annual exclusion amount. Each individual is able to give $14,000 per person to any individual. So what you can do is— If you give more than that, then you have to get into filing a gift tax return. You get into some complexities. With a 529 plan, there’s a special provision that allows you to frontload them with five years’ worth of your $14,000 annual exclusion, so you can put in $70,000 for a newborn and get that money working right away.
Joel Dickson: Per person.
Tony Giordano: Per person.
Emily Farrell: Now, is that a one-time exclusion?
Tony Giordano: It’s a one-time exclusion. Now you then cannot give the $14,000 to that person for the next four years.
Emily Farrell: Gotcha, okay.
Tony Giordano: So once you get to the sixth year, you can start giving to that person again. But, again, the idea is time value of money is get that money working hard early. So that’s one thing that grandparents can think of. The other thing is they can put the 529 plan in their own name. They can be the owner. And if you’re a really high-net-worth investor, that money will be actually excluded from their estate. So that’s a nice benefit to know that you can be the owner, you can control the 529 plan, but it’s not necessarily included in your estate if you die.
Joel Dickson: There are also some other sort of things that you can think about that are a little bit more maybe esoteric or that people don’t normally think about. And one of these is, if you have a grandchild that has a summer job—teenager, summer job, and so forth—you as a grandparent could make a Roth IRA contribution potentially for them. I mean, you give them the money and they make the contribution, but if the grandchild has earned income, they could contribute up to $5,500 or the amount of their earned income. Well, if the grandparent gifts them some of that money to do that, then they’ve started on that long road of savings early on, which is the best time to start, and at the same time, teaching them about investing and saving. And they can still use the money that they earned for their other sort of spending.
Tony Giordano: Babysitting, cutting grass, those are things, if you keep really good records, you can start getting young people to really learn the value, the time value of money and the concept of compounding interest and some very good concepts for you people to learn about.
Emily Farrell: And we know teenagers are so good at keeping records and staying organized, right? Maybe the grandparents can do it for them.
Joel Dickson: That’s right, exactly.
Emily Farrell: So I’m going to go back a little bit and talk a little bit more about investment decisions. And Barry from Roslyn Heights, New York, had asked us previously, “Exchanging a long-held position in a less tax-efficient fund into a fund boasting a more tax-efficient strategy will be a taxable event. How can the conversion be justified?” Joel?
Joel Dickson: So, yes, it may be a taxable event. The question is how much of a taxable event will it be? So if you bought the investment originally for $10,000 and now it’s $11,000, well, it’s $1,000 of gain which may not be that burdensome. If it’s $10,000 and it’s now worth $20,000, well, that may be a different decision. And it gets back to sort of what’s the transaction cost of doing that trade? So it kind of depends on the situation where you are with the investment. But if you know that year after year after year this tax-inefficient investment is throwing off gains or ordinary income that you really think could be better off sheltered, it may just simply be that you’ve got to bite the bullet, pay the gains, and get to that more tax-efficient long-term investment. At the end of the day, though, this is that getting back to sort of one of the points made at the beginning about the difference between being a tax-efficient investor and using tax-efficient investments. I see the other side of this which is that people will say, “Yes, I’m worried about tax efficiency so I’m invested in a tax-efficient vehicle.” And then they trade it every three years. Well, they’re not really getting any benefit from tax efficiency doing that. Tax efficiency, like cost, is something that builds and compounds over long periods of time. It’s a 10-, 15-, 30-year strategy, not a 1-, 3-, 5-year strategy. So in that situation, if I have a really tax-inefficient vehicle, but I’m a long-term buy-and-hold investor, it may make sense to actually just cut the losses in terms of the tax efficiency piece of it. Get into a more tax-efficient vehicle over the long run.
Tony Giordano: And I would just add there, you know, we talked about tax-loss harvesting earlier tonight. So there are years, nobody likes to lose money. But if there is a year where we’ve lost some money in a particular security or securities across the account, that’s the opportune time to really go in and get out of, for that individual’s question, to get out of that position. You may be able to do it tax-neutral. You may be able to find losses in the portfolio to offset the gain and then get out of that very tax-inefficient mutual fund and get into something more tax-efficient going forward.
Joel Dickson: Right, and even the investment itself may not have much of a gain in it simply because it’s been tax-inefficient. So it’s distributed the gains it has otherwise generated. So you might actually find it doesn’t cost that much to actually get out of it.
Tony Giordano: That’s true. Right.
Emily Farrell: I think what a really interesting takeaway of a lot of the topics we discussed tonight is that tax efficiency or valuation of your tax efficiency is not a one-time thing, and it’s maybe not even an annual thing. It’s probably an ongoing type of exercise.
Joel Dickson: Oh yes.
Emily Farrell: So that was, at least for me, an important takeaway for me tonight. Tony, I have another question about specific investments. Glen from North Carolina, and this kind of reminds me of some of our earlier conversation, asked about if muni bonds should figure into retirees’ portfolio? So we had a couple of stories about muni bonds earlier. So what do you think?
Tony Giordano: Yes, so I think it depends on the individual investor. I will tell you, absolutely, with clients that I work with the majority, as Joel mentioned earlier, as you go upmarket and the portfolio sizes grow larger, most of the money ends up being in taxable portfolios. So we are absolutely using a significant amount of either individual municipal bonds or municipal bond funds for clients in retirement. I think the decision point comes with some of the discussion we had earlier with asset location. So if we determine what a client’s bond exposure should be and we fill that entire exposure in the tax-sheltered accounts, and we need to buy more bonds because the most important decision is your asset allocation strategy. So if we need that, there becomes a decision point as to, “Okay, now I’m in my taxable accounts. I’ve already put all the taxable bonds I could in the tax-sheltered accounts. Now what tax bracket am I in?” If I’m in a 25% to 28% or higher tax bracket, we’re probably talking about municipal bond funds. If you’re in maybe a 15% tax bracket, Joel used the example earlier, then you probably are looking at a taxable bond portfolio. So it really depends, but I would say absolutely, you know, definitely municipal bonds in retirement. And then when you’ve got things like the Affordable Care Act, the additional 3.8% tax for a lot of individuals, municipal bonds are not subjected to that Affordable Care Act, that additional 3.8%. So they become a little more valuable when there’s some unique portions of the tax code that are being taxed.
Emily Farrell: Well, certainly left us with a lot to think about and I wish we could go on. Believe it or not, we’ve reached the end of our discussion. Before I wrap up, any final thoughts for our audience at home? Joel?
Joel Dickson: I’d just highlight, again, it’s not about a product-by-product look on tax efficiency. That’s kind of lower down in the pecking order. It’s about being a tax-efficient investor and building a long-term tax-efficient portfolio that maximizes your after-tax return. Saving appropriately, maximizing tax-favored opportunities and account types, and then thinking about things like low cost, asset location, and then individual tax efficiency at the product level in a taxable account.
Emily Farrell: So certainly reframing the discussion altogether. Tony, any final thoughts?
Tony Giordano: I agree with everything Joel said. I would just really add to that the broader asset allocation decision. That’s really the driver for clients’ portfolios. It’s the driver in terms of the future returns and the volatility of the returns in the portfolio. So don’t lose sight. We’re targeting in on taxes here tonight, but don’t lose sight of the broader objective, which is the asset allocation we think is the number one decision and then all the other decisions kind of come underneath that.
Emily Farrell: Certainly more of a holistic planning perspective.
Tony Giordano: Exactly.
Emily Farrell: Now, again, I want to thank you both for your insights. Fantastic thoughts. Fantastic takeaways for our audience. Now, in a few weeks, we’ll send you an email with a link to view highlights of today’s webcast along with transcripts for your convenience. If I could have just a few more seconds of your time, we’d love if you could take a quick survey. Just click on the red widget at the bottom of your screen. We appreciate any of your feedback and, also, any suggestions on topics you might like us to cover in the future. Now from all of us here at Vanguard, we’d like to thank you for joining us this evening. Have a great night.
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