Archives for August 2009

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Rebalancing Across Accounts

We tag certain pools of money for certain purposes. We have emergency funds, opportunity funds, new car funds, etc.

Similarly, most of us tend to see retirement accounts and taxable accounts as separate entities. We think of retirement accounts as intended for long-term goals and taxable accounts as intended (at least partially) for short-term goals.

The natural result, then, is that most of us invest our taxable accounts conservatively and our tax-sheltered accounts more aggressively.

From a purely mathematical standpoint, however, there’s no benefit to doing so. In fact, most of us could earn greater after-tax returns if we flipped our asset location so that it would be closer to:

  1. Taxable accounts holding your equity investments (preferably ETFs due to their tax efficiency).
  2. Tax-sheltered accounts holding your fixed income investments.

But very few people do that.

It’s All One Portfolio

The trick is to learn to look at your entire portfolio as a whole.

For example, let’s imagine that you have $100,000 in a taxable account and $70,000 in a Roth IRA. Also your ideal allocation is to have $20,000 in cash (ready to go for emergencies) and then split the rest so that it’s 2/3 in stocks and 1/3 in bonds.

My suggestion would be to invest as follows:

  • Taxable account: $100,000 in stock ETFs
  • Roth IRA: $20,000 in something very liquid (money market, for instance) and $50,000 in bond index funds.

The problem most people would have with this allocation is that it appears dangerous: What if you need to tap the emergency fund?

  • If you pull money (aside from original contributions) out of a Roth, you’ll have to pay the extra 10% tax on early withdrawals, and
  • The stock ETFs in your taxable account make a poor emergency fund because they’re so volatile.

In reality, however, you still have an accessible emergency fund. You just have to be slightly more creative to get to it. For example, let’s imagine that at some point, you need to access $10,000, but the market has just had a severe decline, so you don’t want to liquidate your stock holdings. My approach would be to:

  1. Sell $10,000-worth of stock ETFs in your taxable account.
  2. Move $10,000 in your Roth from the money market into stock index funds.

By doing so, you’ve accessed $10,000 in cash and your total stock allocation is untouched (meaning you haven’t had to “sell low”).

In Short

By remembering to look at your portfolio as a whole, you can take better advantage of the tax shelter provided by retirement accounts. End result: You earn a greater after-tax return using the exact same asset allocation you already have.

If Contents Ignite…


We have a little toaster oven in our kitchen. Right on the glass door the following warning is painted:


I like that. Right upfront, it warns you about the worst-case scenario and gives you sound advice about how to react in case such an event occurs.

Everyday when I use the toaster oven to make breakfast, I see that warning. Should my bagel ever catch fire, I’ll know immediately how to respond. 🙂

Warnings on Credit Cards

What if credit cards came with warnings like that? What if (preferably somewhere on the card itself) a mandatory warning was included:

Warning: Do not purchase something if you could not buy it with cash. Doing so could result in a downward spiral of debt accumulation.

Or perhaps monthly credit card statements should come with the following disclosure:

Warning: Not paying off your balance in full will result in the payment of extremely high rates of interest.

Warnings on Mutual Funds

Or what if mutual funds came with better, more prominently displayed warnings?* Here are my votes for a couple:

Warning: Actively managed mutual funds have a less than 50% probability of outperforming low-cost index funds with a similar asset allocation.

Warning: Equity mutual funds tend to be extremely volatile. In all likelihood, this fund will experience dramatic declines in value from time to time. It’s generally a poor idea to sell immediately after such a decline.

*Yes, mutual funds come with many warnings in their prospectuses, but the reality is that most investors do not bother to read the prospectus before investing in a fund. I’m proposing including such warnings prominently in all mutual fund advertising materials.

Warnings on Stock Trades

And what if, prior to placing a stock trade, a pop-up window appeared with the following reminder:

Warning: Frequent trading leads to increased costs and increased taxes, with no increase in expected return.

What do you think?

Do you think such bold, in-your-face warnings would help people to avoid making serious financial mistakes? Or would they (much like the warnings on cigarette packages) go mostly unheeded?

If you do like the idea, what warnings would you suggest?

Results of a Balanced Portfolio

For whatever reason, anytime somebody brings up index funds one of the bigger personal finance blogs (like The Simple Dollar or Get Rich Slowly), there tends to be somebody in the comments who says something to the effect of “Index funds failed investors over the last decade.”

I can’t tell you how much this frustrates me given that:

For those who are not aware: “Index Fund” is not synonymous with “S&P 500 Index Fund.” There are index funds that track a whole host of other things, including bonds, commodities, and REITs.

How did a (re)balanced portfolio perform?

Just to set the record straight, I thought I’d take a minute to share the results internationally diversified portfolios, constructed from real index funds over the last decade.

The following portfolios are assumed to have been rebalanced annually on January 1 of each year. The stock portion is assumed to be 30% international (Vanguard’s Total International Stock Index Fund) and 70% U.S. (Vanguard’s Total Stock Market Index Fund). The bond portion is assumed to be Vanguard’s Total Bond Market Index Fund.

From 1999-2008, the following are the annualized rates of return for various asset allocations:

  • 70% bonds, 30% stocks: 4.44%
  • 60% bonds, 40% stocks: 4.02%
  • 50% bonds, 50% stocks: 3.54%
  • 40% bonds, 60% stocks: 3.00%
  • 30% bonds, 70% stocks: 2.39%

[You can see a screen shot of the spreadsheet with all the results here.]

Now, I’ll be the first to admit, those returns are hardly spectacular, and they were almost certainly below investor expectations. But they’re hardly the catastrophic declines in value that some people seem to think occurred.

Dealing with Unrealized Capital Gains

Readers often email me to ask what to do when you have asset that you’d like to sell, but which has a large unrealized capital gain. The two most common examples being:

  1. Shares of a given stock which now make up far too high a percentage of their overall net worth, or
  2. An actively managed mutual fund with unreasonably high costs.

Generally, my suggestion is as follows:

First, calculate precisely how much you would owe if you were to sell the asset. If we assume you’ve held the asset for greater than one year, the Long-Term Capital Gain would be taxed at a rate of 15% (unless you’re in a tax bracket of 15% or lower, in which case LTCGs are taxed at a rate of 5%).

Next, weigh the cost of that taxation against the benefits of having an appropriately-balanced portfolio.

Holding Too Much of One Stock

For example, let’s say you own shares of a stock and (in total) they’re currently valued at $100,000. You purchased them (all at the same time, at the same price) for $30,000.

If you were to sell all of your shares, you’d be realizing a LTCG of $70,000. Assuming you’re in the 25% (or greater) tax bracket, the gain will be taxed at a rate of 15%, meaning you’d be paying $10,500 in tax.

Is that too high a price to pay for diversification? If this $100,000 makes up a significant portion of your net worth, it may be wise to accept that 10.5% decline in value now rather than expose yourself to the much larger potential losses that can come from having so much money invested in one company.

It’s also important to note that, assuming you plan on selling the shares at some point in the future (and assuming they don’t decrease in price), you’re going to be paying this tax eventually.

Selling Actively Managed Funds

Alternatively, let’s imagine that you own an actively managed fund and would like to sell it (having been convinced of the benefits of index funds), but your cost basis is significantly below the current value. (Again, let’s use $30,000 and $100,000.)

Again, if you sell, you incur a cost of 10.5%. Essentially the question comes down to how long it will take for the reduced expenses to recoup the tax paid. Often, it’s a much shorter time than you’d think.

For example, it wouldn’t be unheard of for your total costs to decrease by 2% per year or more:

At that rate, it would take barely 5 years before your savings more than outweighed the cost of paying the tax. (And you’d now have a higher cost basis in your holding as well, meaning that when you sell the index fund at a later date, you won’t be paying as much tax as you would had you held the original fund.)

In Summary…

Obviously, this sort of situation is something that must be considered on a case-by-case basis. That said, in my own experience, I find that investors tend to overestimate the cost of selling and underestimate the benefits of having an appropriately constructed portfolio.

One final note: In the above analysis, I assume that you don’t have any investments which a) you’d like to sell, and which b) have unrealized capital losses. If you do have such investments, the solution sometimes becomes a no-brainer: Sell both, use the capital losses to offset the capital gains, and invest the cash as you choose.

Getting Started Investing: Index Funds

Quick weekend update: Poorer Than You is hosting a giveaway for a laptop + netbook combo. The requirement for entry is to “create a piece of multimedia that embodies a sound personal finance concept” (hopefully one particularly relevant to young people).

I created a video explaining (what else?) the benefits of investing via index funds. The content will be nothing new to regular readers here, but I thought I’d share it in case anybody wanted to take a look.

Getting Started Investing: Index Funds from Mike Piper on Vimeo.

Hope you’re all enjoying your Friday evening. 🙂

Tax Efficiency of Index Funds and ETFs

When discussing index funds as opposed to actively managed funds, I tend to focus primarily upon their lower expense ratios and lower turnover costs. But for those of you investing in taxable accounts, index funds (and ETFs) offer an additional advantage over actively managed funds: They’re decidedly more tax efficient.

Increased Turnover Means Increased Taxes

As compared to actively managed funds, index funds and ETFs allow you to:

  1. Pay less taxes, and
  2. Defer your taxes.

With mutual funds (as opposed to, say, shares of individual stocks), you don’t pay taxes only when you sell the fund. You pay taxes each year on your share of the capital gains realized within the fund’s portfolio.

With portfolio turnover in actively managed funds averaging roughly 100% per year, a great deal of the gains end up being short-term capital gains. Because STCGs are taxed at your ordinary income tax rate (as opposed to LTCGs which are taxed at a maximum rate of 15%), investors in actively managed funds end up paying more in taxes than they would with a fund that holds onto its investments for longer periods of time.

Also, the longer holding period for shares within an index fund’s portfolio allows you to defer taxation for a greater period of time (thereby allowing your money to grow more quickly).

ETF Tax Efficiency

In addition to the above tax benefits, Exchange Traded Funds (ETFs) have a significant tax advantage due to the way in which they’re created.

When a typical index fund needs to raise cash (due to investors liquidating their holdings), it must sell investments from within its portfolio. If these investments were sold for more than their cost basis, the transaction triggers a capital gain, which must be paid for by remaining shareholders.

In contrast, when large ETF shareholders want to redeem their shares, they’ll often simply exchange them (with the ETF sponsor) for shares of the underlying companies owned by the ETF. The ETF sponsor makes it a point to distribute the shares that have the lowest cost basis, thereby minimizing unrealized capital gains within the ETF’s holdings.

The end result is that ETFs tend to distribute smaller, less frequent capital gains to their shareholders–thereby allowing shareholders to defer the majority of taxation until they actually sell their shares.

Taxes Are Costs Too.

After considering expenses, the majority of actively managed funds underperform their respective indexes. When you factor in the impact of taxes, the results become even more dramatic. In fact, some studies have shown that the likelihood of an actively managed fund outperforming its index on an after-tax basis is less than 10%.

Why take those odds?

For More Information, See My Related Book:


Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"
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