Running out of room in tax-sheltered accounts, a future problem -tl;dr

TheMetetron · #1 04-27-2007, 04:04 PM

So, I'm finally starting to come around to those of you who think that my taxable and tax-sheltered accounts are really part of the same big portfolio. This is all good and well but it has one big short-coming. I am going to run out of space in tax-sheltered accounts to keep my portfolio properly diversified.

Here is the asset allocation I would ideally like to have:

Taxable Accounts (45%):

Vanguard Tax-Managed Capital Appreciation Fund (VMCAX) - 12.5%
Expense Ratio: .15% (.10% with Admiral Shares)
Tax-Cost Ratio: ~.25%
*1% fee on shares held less than 5 years

Vanguard Tax-Manged Small-Cap Fund (VTMSX) - 12.5%
Expense Ratio: .14% (No Admiral Shares)
Tax-Cost Ratio: ~.19%
*1% fee on shares held less than 5 years

Vanguard Tax-Managed International Fund (VTMGX) - 20%
Expense Ratio: .20% (No Admiral Shares)
Tax-Cost Ratio: ~.34%
*1% fee on shares held less than 5 years

Tax-Sheltered Accounts (55%):

Vanguard Value Index (VIVAX) - 12.5%
Expense Ratio: .21% (.11% with Admiral Shares)
Tax-Cost Ratio: ~1.40%

Vanguard Small-Cap Value Index (VISVX) - 12.5%
Expense Ratio: .23% (No Admiral Shares)
Tax-Cost Ratio: ~1.20%

Vanguard International Value Fund (VTRIX) - 20%
Expense Ratio: .46% (No Admiral Shares)
Tax-Cost Ratio: ~1.20%
* 2% fee on shares held less than 2 months

Vanguard Emerging Markets Index (VEIEX) - 10%
Expense Ratio: .42% (.30% with Admiral Shares)
Tax-Cost Ratio: ~.60%
*.5% fee on shares bought and redeemed

As you can see 45% of my assets are tax-friendly and will be in taxable accounts. The other 55% isn't and is best suited for tax-sheltered accounts. Here is where the problem comes in. This year, I will have approximately $150,000 to invest at the minimum. It could be more and it will probably go up in future years.

However, my SEP IRA only allows contributions of up to $45,000. Which means that total I could only invest $81,800 per year and still preserve this asset allocation. Obviously, I need to come up with a new plan, but I am not sure what it is.

This also doesn't take into account bond funds which I will be wanting to add to my accounts with about 80% in stocks and 20% in bonds.

Here are the potential bond funds I'd be interested in:

Vanguard Intermediate-Term Treasury Fund (VFITX) - 70%
Expense Ratio: .26%
10 Year Returns: 6.45% (4.29% after-tax)

Vanguard Short-Term Treasury Fund (VFISX) - 30%
Expense Ratio: .26%
10 Year Returns: 4.99% (3.19% after-tax)

or

Vanguard Intermediate-Term Tax-Exempt Fund (VFITX) - 70%
Expense Ratio: .17%
10 Year Returns: 4.94%

Vanguard Short-Term Treasury Fund (VFISX) - 30%
Expense Ratio: .16%
10 Year Returns: 3.20%

Obviously if I keep bond money in taxable accounts, the tax-exempt bonds win out especially because I'll be in a high tax bracket. But you guys all thought I was a lunatic for even considering that and not just putting my bond funds in my SEP IRA. But where exactly am I supposed to find room to do that?

The bond funds seem even less tax efficient than the value or emerging markets stock funds. In reality I should be putting those into my taxable before bonds. In fact, let's do that. I'll put emerging markets into my taxable and put some treausry funds into my IRA.

New asset allocation:

Taxable Accounts (Everything over $45,000/yr or approx 70% of assets):

Vanguard Tax-Managed Capital Appreciation Fund (VMCAX) - 30% of taxable, approx 21% of total
Expense Ratio: .15% (.10% with Admiral Shares)
Tax-Cost Ratio: ~.25%
*1% fee on shares held less than 5 years

Vanguard Tax-Manged Small-Cap Fund (VTMSX) - 30% of taxable, approx 21% of total
Expense Ratio: .14% (No Admiral Shares)
Tax-Cost Ratio: ~.19%
*1% fee on shares held less than 5 years

Vanguard Tax-Managed International Fund (VTMGX) - 30% of taxable, approx 21% of total
Expense Ratio: .20% (No Admiral Shares)
Tax-Cost Ratio: ~.34%
*1% fee on shares held less than 5 years

Vanguard Emerging Markets Index (VEIEX) - 10% of taxable, approx 7% of total
Expense Ratio: .42% (.30% with Admiral Shares)
Tax-Cost Ratio: ~.60%
*.5% fee on shares bought and redeemed

Tax-Sheltered Accounts (Everything under $45k/year or approx 30% of assets):

Vanguard Value Index (VIVAX) - 20% of tax-sheltered, approx 6% of total
Expense Ratio: .21% (.11% with Admiral Shares)
Tax-Cost Ratio: ~1.40%

Vanguard Small-Cap Value Index (VISVX) - 20% of tax-sheltered, approx 6% of total
Expense Ratio: .23% (No Admiral Shares)
Tax-Cost Ratio: ~1.20%

Vanguard International Value Fund (VTRIX) - 35% of taxable, approx 10.5% of total
Expense Ratio: .46% (No Admiral Shares)
Tax-Cost Ratio: ~1.20%
* 2% fee on shares held less than 2 months

Vanguard Intermediate-Term Treasury Fund (VFITX) - 25% of tax-sheltered, approx 7.5% of total
Expense Ratio: .26%
10 Year Returns: 6.45% (4.29% after-tax)

This has some new shortcomings, namely I'm coming to the conclusion that having bonds in my tax-sheltered accounts means that evening having 20% of my assets in bonds means that 68% of my IRA is in bonds. Yikes.

Also trying to keep value in tax-sheltered isn't working so well either as my value allocations are well below what I ideally wanted.

There are a few ways to handle this. I could just go completely aggressive in my tax-sheltered account and load it with Value & Emerging Markets funds. Then have my 3 tax-managed funds in taxable. I would have to figure out a solution for bonds in the future. I would keep my bond allocation lower than what I'd like which would add risk, because I'd probably just go with tax-exempt bonds in taxable. I'd have to live with the approximately 25% lower returns of tax-exempt bonds, but I'd try to mitigate this in the future by taking on more risk with a heavier stock portfolio.

I could just say screw the tax implications and just load my tax-sheltered with bonds while trying to keep the value %'s I want by moving some value funds in taxable. This has really [censored] tax implications and big problems if my income ever goes down before I retire and then I need to sell some value from taxable and put it back into tax-sheltered.

An example of it decided to just go aggressive in tax-sheltered and probably hold tax-exempt bonds in taxable at a later date.

Taxable Accounts (Everything over $45,000/yr or approx 70% of assets):

Vanguard Tax-Managed Capital Appreciation Fund (VMCAX) - 30% of taxable, approx 21% of total
Expense Ratio: .15% (.10% with Admiral Shares)
Tax-Cost Ratio: ~.25%
*1% fee on shares held less than 5 years

Vanguard Tax-Manged Small-Cap Fund (VTMSX) - 30% of taxable, approx 21% of total
Expense Ratio: .14% (No Admiral Shares)
Tax-Cost Ratio: ~.19%
*1% fee on shares held less than 5 years

Vanguard Tax-Managed International Fund (VTMGX) - 40% of taxable, approx 28% of total
Expense Ratio: .20% (No Admiral Shares)
Tax-Cost Ratio: ~.34%
*1% fee on shares held less than 5 years

Tax-Sheltered Accounts (Everything under $45k/year or approx 30% of assets):

Vanguard Value Index (VIVAX) - 25% of tax-sheltered, approx 7.5% of total
Expense Ratio: .21% (.11% with Admiral Shares)
Tax-Cost Ratio: ~1.40%

Vanguard Small-Cap Value Index (VISVX) - 25% of tax-sheltered, approx 7.5% of total
Expense Ratio: .23% (No Admiral Shares)
Tax-Cost Ratio: ~1.20%

Vanguard International Value Fund (VTRIX) - 35% of taxable, approx 10.5% of total
Expense Ratio: .46% (No Admiral Shares)
Tax-Cost Ratio: ~1.20%
* 2% fee on shares held less than 2 months

Vanguard Emerging Markets Index (VEIEX) - 15% of tax-sheltered, approx 4.5% of total
Expense Ratio: .42% (.30% with Admiral Shares)
Tax-Cost Ratio: ~.60%
*.5% fee on shares bought and redeemed

This gives me 57% domestic, 43% international; 74.5% blend, 25.5% value; 71.5% large cap, 28.5% small cap. This compared to 50% domestic, 50% international; 55% blend, 45% value; 75% large cap, 25% small cap that I originally wanted. The cost is obviously my weighting isn't what I originally wanted and also is going to fluctuate based on my income. If my income goes up this is going to get thrown out of whack even more. If my income goes down it will fall more in line with what I originally wanted. And of course the biggest downside is that my bond allocation is going to be kept low on purpose by me and will be in tax-exempt bonds with lower returns instead of in tax-sheltered accounts with normal bonds.

This is starting to get way too long and I need to start making some of that money I mentioned in this post, so I'll let you guys chime in and come back and give more of my thoughts later. This is an interesting problem to me that I'd like to solve as best as I can.

dlk9s · #2 04-27-2007, 07:47 PM

I read the beginning (as you said, tl;dr) and read the part about hitting your SEP-IRA cap (I just set one up myself - I wish I had your problem [img]/images/graemlins/smile.gif[/img] )

Seems like you like Vanguard, but I do know that Fidelity and T. Rowe Price have accounts called "self employed 401(k)" which are basically what they sound like. I opted against these mainly because they were more complicated to setup.

But, if you can wade through the paperwork, they may be a good option to get some more money in tax-sheltered retirement accounts. Plus, both companies have good funds with low fees.

TheMetetron · #3 04-27-2007, 07:56 PM

dlk9s,

I'm hitting the $45,000/year cap plus another $105,000 year that I am putting into taxables for retirement. Individual 401k's are also capped at $45k/year but are better for people making less than $200k as it allows you to reach that $45k with a lower income.

My problem is my asset allocation plan gets severely screwed up when trying to keep my non-tax-friendly assets in tax-sheltered accounts. I have too many to fit. I either need to say screw my asset allocation %'s or I need to come up with a better plan. That is the point of this thread.

Edit: The companies you mentioned have some good low-cost, index funds, but not nearly enough for the assets I want to hold, but that doesn't matter anyways since my problem can't be solved by using an individual 401k instead.

Jeff W · #4 04-27-2007, 09:45 PM

You're probably not going to sustain the value tilt you want. You only have so much room in tax-deferred and its a bad idea to hold value in taxable because the tax laws for long term capital gains rates are going to revert back to the higher rate in 2010.

Get as close as you can to your target and then forget about it. Don't make investing more complicated than it has to be--value tilt is not that important(my portfolio has close to 0 value tilt because of the same problem you have).

TheMetetron · #5 04-27-2007, 10:13 PM

[ QUOTE ]
You're probably not going to sustain the value tilt you want. You only have so much room in tax-deferred and its a bad idea to hold value in taxable because the tax laws for long term capital gains rates are going to revert back to the higher rate in 2010.

Get as close as you can to your target and then forget about it. Don't make investing more complicated than it has to be--value tilt is not that important(my portfolio has close to 0 value tilt because of the same problem you have).

[/ QUOTE ]

That's what I was planning to do. What about bonds though? I am either going to lose all value (or close to all) by putting bonds in tax-deferred. It's just eventually going to take up so much room in my portfolio.

For now I don't need/want bonds, but I will in the future.

Jeff W · #6 04-27-2007, 10:44 PM

There's really no godo solution. Even if you put all your bonds in tax-deferred(which I would), they're going to grow at a slower rate than equities, so equities are gradually going to take up a larger and larger percentage of your portfolio.

TheMetetron · #7 04-27-2007, 10:49 PM

[ QUOTE ]
There's really no godo solution. Even if you put all your bonds in tax-deferred(which I would), they're going to grow at a slower rate than equities, so equities are gradually going to take up a larger and larger percentage of your portfolio.

[/ QUOTE ]

Crap, that's a good point. Eventually whatever is in my tax-deferred is going become an increasingly smaller portion of my portfolio. I guess I'll just load it with value and emerging markets and worry about bonds in the future. However, eventually my bond needs will outweigh even my SEP IRA's capacity and I'll have to get tax-exempt bonds at some point.

Never thought $45,000 a year in a retirement account wouldn't be enough. There's the other point that putting more than that into it is probably useless anyways since I don't need a ton of money lying around when I die.

TheMetetron · #8 04-28-2007, 12:38 AM

Jeff & others,

Thoughts on Vanguard's Tax-Managed Capital Appreciation Fund (VMCAX) over Vanguard's Tax-Managed Growth & Income Fund for Large Cap Blend exposure in a tax-managed accounts?

I feel fortunate to even have two good choices from Vanguard, but I feel like the Capital Appreciation Fund does a better job of reducing tax liability and also doesn't follow the S&P 500 which doesn't allow it to get taken advantage of. However, it follows an index of 1000 large stocks so it isn't as mega-cap weighted whether that is a good thing or not. I'm pretty sure I'm going to stick with it, but arguments for the Growth & Income instead?

Jeff W · #9 04-28-2007, 01:16 AM

Doesn't make any difference. Total Stock Market ETF would be fine, too. I think they'll all have basically identical after tax returns in the long run.

Jeff W · #10 04-28-2007, 03:32 AM

I'm a bit loathe to complicate your life, but if you really want to min-max your portfolio:

One thing I'd consider is to use the Vanguard Mid Cap fund in taxable. It is the most tax efficient way to add size loading.

Size loading is the avg market cap for your portfolio. It's misleading to think of stocks in terms of Large vs Small--there is a gradient from the megacaps all the way down to the Microcaps. As you go lower down the scale, Std Dev increases and so does return. Aside from the largest dividend paying stocks and "true microcaps"(CRSP Decile 10--impossible to own via index funds), there are no market cap based "free lunches".

100% of my domestic portfolio is Mid Caps right now(I use IJH, but Vanguard's VIMSX is good too--it was a very tough decision between VIMAX(VIMSX admiral shares) and IJH). Mid Caps tend to perform between small and large caps in every market. The Vanguard MidCap fund is incredibly tax efficient because it keeps stocks that grow from MidCaps into low-end large caps, which reduces turnover.

Also, a good way to achieve more value loading with limited taxable space is to load up on value via the Rydex Pure Value ETFs. They have a substantially lower price/book ratio(the best correlary to the value premium) than Vanguard's Value funds.

That said, just pick a portfolio and be done with it. Trust me--I've done tons of research and I ended up with a 3-fund portfolio.