Tax Efficient Investing

[Badger]

So I've been maxing out my Roth, and putting a decent chunk in my 401k. I'm getting to the point where money is piling up in my internet savings account that I feel I should be doing something else with.

Soon I plan to start putting money away in index funds and ETF's that I don't have to manage for the time being. I'm 25 and I feel that I've got much better things to do than study the stock market right now. I feel pretty confident that I have enough basic knowledge to start doing a good job of this myself (i.e. picking who I let manage it for me).

One thing I'd like to better understand before I do this is the tax implications of what I choose. Can you explain to me the basic ideas that I should be considering when making an investment.

This money will probably be sitting around for quite some time. The only thing I could see myself dipping into it for would be a home purchase, but even then a majority of what I'm saving is still in it for the long haul.

To clarify, I'm not asking for fund recommendations, there seems to be plenty of good information on that here. I'd like to clear up what tax implications I should be considering since this is a non-retirement account. Does this change at all if I end up donating a sizeable chunk of my investment?

Thanks so much for helping me out with my first real investment work.

[Jeff W]

You can find how much funds lose to taxes on their websites.

iShares S&P 500 Index Fund

Click on Fund Fact Sheet link on the left and in the performance history it will show After Tax Held returns--these are your returns as a buy and hold investor after taxes.

In this case, 1.26% Annual Pre-Tax Return and 0.89% Annual Post-Tax Return. 0.37% is lost to taxes... that is quite tax efficient. Just look for ETFs/Funds like that with a history of tax efficiency.

When you sell, you will have to pay capital gains tax... no way you can avoid that. Keeping taxes low is like receiving a 0% interest loan from the government and you might even have a lower tax rate when you retire, which means you get to pocket the difference between your current tax rate and retirement tax rate as well.

[john voight]

Aren't there a lot of tax benefits when in vesting in property?

IE: you buy a house, rent it out, and get tax refunds for the interest you pay on the property? Is this accurate (in the state of California at least)? Or did I misread something?

[TheMetetron]

[ QUOTE ]
Aren't there a lot of tax benefits when in vesting in property?

IE: you buy a house, rent it out, and get tax refunds for the interest you pay on the property? Is this accurate (in the state of California at least)? Or did I misread something?

[/ QUOTE ]

Except property sucks as an investment.

[TheMetetron]

OP:

Vanguard Tax-Managed Index Funds.

[Badger]

[ QUOTE ]
OP:

Vanguard Tax-Managed Index Funds.

[/ QUOTE ]
OK, but why exactly? If I'm looking at fund A vs fund B as far as taxes go how can I predict what the difference will be. If I hold A and B for 3 years each I understand that I can pay significantly different taxes on the two funds even though I've bought and sold at the same time. Is this due to how often the fund buys and sells its holdings? I haven't had a chance to do any research since making my post, so I'm none the wiser at this point.

This sounds like a good idea, but I'm more interested in the why as opposed to the what.

[Jeff W]

Basically, taxes come from two sources: Dividends and Capital Gains.

Methods that fund managers use to reduce taxes:

Don't sell shares that have appreciated in value(low turnover facilitates this).
Pick stocks with low dividends(this produces a growth tilt).
Harvest losses by selling depreciated shares.

ETFs have special advantages/tools for tax efficiency. For example, Institutional investors can redeem ETF shares for a basket of the underlying stocks when arbitrage opportunities arise(i.e. an ETF trades too far from its Net Asset Value). ETF managers use these these opportunities to unload the shares that have appreciated the most in value.

[Newt_Buggs]

[ QUOTE ]
OP:

Vanguard Tax-Managed Index Funds.

[/ QUOTE ]
Is there any reason to invest in a regular fund over the tax managed fund if you are going to keep the investments for a long time? I'm assuming that this is at least somewhat dependent on each investor's tax bracket.

So far none of my vangaurd investments are in tax managed accounts because I don't want to commit the funds for five years but I'm wondering if I'm giving up too much EV by not moving some of my savings into more tax efficient funds.

[Jeff W]

ETFs are pretty much just as good as tax-managed funds. I wouldn't sweat it.

[mtgordon]

I've also heard (but do not know) that the returns on non-tax managed funds are better because the 'managers' don't have as many restrictions. For instance they might sell a certain stock to offset a gain/loss and then they can't buy it for a certain period of time due to tax laws (well, they could but it wouldn't work out tax wise). Anyone want to tell me how wrong I am?