My investing strategy part 4

Tax Efficiency

In simple terms, tax efficiency is the expected tax cost of any given security based on current tax laws. When it comes to stocks, short term capital gains and ordinary dividends are taxed at your ordinary income tax rate. That means if you’re in the 25% tax bracket through your job, any capital gains occurred when you sell and/or ordinary dividends you obtain will be added to the top of that and taxed at that 25% or even higher if they push you into the next bracket. Makes sense right? It’s income and it’s taxed at your ordinary income rate.

But what makes investing such a great deal is that long term capital gains and qualified dividends are taxed at a lower rate! That rate is 0% for the 10-15% bracket, 15% for the 25-35% bracket and 20% for the 39.6%. There are some other taxes that may apply if you make above a certain threshold(200k+ generally) but for the majority of people, this is what applies.

Remember when it comes to capital gains, the taxes are paid for the year you sell the security(if I buy in 2010 and sell in 2015, I don’t pay taxes until the 2015 tax year). When it comes to dividends, the taxes are paid for the year the dividends are paid.

Now if you look at these numbers and want to minimize your tax bill in April, you can come to a at least two conclusions.

1. Long term capital gains are better than short term capital gains when we’re dealing with taxable accounts. In my case, 15% is better than 25% and I get the 15% rate if I hold a security or fund for one year or more than sell it versus a 25% rate if I sell it within one year.
2. Qualified dividends are better than ordinary dividends when we’re dealing with taxable accounts. Again the 15% rate I’d pay for any qualified dividend distributions is better than the 25% rate I’d pay for any ordinary dividends.

This is the basic concept behind tax efficiency. Essentially, in order to maximize total return when it comes to taxes, you want to make sure to keep your most tax efficient funds in your taxable accounts and allow the least tax efficient funds to grow in your tax-advantaged accounts.

To reference the above two conclusions, you want your taxable accounts to contain securities or funds that you expect to hold for at least 1 year(long term capital gain) before selling and if those stocks/funds pay dividends, you want to make sure they are qualified dividends.

That means that all alternative securities(REITS or Bonds which are both heavy dividend payers that are both taxed are your ordinary income rates), any securities you are trading in the short term or securities that offer ordinary dividends(mostly international stocks) should be held in your tax-advantaged accounts. Now this may not always be possible depending on what options you have in your 401k or IRA but you have to do as best a job as you can in order to maximize tax-efficiency.

Here’s the rules I go with as long as I have the space for it. You may find yourself out of tax-advantaged space pretty early on depending on how much you’re contributing.

Rule 1: REIT and bond funds go into tax-advantaged accounts. Both are high yielding securities with dividends that are taxed at your ordinary income rate. REITs have high potential growth which means a potential large capital gains bill when sold combined with a dividend taxed at your ordinary income level means they below in tax-advantaged accounts. Bonds don’t have high potential growth but the dividends are monthly and taxed at your ordinary income tax so they also belong in tax-advantaged accounts. In my case, my 401k doesn’t have a great bond fund and it doesn’t have a REIT fund so both of these reside in my Roth IRA.

Rule 2 : Any actively managed stock funds or stocks that you may sell in a short period of time should go in your tax-advantaged accounts as well. It’s odd to say but if you happen to be a day trader and have access to tax-advantaged accounts, your day trading would be best off being done in an IRA or 401k. There are 401k options that essentially function like brokerage accounts for some companies. I don’t advocated day trading or short term trading but if you want to minimize taxes, you’d do that in your tax-advantaged accounts. Any short term buys should also be in there. Actively managed stock funds belong here as well as they are more likely to have short term or long term capital gains paid out towards the end of the year as they are much more likely to sell their holdings during the year than index funds. In my case, I have one actively managed fund in my portfolio because it’s the best option to fulfill my asset allocation in my 401k and I have no room in my Roth IRA.

Rule 3 : This is where it gets a bit less obvious. If you’ve got any long term holdings that issue ordinary dividends, try to put those in your tax-advantaged accounts. In a lot of cases, this will be some international stock or fund or a small cap stock or fund. These types of stocks/funds will generally be qualified only about 50-75% of the time depending on the type of fund you’re looking at whereas most US large-cap stocks will be 100% qualified. The one thing that’s tricky in this regard is that international stocks/funds/etfs will earn you a foreign tax credit on your taxes which reduces the tax liability a good deal. If those international stocks/funds/etfs are in tax-advantaged funds then you miss out on that. Really, once you make sure you’ve got REITs, bonds and short term trades in your tax-advantaged accounts, the rest is a toss up. I have some international in my tax-advantaged, some small-cap in my tax-advantaged and even some large-cap in my tax-advantaged just because of the options available in my 401 and the amount I can store in the tax-advantaged.

Rule 4 : Now you’re likely in your taxable accounts after maxing out your tax-advantaged space. The most important thing to keep in mind here comes back to those conclusions we made earlier. Qualified dividends and long term gains rule the day here. In my taxable account, I keep mainly stocks or stock etfs that I plan to hold for at least a year(most often longer) and who pay a qualified dividend(100% qualified if an ETF unless it’s international which often gets offset by the foreign tax credit).

The long term strategy here is to buy individual stocks at attractive valuations that will generate a good long term total return. I’m not overly concerned with dividend income at the moment because in theory, returns being equal(7% total return as an example), a total return with no dividends will mean you have more money than a total return that includes dividends since you’ve been paying 15% taxes on those dividends every year until you sell.

There are plenty of investors out there who plan to retire early and live off their dividends and never sell and that’s also an adequate strategy. Dividend investing offers a sense of stability and a continual cash flow which is nice to see during rough market times. If it lends piece of mind and helps you hold onto a security that you might otherwise sell during a market downturn then you might benefit from the dividend in the long run.

When I look at stocks, I don’t necessarily focus on the dividend but I certainly don’t avoid it either. I own stocks that I think have growth potential and pay no dividend that I plan to hold onto for quite a while and I also own stocks that I think have growth potential and do pay a dividend.

In general, my strategy is more passive than a lot of early retirement investors whose blogs I read on the web as I like to have a continual stream of money going into the market and only buy individual securities when they are very attractively priced which means I don’t own a ton of individual securities but often funnel my money into an ETF when I don’t see anything out there that looks attractive to me.

I follow and track nearly 100 individual stocks with more being added daily but I have a lower risk tolerance than most people so unless I’m really, really sure about a stock, I’d rather just buy a diversified ETF than take the chance on the stock. On top of that, I’ve been lax in the past few years in my research so I’ve likely missed a lot of good opportunities that I hope to jump onto with this project as it’ll force me to get out there and delve deep into the companies I’m following and decide whether or not they’re worth buying.

As such, as of right now, I only own 4 individual stocks and everything else is in diversified index funds or mutual funds. These stocks have performed very well for me but the low number of them shows how picky of an investor I am. I think for me at least, the amount of work required to properly analyze a security is pretty high because if you want to buy Company Y for example, you want to make sure that Company Y has the ability to outperform the market by a decent amount because otherwise, why even bother buying it? It’s still a guessing game to some extent and you’re not guaranteeing a superior return by doing that sort of analysis but it does increase the probability of beating the market and that’s really the best you can do.

I don’t know if there’s much more to say here. I’ve rambled quite a bit on here and there’s a lot of information to digest but I think a lot of these topics are very important and remembering them by writing them out will help me along in my journey. I’ll probably pick out some of the more important topics in these four entries and do entire posts on them in the future, going more in depth and clarifying certain things but for now I just wanted to give you a guys a basic understanding of where I’m coming from as an investor and what my current strategy looks like. I’m not sure if this strategy will be exactly the same when I hope to retire 10 years from but it’s the one I use now and it’s worked relatively well up till now. Let this serve as a sort of time capsule I can look at years from now and see if what I was doing here was right or if I’ve learned something along the way.