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Friday, March 21, 2008

Tax Time

A couple of folks asked me to help with their taxes and/or investments recently. As I helped them, I noticed a few items that came up that are worth mentioning:

  • If you're a fresh graduate funding an IRA (maximum $4000 contribution for 2007), do the no-brainer thing and just buy one of the Vanguard Target Retirement funds. Your portfolio isn't large enough to justify an inordinate amount of time tweaking them. Conversely, if your portfolio is large enough, the Vanguard Target Retirement funds are still OK, but you might get a bit more by breaking out the bits. More on that later.
  • I like to abuse the table fromearly retirement page on safe withdrawal ratesand use that to decide on a broad asset allocation. I realize that the table isn't meant for that purpose, but it's close enough for what I tend to do.
  • It is not generally a good idea to mix the Target Retirement Funds or the Life Strategy Funds with a general asset allocation strategy. Those funds are intended to be one-stop shops for investing with minimal fuss, and owning them will complicate your asset allocation strategy otherwise.
  • If you are holding a taxable account, rather than owning the Total International Stock Index, consider owning the individual components of it, since that will give you foreign tax credits, which will help reduce your taxes. (Taxes swamp even investment expenses in overall costs, so keeping an eye on your taxes is important)
  • Conversely, it is more tax efficient to own the Total Stock Market Index than its components, because as companies grow from Small-Cap to Mid-Cap, you end up buying that company in the larger index and selling it in the smaller index, causing churn which raises your taxes. Note that this argument doesn't apply to the International Fund because companies don't shift from country to country (or region to region) in the case of these index funds. If you wish to tilt towards value or small caps, buy those funds separately as an addendum to your holdings of the Total index.
  • The Tax-Managed funds might not be more tax-efficient than the Total Stock Market Index fund, especially for the U.S. By owning the entire market, you're already reducing portfolio churn. It's hard to do better than that!
  • There's some evidence out there that purely splitting the market down the middle on Growth versus Value might not enable you to capture the value premium. I'm not sure how much of this is DFA marketing literature, but to a large degree, unless you have a large enough portfolio (quarter million or more), it is probably not worth the effort to buy into DFA's expensive funds.

As usual, all the disclaimers apply: I am not a financial adviser (heck, I have a liberal arts degree), and you need to do your own math and numbers before coming up with a strategy that's right for you. I recommended two completely different strategies (maybe even contradictory) for two different people because they were in completely different life situations. There is no one-size-fits-all solution when it comes to financial planning.

1 comment:

Unknown said...

I believe the Total International Stock Market Fund structure has now changed. It now holds the securities directly instead of having a fund-of-funds structure. Hence the foreign tax credit advice above should no longer apply.