There are a few core design principles I have used in designing my version of the Passive Income Streams. These principles guide me in deciding where to invest the money in my taxable accounts. Here goes.
- Spread the money into different risk buckets (Vanguard 1 to 5 risk buckets)
- For each risk bucket, have a minimum of two investment vehicles.
- Almost every dollar has to provide some income in return.
- Invest some money in Capital Appreciation (high risk) buckets
- All the investments coming from taxable accounts have to be TAX-EFFICIENT.
- Automate as many investments as possible
6. Automate as many investments as possible
As I have said before, I do not have the knowledge nor the time to acquire it for individual stock picking at this time. In addition to that, I am not very organized to keep tabs on the investments and make investment changes based on market and/or life events at this time. So, fund based investing was the way to go for me. I am ready to pay for a mutual fund that has exhibited good characteristics…whether it be managing risk, growth, etc etc.
That said, the next question was: Mutual Fund OR ETF. There has been tonnes of info published on the web about these two. In my mind, here is what appeals to me about the two options:
- Mutual Fund
- Best suited for regular and automated investments
- Investment amount does not have to be on stock boundaries
- Tax loss harvesting…up market accumulates gains in the fund, downmarket uses tax loss harvesting.
- Capital gain distributions is out of my control…some other investor in the same mutual fund might sell and hence capital gains will be distributed to all mutual fund participants.
- Instant fund purchases are not possible…..if stock market fell big time today, I cannot purchase more of the fund right away. There is a wait time till end of day when the fund NAV prices are published.
- More tax efficient in that capital gains distributions will not happen out of my control i.e. I do not sell etf shares, I do not realize capital gains or losses.
- More suited for a relatively active investor (compared to a lazy mutual fund investor)
- Automated investments are not possible.
- Investment amount has to be on exact stock boundaries…no fraction of stocks can be purchased.
- Tax loss harvesting is the responsibility of the investor.
- Instant (intra-day) purchases possible.
- ETF shares have a bid-ask spread i.e. they trade like stocks. So, one has to know stock valuation techniques to evaluate ETF shares…basically, ask the question of: how much is good value for each ETF share, etc tec.
- Each ETF shares buy/sell may cost brokerage fees…just like normal shares.
Considering the above points, I chose mutual funds as the vehicle, inspite of ETFs being considered the more Tax Efficient Vehicle. The advantages of mutual funds fit more cleanly with my current requirements of automated investments and lack of time.
5. All the investments coming from taxable accounts have to be TAX-EFFICIENT.
Being in the higher tax bracket, tax efficiency in investments would be really nice. What does tax efficiency mean to me?
- If possible, don’t pay taxes on the gains/profits/interest/dividends 🙂
- Bank account Interest => pay taxes
- MUNI bond dividends => may not pay both federal and state taxes
- If I do have to pay taxes on the gains, limit the taxes
- Short term capital gains taxed as ordinary income; Long term gains at a lower rate.
- Qualified dividends (most US companies) less rate; Unqualified dividends taxed as ordinary income
- REIT investments => taxed as ordinary income …avoid it in taxable accounts
- Invest in some stocks fur purely capital appreciation and no dividends.
- No dividends => no taxable distributions.
4. Invest some money in Capital Appreciation (high risk) buckets
As I have said before, Taxable account investments are getting funded from money saved through the entire month. There have been a lot of sacrifices that went in to saving this money. So, the safe place to actually invest this money is in cash (CDs, high interest rate online banks, etc). But, low risk => low gain. So, the next level up is bonds and dividend paying stocks. But, even bonds and div paying stocks payout somewhere between 1 – 3%.
So, cash, bonds and dividend paying stocks are more tuned towards capital preservation, with small gains rather than big gains. IMO, this approach will not make you rich…or rather, it will take a long time to do so. Is there a way to score a home run and get rick faster 😉
In that vein, I have decided to set aside some percentage of the investments to fund high growth stocks….like funding a lottery ticket purchase. These stocks have the capacity to score big once in a while, but there is a high risk of loss of capital also. Since these stocks tend to be growth oriented, there will be no dividend distributions from them i.e. they can lose money but they are tax efficient 🙂
3. Almost every dollar has to provide some income in return.
Apart from the captial appreciation investments, every investment dollar has to work hard to get me some money 🙂 Each dollar can get me different amounts of money based on whether they are invested in bonds, stocks, etc. But, they have to get me some money. It does not matter also if the gains are a bit tax inefficient in the short term (say dividends) but hopefully in the long run when our tax brackets go down, the tax efficiency will kick in. I would rather get $10 and give away $3 than getting $0.
2. For each risk bucket, have a minimum of two investment vehicles
A big risk with mutual funds is that investment control is with one fund manager most of the time. If the manager lays one wrong bet, then there is cause for concern. So, for the same investment risk bucket, I would like to spread the risk by choosing two different funds that provide similar investments, but under different fund managers. For example, VCAIX is a Vanguard municipal bond fund. A similar tax efficient bond fund is VWAHX or VWITX. Splitting the investments in two similar but different vehicles will create some diversity and spread the risk.
1. Spread the money into different risk buckets (Vanguard 1 to 5 risk buckets)
Vanguard has a risk reward scale of 1 through 5, 1 being the least risky and least rewarding and 5 being the most risky and most rewarding. All my investment money is spread into the 5 different buckets based on some percentage. For example, cash (1), bonds(2), dividend funds(3), large cap capital appreciation (4), and small cap capital appreciation(5). In each risk bucket, the ultimate goal for me is to have two different investment vehicles to balance out the risk.
|Risk Bucket Name||Investment Vehicle 1||Investment Vehicle 2|
|Risk 1 (Cash in banks)||Smarty Pig (online)||Credit Union (brick & mortar)|
|Risk 2 (Bonds)||VCAIX (ca munis)||N/A|
|Risk 3 (Balanced Funds)||VTMFX (has natl munis)||N/A|
|Risk 4 (Dividend Investing)||VDIGX (div growth)||VHDYX (high curr div)|
|Risk 5 (Capital Growth)||VTCLX (large+mid cap)||VTMSX (small cap)|
|Risk 5 (International Funds)||VTMGX (large blend)||N/A|