Before we talk about tax efficient investing, lets talk about the two different types of accounts: Tax-advantaged and Taxable accounts.

Tax-Advantaged Accounts

Examples of this type of accounts are 401K and IRA accounts. I do not have to pay taxes when I file taxes every year for any gains produced by investments in these accounts. The gains can be via capital gains, dividend distributions, interest, etc. The gains can grow in a tax-free environment  until money is withdrawn from these accounts. At that time, taxes will need to be paid based on the tax bracket one is at that time.

Taxable Accounts

Any account that is not tax-advantaged is a Taxable account. For example, my bank account with cash that produces interest is a taxable account because I will have to pay taxes on the interest money reported by the bank. Likewise, my Vanguard investment accounts, using post-tax money from my bank account, are taxable as well i.e. any dividends and/or capital gain distributions are taxable as well.

Tax-Efficient Investing

Gains produced in taxable accounts will be taxed according to the tax bracket one is in. Lets take an example. Consider the fund VDIGX…a dividend growth fund from Vanguard. The expected distributions for this fund for the  year 2014 are as follows:

Dividend Growth Fund    VDIGX

• Dividends: $0.17
• Short Term: $0.07
• Long Term: $0.25

Each of the different category of gains are taxed at different levels depending on the investor’s tax bracket

• Short term gains taxed at investor’s tax bracket (say 33%)
• Long term gains taxed at 20% (fixed)
• Dividends (qualified 100%) taxed at 15% (for folks in 33% tax bracket)

Tax-efficient investing is choosing investments in such a way that the taxes paid on the gains is minimized as much as possible. In the above example, it would be most tax-efficient if all of the gain comes in the form of dividends which are the least taxed category at 15%.

Consider another example of VCAIX….a California MUNI fund from Vanguard as well. This fund invests in MUNI bonds within California. The special treatment given to such bonds is that the gains form such bonds are both Federal and State Tax free and in most cases AMT free as well. For now, lets ignore AMT free…I will talk about this in another post. Now consider the gains produced by VCAIX for the calendar year 2014.

CA Intermediate-Term Tax-Exempt VCAIX

• Dividends: $0.02
• Short term: $0
• Long Term: $0

For a resident of California, all the gains produced by VCAIX are completely *tax-free* i.e. both federal and state tax free. If not a resident of California, then it is only Federal tax free and state taxes have to be paid. So, in comparison to VDIGX,  for a resident of California, VCAIX isdefinitely more tax efficient than VDIGX.

So, tax-efficient investing is not about NOT_PAYING_TAXES. It is about MINIMIZING-TAXES-PAID and hence maximizing the gain that the mutual fund delivers.

NOTE:

• VCAIX offers an appx gain of say 3%.But, being tax free means I get to keep the 3% completely.
• For a taxable (or a less tax-efficient) fund to allow me to keep 3% post taxes, the fund has to produce a gain much higher than 3% to compensate for the taxes that need to be paid.
• There is a calculator called Taxable Equivalent Yield Calculator (link below) where if I put in 3% and 33% as my tax bracket, I get the result of 4.48%. So, before paying taxes, the fund has to provide a gain of 4.48% so that post tax, I get to keep 3%.
• For a portion of my portfolio, I may decide to take less risk and go for VCAIX at 3% vs taking more risk and investing in another fund that produces 4.48% gain. Now you see the power of tax efficiency 🙂
• Of course, I do not want all my investments to be in VCAIX right…it is not diversified enough. So, asset allocation should still be higher priority than tax-efficient placement. Another post for this later….but for now, read the first link in the reference links below.

Reference Links

• Principles of Tax Efficient Fund Placement
• Qualified Dividend Taxes
• Taxable Equivalent Yield Calculator