Tax Efficiency

[moda0306]

I am an accountant and would like to offer some insight and a general discussion about tax efficiency:

Here is a short description of the problems/benefits of each section of the permanenent portfolio:

Stocks: Dividends are issued yearly for some of the TSM, so there is some tax inefficiency, but most of your gains would be realized through capital gains, which are somewhat few and far between if using 10%+/- bands, plus (at least right now) you get preferential 15% tax rates for federal purposes.

LT Bonds: Not so much now, but often throw out high interest every year, and capital gains every now and then.  Probably more tax-inefficient than stocks since more is tossed out in interest than your average dividends.

ST Treasuries/Money Market: Pretty much all interest, but usually at relatively low rates (especially now).  Since these aren't going to be carrying around big capital gains, it's easy to bounce these in and out of taxable/nontaxable accounts as interest rates become a factor.

Gold: At 28% for collectibles, it's never fun having to sell, but with no dividends & interest, the year-by-year affect is better than the others.  Also, if you play games with the wash sale rules (below), you can eliminate those difficult years when you actually have to sell a chunk of gold in the PP.... continued...

[moda0306]

The next piece brings me to tax-deferred accounts (IRA, Roth IRA, 401k, Roth 401k... even Health Savings Accounts, your kid's 529 education plan, educational IRAs, etc.)

With all of these you have to weigh 1) liquidity risk: In a real time of need, do you want something stuck in an account that your going to pay a penalty to pull it out, and 2) tax rate risk: are taxes going to be lower or higher when I start pulling out benefits.  This will affect my roth vs traditional decision.  If you're in your 20's (general rule) go roth with your yearly contributions.  40's, probably traditional IRA or 401k.  401k limits are much higher than IRAs and your employer usually gets good group investment fees for you, but IRAs (especially Roth) offer huge flexibility.  You can even use your HSA or kids education fund, if set up properly, to allocate more of this type of activity... always keep in mind liquidity risk though.  Taxes aren't everything.

- Since the general theory is that your emergency fund is included in your cash portion of your portfolio, and especially at todays interest rates, keep cash outside a tax-deferred account.

- Long-term bonds at todays rates may be tempting to put outside your tax-deferred account, but generally, they throw out very lucrative interest and you would rather have those in your tax-deferred accounts.

- Stocks are at preferential dividend tax rates and so are capital gains, plus dividends are usually pretty small.  Keep 'em taxable.

[moda0306]

Gold is a fickle B!tch... It sucks picking up a 28% rate, but you can only put so much in tax-deferred accounts, and really, gold doesn't belong there with no interest/dividends... here's the trick though.

Since the PP is so volatile in individual pieces, usually something's going down if gold is skyrocketing.  I won't use today as an example cuz we're in some crazy times with the economy and PP, but usually often you'll have some stock losses you can realize by selling them.  The "wash sale rule", though, gives you a 30-day break where you can't buy a security back unless you want to lose that loss.

If you're in vanguard or something, and were suffering heavy stock losses during gold gains... go ahead and sell the stocks... just make sure you go from TSM to maybe the S&P Vanguard fund, and you'll have relatively the same portfolio, will have just absorbed a bunch of losses you can offset your 28% gain with (and later take gains at 15% under current tax rates), and hopefully vanguard won't charge you BS fees for going from one of their stock funds to the other.

I am three beers in and sometimes go a little fast, so if you have any strategy questions let me know. 

Final Note:  Roth IRAs (employer plans don't always allow this, so be sure to check with the Roth 401ks) allow you to remove your contributions after 5 years w/ no penalty.  This can offer Roths flexibility that traditional plans don't have.

[moda0306]

Further, if you track your individual contribution to certain taxable funds in excel, you're allowed to use a method of gain recognition where you can go in and pick an individual security purchase and treat that as your sale... so when you sell gold, sell your most recent (high cost, low gain) purchases, and when you sell some security to offset it (if you have something like that in your taxable accounts), then pick the securities purchase dates where you paid the least for it to do your basis calculation.

If you track all this in excel, you can eliminate a lot of the problems of gold in particular, but any capital gain in general.  You're simply hand-picking your buy/sell dates and acting like "that security" is the one your selling, meanwhile recording as little gain as possible.

Careful with changing rates though.  You want to make sure that if rates on stocks go from 15% to 20% or higher, if you're going to be needing the money soon, it may make sense to take the gain now at lower rates, and have a higher basis when you sell 3 years from now at 20%.

[l82start]

thanks for all of this great information,

[moda0306]

BUMP.

Just thought there's some useful information here people may not have seen.

The key is using the flexibility these things have to offer.  Roth IRAs: you can pull your principal out, HSAs: you can pull money out for medical expenditures.

Any questions or comments are welcome.

[6 Iron]

Moda,

Thanks for the input. Do you see any differences in the above advice as one transitions into retirement, particularly if one retires prior to being able to withdraw from tax advantaged accounts without penalty?

[Lone Wolf]

This is excellent.  Thanks for the tax information.

I've often thought that with the Permanent Portfolio allowing you to "auto-pilot" so many investment decisions, there's not a lot of need for tinkering.  Tax minimization seems like it might be the best outlet for any spare "tinkering energy" a PPer might have.  That's probably a more profitable tinkering outlet than doing something unwise with one's Variable Portfolio. 

[moda0306]

6 Iron,

Yes, as you approach the point of actually needing the money, it becomes very important to have enough in taxable accounts to get you to 59.5.

Assuming you have the proper amount in your taxable accounts, but allocate the most tax-efficient assets to those accounts, your draw-dawn will begin to skew your portfolio.  At that point, it's just a matter of making sure that overall, your allocation keeps up.

As far as making sure you have enough wealth in accessable accounts, I really can't help with that.  It's up to you to decide how much you need for emergencies, early retirement, big purchases, etc.

I will reiterate, though, that a Roth IRA will let you pull out the principal penalty-free after it's been in the account for 5 years, so if you try to maximize that contribution every year, and keep track of the principal in your Roth accounts that allow distributions like that, then you have a lot of flexibility built up for withdrawals you may need.  (Roth 401k too... but sometimes your plan won't let you, even though the tax code will.  You should read up on your plan.)  Even HSA's, Educational IRAs, and 529 plans offer some degree of tax deferral, but withdrawals are allowed before retirement, for specific reasons of course.  Use those depending on your needs for future withdrawals within those categories. (Ie, if you have 2-3 kids, a 529 plan or ed. IRA will probably be very helpful.

[KevinW]

Yes, as you approach the point of actually needing the money, it becomes very important to have enough in taxable accounts to get you to 59.5.

There's also the option of taking Section 72(t) early retirement distributions.  The paperwork seems a little intense so my preference would be to try to get to 59.5 on Roth contributions alone.  But if that didn't work, there's always the 72(t) rule.

[MadMoneyMachine]

Here's something I'm having trouble wrapping my head around:

My taxable account is "Money I can't afford to lose(tm)" which means I need to invest in the Permanent Portfolio, right!?!

Yet, I could maximize tax efficiency by only putting LTBonds in my IRA.

But by doing so, my taxable account is no longer invested in a Permanent Portfolio, setting it up for risk, loss, no safety.

So which do I pick for my taxable account, safety (PP) or efficiency (no LTB)? Remember, it is "Money I can't afford to lose(tm)"!

I've pretty much come to the conclusion that PRPFX is the answer, even though it costs .82%/yr.

[MCSquared]

BUMP.

Just thought there's some useful information here people may not have seen.

The key is using the flexibility these things have to offer.  Roth IRAs: you can pull your principal out, HSAs: you can pull money out for medical expenditures.

Any questions or comments are welcome.

Thank you for the good information.

[moda0306]

MMM,

Great point, and I've thought about that same thing.  I guess money you "cant afford to lose" you should look at and ask yourself, "why can't I afford to lose it."

There's 2 major reasons: 1) someday you won't be able to work (retirement), and 2) you may lose your job for up to xx months (unemployment).  I can't think of too many other reasons you "cant afford to lose" money, as you should be insured for any other large loss (home, health, car, disability, life of family member, etc)

You should specifically make sure you have enough in a non-retirement account to cover #2 (unemployment) for a reasonable time... especially in a low interest rate environment, having cash represent this amount makes sense.  Anything for #1 (retirement) can and should be in a retirement account.

If you can think of other life incidents that would make you dip into a lot of that money, I'd like to know.  I'm still honing my strategy on all this.

[Jan Van]

Thanks for the write-up, moda0306!

One question, and of course this is for the VP :-), do you know anything about tax rules concerning commodity ETFs like DBC? Should they go in tax-sheltered or not? What I've read so far when googling this hasn't cleared up anything for me...

[craigr]

Many would say that you should look at your assets in total and not separate taxable/tax-deferred amounts. So I would think that all your money is the Permanent Portfolio regardless of how it is being saved.

[KevinW]

Yeah.  I think of all my assets as one huge portfolio, regardless of whether they're held in taxable or tax-deferred accounts.  Since securities are fungible you can effectively move assets between accounts by doing symmetric buys and sells at the same time.

[MadMoneyMachine]

Many would say that you should look at your assets in total and not separate taxable/tax-deferred amounts. So I would think that all your money is the Permanent Portfolio regardless of how it is being saved.

I've heard that also. But if my taxable account gets drawn down to a point where it won't last me until 59 1/2, then I would have to tap into the IRA early, which I could do penalty-free with SEPP. It would take some additional planning to accomplish. 

[KevinW]

Well if you have Roths, then you can withdraw your contributions (but not compound interest) from those penalty-free too.  Between Roth contributions and taxable accounts there can be a substantial moat of penalty-free withdrawals before you need to invoke 72(t).  Also I choose to keep cash taxable, which means I don't have to worry about whether volatility will cause me to burn through taxable accounts faster than anticipated.

[moda0306]

Ideally, you'd have your "emergency fund" in the form of $200-500 in a safe, whatever else you need for 6-12 months of living expenses in a savings account, and maybe some bullion in case of bad inflation.

The next level of liquidity, as Kevin points out, would be your roth contributions of over 5 years.  Those can be taken out penalty free.

The rest of the "money you need" can be in retirement accounts, as, unless I'm wrong, your inability to work is the only reason you'd "need" lots of money if you're properly insured.

[steve]

Thanks for the write-up, moda0306!

One question, and of course this is for the VP :-), do you know anything about tax rules concerning commodity ETFs like DBC? Should they go in tax-sheltered or not? What I've read so far when googling this hasn't cleared up anything for me...

DBC and other commodities etfs invest in futures contracts. They issue K1 forms which is a type of partnership that holders of the ETFs have with the fund, they pass income from dividends and capital gains to the ETF holder to be taxed on. This income is not distributed to the holder , the holder adds that to the total cost of their investment at the time it is sold. If you are comfortable with a K1 form I think it is ok in a taxable account, If you have it in a tax sheltered account I think you can ignore the K1 which would make it less complicated when it come to tax time. You may have to do further research. Once you understand how to fill out K1 forms it really is not that complicated.

[Jan Van]

Once you understand how to fill out K1 forms it really is not that complicated.

Thanks Steve! I was hoping my TaxCut software would know how to fill out K1 forms...

[walkerjks]

Once you understand how to fill out K1 forms it really is not that complicated.

Thanks Steve! I was hoping my TaxCut software would know how to fill out K1 forms...

Its pretty simple with tax software - tell them you have a K-1, and fill in the blanks.  What each sectoin really does is baffling to me, but the tax software figures it out for you.