As you probably know, I am a proponent of using index funds for all of your accounts, including your taxable account. But with so many index funds out there spanning nearly every asset class you can think of, it can be difficult to choose which ones to use. I think that it is a very important decision, because changing your taxable portfolio can have potentially costly implications. Let me explain.
The Power of Compound Interest
Most physicians should be saving approximately 15–20% of their gross income each year, and should not need any money in the taxable account. Therefore, if you are investing for the long term, you should rarely be selling stock to pay expenses. Of course, there are exceptions with big lump-sum payments, such as a down payment for a house, a new car paid with cash, or your child’s tuition bill. You should not be selling stock to pay for routine expenses, and ideally, you should not be selling index funds to reallocate it to another index fund or asset allocation.
We all know about the power of compounding. This is primarily used to encourage young investors to invest early and often, reaping the benefits of compound interest. I’ve also used this argument to emphasize how important it is to keep costs low, as saving 1% on the fees to mutual funds or financial advisors can make a huge difference in retirement. Avoiding selling your index funds to reallocate it to another asset class is important, because doing so can be very expensive.
The reason for this is that each time you sell your index funds, you incur a taxable event. Hopefully, you have invested in this index fund for more than a year, so you pay the long-term capital gains tax, which is 15% for most physicians (20% for you specialists in the top 39.6% tax bracket). This decreases your ability to maximize your returns, because by paying long-term capital gains tax on your profits, those taxes will not be able to earn interest going forward. The absolute value of this is less than you think, because if you choose not to sell, of course you’ll have to pay the long-term capital gains in the future, when you eventually sell your stock. But you lose the ability to earn interest on your interest.
Asset Location
What all this means is that you have to choose your asset allocation of your taxable account wisely. One option would be to simply invest your taxable account with the exact same allocation as your retirement accounts. This is acceptable, but that’s not quite maximizing your returns because you have not taken advantage of asset location. In general, you would want to have stocks in your taxable account, while having bonds in your retirement account, because of the higher tax efficiency of the stock funds. While the value of asset location is questionable, particularly in the current low-interest environment, since you have to set your asset allocation early as an attending, I would follow the standard advice.
Which Asset Class and Mutual Fund
Once you decide what your asset allocation will be in your tax account, you need to decide which specific kind of stock index fund you will use. When making this decision, I advise that you keep things very simple, because you cannot change your mind without tax consequences. Specifically, I recommend that you use either an S&P 500 or a total stock market index fund.
This is not the time to become fancy and purchase more exotic index funds, such as small cap, value, or other slice-and-dice index funds which may have in the past been associated with better returns. Remember, you cannot change your asset allocation without tax consequences, and if you change your mind, or new research shows that a different asset class may be superior, you have no choice but to take a taxable event to reallocate your portfolio. The same thing goes for international and emerging markets index funds. If you prefer to have bonds in your taxable account, I would favor a total bond market index fund over the numerous slice-and-dice index funds that are out there. Again, there may be a strong argument for a specific type of bond fund, but bond market trends are cyclical, and you want to stick with something simple, so you don’t have to suffer tax consequences to reset your allocation.
Another reason why I favor keeping it simple in your taxable account is that I don’t believe that the index fund market has fully matured. There will be continued competition amongst the mutual fund companies, and the investor will benefit with improved index fund offerings offerings and declining expense ratios. For example, Fidelity introduced the Fidelity Total International Index Fund (FTIHX) in 2016, which is an international stock index fund that includes both developed and emerging international markets, as well as small-, mid-, and large-cap stocks. This is truly a total international stock index fund. This fund, in combination with the total stock market index fund FSKAX, enables you to have truly global stock exposure. They even offer this at a very low expense ratio (0.06%). If you invested in international stocks a few years ago in your tax account, you are locked into that mutual fund, and cannot take advantage of the new offerings at Fidelity and Vanguard can offer. Therefore, this is why I strongly recommend using only the index funds that you know will be the foundation of your portfolio, that is, either an S&P 500 index fund or Total Stock Market index fund. There is plenty of space to slice-and-dice and experiment in your retirement account, because there are no tax consequences to tweaking your portfolio.
An Example
For these examples, we will assume that a physician invests $25,000 in their taxable account at the age of 35 with an 8% annual return with a 15% long-term capital gains rate and liquidates the portfolio at age 70.
Example 1: The Physician Who Sells Annually
Because this physician sells his stock annually, he earns an after-tax return of 8% x (100%-15%) = 6.8% return. His initial $25,000 investment will be worth $249,996 at age 70.
Example 2: The Physician Who Switches Their Portfolio Once After 5 Years
This physician decided to change his allocation at age 40 after 5 years. Otherwise, he does not touch his portfolio, and his initial $25,000 investment will be worth $306,600 at age 70.
Example 3: The Set It And Forget It Physician
This physician will allow her portfolio to growth at 8% for 35 years, and pay long-term capital gains (15%) at age 70. Her initial $25,000 investment will be worth $317,939 at age 70.
ETFs Slightly Better Than Mutual Funds at Non-Vanguard Companies
ETFs are slightly more tax-efficient than mutual funds that track the same index. This is because ETFs don’t have to distribute capital gains, while mutual funds do. This can give ETFs a slightly higher after-tax return than mutual funds. As a Fidelity investor, I personally invest in the ITOT ETF in my taxable account, as opposed to the FSKAX mutual fund.
Vanguard’s mutual funds are structured like ETFs from a tax perspective, so you can use either a total stock market index fund (e.g. VTSAX) or its equivalent ETF (VTI) if you invest your money at Vanguard.
Conclusion
This article presents a relatively subtle, but important approach to your index fund investing. You don’t want to be in the situation where you have to unwind a portfolio because you are in investments that you don’t want to hold for the long-term.
What do you think? What is your taxable account allocation? Have you had to tweak it over the years?
Hi! I am a pulm-ccm physician in the South-wife is an MD as well. So for us, in our taxable account I use a Roboadvisor-I use Fidelity Go-I know-I could do it myself, and I know all about stocks, bonds, ETFs, indexing, etc…but I tend to tinker too much-So, I choose to let Fidelity do it for me-I have a small acct at Betterment, but worry about their sustainability, esp with all the big firms getting in the “robo” game.
The Fidelity Go portfolio is ok-sure it could be better I guess, but it does what it should, and it keeps me from trading/swapping out into supposed “better” portfolios.
Just my 2 cents–BTW enjoy your writing and hope the blog is successful!
Thank you for the kind words, DG. Fidelity Go is definitely a reasonable option for people who want to hand off their investments to a financial advisor. Have you considered a target-date fund and checking your investments rarely (e.g. annually)? If you’re worried about not being able to stay the course during market downturns, keep in mind that you can probably tell Fidelity Go to convert your money to cash or remove money from the service during a market panic.
Great points–but I only use the Fidelity Go for taxable investing–so only Muni Bond funds are used in that portfolio–for all my and my spouse’s retirement accounts we use target date funds or the Vanguard LifeStrategy Funds–I believe these are the best for us in our 401ks/IRAs/403b account given the taxable bonds. I try to keep it 80/20 stock:bond ratio and leave it as is. During 2008, kept adding more to them and made a good bit of $$$–so we can hang on when there is a market downturn and keep adding more.
DG
Sounds like you have a great, well-thought out plan that serves your needs and has worked out well both in good markets and bad.
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Great article! As a pediatrician in a high cost of living area, I only recently became able to start contributing meaningful amounts to a taxable account. I ended up deciding to go with a two fund approach, using Fidelity’s S&P 500 fund FUSVX (0.045% cost) plus their extended U.S. market fund FSEVX (0.07% cost). When combined in a 4:1 ratio it replicates their total US market fund FSTVX with an overall expense ratio of 0.05%. While this combination is slightly more expensive than FSTVX alone, it gives me the opportunity to tilt a little more or less to smaller stocks by changing the proportion of FUSVX to FSEVX with future contributions.
Portorafti — looks like you’ve found the taxable asset allocation that you will stick with for the long-term. Your asset allocation also allows you the flexibility to tweak your portfolio without tax consequences. Just remember to not let recent returns affect how you tilt, for example, don’t let the recent small-cap rally post-election cause you to over-tilt.
Reading this and other articles about fees got me thinking–For a $500 k portfolio Fidelity Go charges me $1750 a year. Over 20 yrs that’s going to be a lot of $$$– maybe should switch to a 2 or 3 fund portfolio. Have always liked the simplicity of VT ( vanguard total world). Don’t know what I’m going to do…..
The purpose of this post was to highlight the importance of sticking with a taxable asset allocation early in your investment life. Whether it’s Fidelity Total Stock Market, Fidelity Go, or some other allocation, an important consideration is that you will stick with it for the long-term to avoid the tax consequences of unwinding a portfolio.
Great to see some attention devoted to the often overlooked taxable account. I agree with choosing a simple portfolio of low cost tax-efficient index funds that you can set and forget. Since most of my savings (>80%) are in a taxable account, and since I prefer not to accept the risk of a 100% stock portfolio, my taxable account consists of 75% stocks (split between total stock market index and total international index) and 25% bonds (in an intermediate term tax exempt bond index). There might be a better allocation, but this seems to be one I can stick with for the next few decades without needing to sell prematurely.
Sounds like you have a plan that you can stick with. You do not necessarily need 100% stocks in your entire portfolio. One approach is to put more stocks in your taxable account and more bonds in your retirement accounts. This is the classic teaching on asset location, although WCI and others dispute the importance of this teaching.
Before really doing my research and understanding the stock market, I wanted to get something going for the long run. So, I opened a target-date fund in my retirement account. Now that I understand more about stocks, bonds, asset allocation/location, etc I have a 90/10 stock/bond allocation. I hold 100% stocks (split btwn VTSAX & VTIAX) in my taxable account and all of my bonds (BND) in my retirement account (along with the target date fund). I have now hit the point where I would like to keep investing but I have maxed out my retirement account, which leads to the issue of maintaining my desired asset allocation. This leads to my question… Is it better to exchange the target-date shares for more bond funds in my retirement account (to allow for my desired AA) since it is tax-sheltered, or is it better to keep the target-date shares and just purchase some muni funds (i.e. interm term tex exempt muni fund) in my taxable account? Is there an advantage to one over the other?
As always, I enjoy reading your blog and appreciate the insight!
Now that you want to exercise a little more control over your investments, I would exchange out the target-date fund for a bond fund. It’s in a retirement account so there won’t be any capital gains issues. My concern about municipal bonds is that they may not give the best returns unless you’re in the top tax bracket and can maximize the tax benefit.
A great post I love your site. Have followed WCI among others but looking for deeper dive on some of these topics.
I am a 50 year old cardiologist who decided about 3 years ago to ditch my 1% of assets under management FA. I was able to convert the accounts over to my name without selling the funds as my FA used Schwab as a custodian. I have a sizable taxable account and live in a state with state capital gains. My struggle right now is if It is worth converting my current actively managed funds to index funds which would of course trigger significant capital gains. I have tax harvested all I can. I put some in a Directed charity account. I am worried that if I incur the tax burden now I loose the compound growth going forward but then face the 1.2% drag on my return due to the high ER.
It is similar in some sense to rebalancing or changing AA in the taxable account.
Any thoughts?
Thanks again for your site and insight.
Great review as always, thanks Wall Street Physician. Excuse the basic question, but would it make any difference in your long term buy and hold examples if the individual had been purchasing ETFs of the Total Stock Market index fund (assume same ER) vs the fund itself? Any added tax efficiency?
There actually is some slight added tax efficiency with ETFs versus mutual funds, but this is only the case for non-Vanguard ETFs. However, the difference is relatively small, so I would not sweat it if you own FSTVX instead of IVV. I would, however, put future taxable account money into an ETF if you are with a non-Vanguard firm.
What your thoughts on Fidelity ETF ONEQ?
I’m not a fan. Expense ratio is 0.21%, which is higher than other index ETF, it has pretty low volume per day (50k per day), and it tracks the Nasdaq Composite, which is less diversified than the S&P 500 or total stock market.
Thank you. I agree and will stick with VOO.
I think maybe the caveat to this article is physicians early in their career. It’s true that you can’t sell profits without tax drag, but given the fact that the majority of earnings are in the future, the effect of dilution can be used to rebalance without selling anything.
Taking a 10% tilt in a small cap index fund on a portfolio of $50K amounts to only a 1% position by the time it reaches $500K, or a 0.5% position at $1M.
Obviously if the 10% strategy is maintained throughout, that’s a different story. But along the way there’s plenty of time to allocate new earnings in a different direction and achieve reallocation on a percentage basis without selling anything.
Thank you for writing this article. A couple questions for you.
1) In regards to your recommendation of FSTVX in a taxable account–what is your opinion of the fact that, because FSTVX has capital gains distributions, it’s not as tax efficient as an ETF ? I ask because I was considering investing in FSTVX in my taxable, but read that some investors were unhappy at the fact that the fund had capital gains distributions and that investors had to pay taxes on those distributions (as opposed to a similar-esque ETF, like ITOT or VTI, where they wouldn’t have capital gains distributions, and therefore would have no taxes to pay on them).
Is this a legitimate concern? Overblown? Somewhere in the middle?
2) As of now, I only have money in a retirement account, but I now have money to invest in a taxable. Some of the money in the retirement account is actually in FSTVX. Is it a bad idea to also invest in FSTVX in a taxable account if I have already invested some money in FSTVX in my tax-advantaged account?
And to be clear, I plan to take the approach of buy and hold for 30+ years.
Thanks!
Brian
I have updated the article to include my opinion that ETFs are preferred over mutual funds at non-Vanguard firms, for the reason you cited. At Vanguard, mutual funds have an ETF-like tax structure, so you can use VTSAX or VTI if you want to invest in the total stock market.
In a taxable account, do you advise dividend reinvestment in index funds? I can never find a clear answer and leave my taxable account for long term stock investments and just take the dividends as income. But I’m not sure if this is good for index funds, and don’t to deal with a tax nightmare someday of figuring when shares were bought and sold of even an index fund in a taxable account. Thank you.
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