Pick Your Taxable Account Allocation Wisely

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?