I spoke to customer service when the rates were first revised and they agreed to grandfather me to the more-friendly rate schedule. This more-friendly rate schedule is still available at their sister brokerage Investrade.com.  The current rate is as follows:

Anyway, I started taking advantage of their low margin rates but in the first quarter, I was hit with a substitute dividend payment in an ETF I was holding in that account. This is the definition of a substitute payment from Fidelity:

Substitute Payments
Substitute payments are payments received in lieu of dividends, interest, or other payments. They may be generated, for example, where a security has been lent to a third party (such as a broker) over a dividend record date. When an investor has a debit balance in a margin account, securities in the account are often eligible to be lent. If the shares are lent over a record date, the investor should receive a substitute payment equal to the amount of the dividend. Although the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) introduced lower federal tax rates for qualified dividend income, substitute payments are not taxed as qualified dividends but are instead taxed as ordinary income. Substitute payments in lieu of dividends and tax exempt interest are reportable in Box 8 of Form 1099-MISC.

So basically, with a substitute dividend payment, you get taxed at the full income tax rate instead of the preferential (15% for most tax payers) qualified dividend tax rate (if the dividend was originally qualified).

The negative consequence of this could be huge. For an ETF like VEA, I could get a year-end dividend in the range of a few thousand dollars. If it gets disqualified, my additional taxes could run into several hundred dollars.

There are a few ways to avoid this

1. Move the assets to a brokerage that “gross-up” the dividends to compensate for the additional taxes you have to pay. I only know of two brokerages that have this voluntary program — Fidelity and TD Ameritrade. As far as I know, VBS (Vanguard) and WellsTrade do not offer this. eOption also does not offer this. Edit: Schwab also offers this voluntary “gross-up” program.
2. Move the assets to the cash position. Some brokerages let you specify the “account type ” of each asset, whether it is “cash” or “margin”. eOption offers this and I moved the assets that potentially produce qualified dividends to “cash”. I left the non-dividend producing assets in “margin”. I don’t believe VBS lets you do this though; all the assets in each account must be the same “type” in VBS.
3. Do not keep a debit balance. If we read Fidelity’s definition carefully, it says that if “an investor has a debit balance in a margin account, securities in the account are often eligible to be lent”. So technically if there is no margin balance, no shares should be loaned out. Personally, I do not regard this method as a fail-safe method. When you sign on the dotted line for a margin account, you are already giving permission to the broker to lend out your shares. It could be possible that the broker will refrain, as far as possible, from lending out your shares in this scenario, but I think there is no guarantee that this would never happen.

Note: FWIW, my experience is that method 3 seems to be true. Until the eOption experience, I have never received a substitute payment with the many margin accounts I have had over the years. The reason could be simply because I have never kept a margin balance except at eOption.

Reference

[1] http://www.fool.com/personal-finance/taxes/2003/12/05/dividend-tax-breaks-at-risk.aspx

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• January 31, 2008 — Tax harvesting from 529 plan? (0)

The following is a list of items to reduce income:

• If you have kids, and you want to help to pay for their college, plan to have more of it funded by 529 accounts. If you have to sell investments or draw down from tax-deferred accounts, that increases your MAGI.
• Pay off mortgage if possible to eliminate income requirement. Again, same thing as college funding, if you have to sell investments or draw down from tax-deferred accounts, that increases your MAGI. Without a mortgage, you have less need to realize capital gains or draw down from tax-deferred accounts.
• Derive income for ongoing expenses from tax exempt bonds (tax exempt income does not figure into MAGI).
• Use a short term tax exempt fund to hold non-immediate cash needs instead of a high yield savings account. Perhaps top up the checking account once or twice a month. This reduces the amount of interest payments reported in MAGI.
• Shift equity investments into lower yield equivalents, while still keeping the general composition of the portfolio reasonably unchanged. One potential candidate would be to invest in US LargeCap Growth instead of US LargeCap Blend. Does not work for US SmallCap (US SmallCap Growth has a poor historical record).
• Invest in rental property and use rental income to fund ongoing expenses (rental income is typically offset by property depreciation).
• Look into MLP investments that shield income for as long as the investment is not sold (you can control when to sell if necessary).
• Delay signing up social security.

Even though it looks like I could potentially benefit from the healthcare reform if I retire early, I don’t agree with the changes. They simply penalize people who are successful and are a disincentive to work. This can’t be good for the economy. But that is another story.

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• February 9, 2007 — Sell mutual fund with short term CG after distributions (0)

If I remember correctly, the increase in May 2009 was due to the increase in the tax bracket from 9.3% to 9.55%. This led to the corresponding increase in withholding from 9.3% to 9.55%. This is a reasonable change (I am just saying that the change in withholding is logical; NOT that the increase in tax rate is in any way logical in a recession).

Above: Tax withholding rates (before 11/1/09)

Above: Tax withholding rates (from 11/1/09)

In the most recent increase, the withholding rate was increased by 10%. For most people, this  increases the withholding from 9.55% to 10.505%. There is no logical reason behind this; the only reason for this was that the state government wants an interest free loan from the tax payers.

Below are some comments reported in the LA times regarding this change:

“Many families are sitting at their kitchen table wondering how they’re going to make ends meet,” said state Sen. Tony Strickland (R-Thousand Oaks). “At the same time, the state of California is taking a no-interest loan.”

Such temporary measures as the withholding tax increase don’t really fix the budget gap, “they just more or less hid it,” said Christopher Thornberg, a principal with Beacon Economics in Los Angeles. “I call it a fraud.”

But there is a way out of this:

Savvy taxpayers can get around the state’s maneuver by increasing the number of personal withholding allowances they claim on their employer tax forms, said Brenda Voet, a spokeswoman for the state’s Franchise Tax Board.

“People can get out of this,” she said, noting that most people would have to change their allowances through their employers. California’s budget leaders are banking on the hope that most won’t.

This is exactly what I did. I submitted the DE-4 form to slash my additional state tax withholding to zero and added the corresponding allowances as provided by the withholding guidelines. This will bring me very close to the 90%-mark for the amount of taxes to be withheld without paying an under-withholding penalty come April 15, 2010.

If you are in a situation to already receive a refund next year, take some time to update your withholding by completing the DE-4 form

http://www.edd.ca.gov/pdf_pub_ctr/de4.pdf

For all you know, as it already happened this year, when it is time to get your refund, the state might not even have the money to pay you and you will get an IOU instead. I would rather owe the state money than the other way round.

Additional links

[1] http://www.bogleheads.org/forum/viewtopic.php?t=45134&mrr=1257174149

[2] http://online.wsj.com/article/SB10001424052748703932904574511923279377100.html

[3] Sign the petition to repeal this additional withholding — No to Sacramento!

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• US LargeCap 11%
• US SmallCap 8%
• US REITs 4%
• US Timber REITs 4%
• US MLP (PIK dividends only) 4%
• INT EAFE 20%
• INT Emerging Market 11%
• PreciousMetal Equity 5%
• Fixed Income 33%

The ranking of the asset classes, in terms of tax efficiency (based on historical dividends), are as follows (most tax efficient at the top):

• US MLPs EEQ & KMR (with PIK paid-in-kind dividends only) : 0% taxed.
• US Timber REITs PCH, PCL & RYN: 0% taxed due to my enormous capital losses accumulated (see related post “Tax-Free Dividends from Timber REIT Investing” HERE).
• US SmallCap (IJS) : distribution yield ~2.0% will be taxed.
• PreciousMetal Equity (GDX) : distribution yield ~2.0% will be taxed.
• US LargeCap (IWB) : distribution yield ~2.8% will be taxed.
• INT EAFE (VEA) : distribution yield ~4.0% will be taxed.
• INT Emerging Markets (VWO) : distribution yield ~5.0% will be taxed.
• Least efficient : US REITs and Fixed Income.

The commonly sprouted ‘wisdom’ of putting International equities and emerging market equity in the taxable account so as to get the foreign tax credit is coming back to bite me now (and probably in future as well) with huge 4% (VEA) and 5% (EEM) distribution yields. This is ironic considering that VEA is simply just another class of Vanguard’s Tax-Managed International stock fund.

On the other hand, US SmallCap Value has a sub-3.0% yield but ‘experts’ usually would recommend putting this asset class into tax-deferred accounts.

Anyway, based on this analysis, I have been re-directing new money in the taxable account to the most tax-efficient assets listed above.

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With that in mind, investments that primarily throw off capital gains have become much more attractive to me (since my previously harvested tax-losses can be used to completely offset against these distributions, i.e. essentially tax-free). There are however very few investments that intrinsically throw off capital gains rather than dividends. (Note: Funds that actively turn over their portfolio, hereby producing capital gains, do not count.)

Nevertheless, there is a class of investments that do intrinsically produce capital gains. These are timber REITs. Generally, the dividends that timber REITs distribute are considered as long-term capital gains, instead of the more common dividend income distributed by general REITs.

The three most common timber REITs, all of which only produced distributions that were classified as capital-gains last year, are

• Potlatch Corporation (PCH).  Current dividend 9.3%.
• Plum Creek Timer (PCL). Current dividend 5.9%.
• Rayonier Inc. (RYN). Current divident 6.8%.

I always held an interest in timber investing. Several years ago, I had invested in PCL for a while before forgoing it. Given the new background scenario, I tweaked my portfolio last month to allocate a small portion into the above three timber REITs. (Disclaimer: Please do your own due diligence if you want to invest in the above securities.)

I shall not elaborate on the pros and cons of timber investing in this post. Instead, I shall leave the links to various discussions / resources on timber investing:

Introduction to investing in timber securities
Timber ETFs…Without the Timber?
Finding the Perfect Dividend Stock
Timber Investing: My articles on ETFs and REITs
Timber for the Individual Investor

Random list of previous posts:

Is there a recommended method of doing a TLH? I tend to like to TLH on market downturns if at all possible. Currently I start with the ETF that I would like to sell. I look at the bid/ask, and I generally choose the higher “ask” price to set as my limit order. Even though I’ve chosen a down day to sell this ETF, obviously I would like to get on the higher side of the bid/ask spread since I am selling. The moment the sale goes through I start working on buying the replacement ETF. At this point I do not like to miss the opportunity to complete the sale due to greed. I put my limit order at exactly the lower “bid” (not the higher ask) price. I observe it closely for a few minutes to half an hour to see what it’s doing. If it looks like it’s veering upwards I will raise my limit to the current bid price. If after a while it looks like I’m going to miss the boat, I simply raise my limit order to the ask price instead of the bid. Generally this will execute the order. Most of the time I execute both orders within a few minutes to half an hour without being hosed too serverely.

I thought it would be interesting to hear what people have to say. Anyway, the following is what I do:

I enter the two orders first, but with out-of-range prices using limit orders. I open two windows — one for the purchase, one for the sale.

At the point when I want to execute the TLH, I modify one of the existing order to the price which would complete the transaction. As soon as I verify that the order is completed, I modify the price of the second order (modifying an order’s price is much faster than entering the complete order).

Depending on the ETFs, sometimes I do the purchase first and sometimes I do the sale first. Generally, I like to complete the transaction with the lower liquidity / volume ETF first.

My preference for completing the transaction on the ETF with lower liquidity / volume first is because if I had done it the other way round, I might be unable to complete the second transaction at a reasonable trading transaction cost (due to undesirable bid-ask spread).

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Many investors are aware that when they sell a mutual fund or stock with a gain, they have to pay capital gains taxes for it. On the other hand, if they sell with a loss, they can claim a tax loss on it, as long as the transaction does not run foul of the wash sale rule. Fairmark has an extensive section “Capital Gains and Losses 101” that covers this in detail.

Unless an investor is selling the entire holding, it is usually best to identify specifically which shares are being sold. However, the identification part is somewhat confusing. The following paragraph from Fairmark explains why this is so:

The traditional way to specify the shares you’re selling is in the form of an instruction to your broker:

Sell 50 shares XYZ from the lot purchased on March 12, 2005.

This makes it sound like the broker has to do something special — possibly locate those specific shares, or at least make a record of some kind indicating what shares you sold. Some brokers will tell you “we don’t offer that service.” But in reality the only thing the broker has to do, besides executing the sale transaction in the normal way, is send you a written confirmation that you specified shares from the lot purchased on March 12, 2005.

This post is a review of my experience with specific share identification mutual fund redemption with Vanguard.

The Process

Prior to the day of redemption, I created a list of the tax lots I wanted to sell. These are basically the tax lots which have the highest cost basis and which will give me the maximum capital gain loss which I can claim on my tax return next year.

I then created the following message (which is a variant of the message, as suggested by seugene, from reference [1])

Subject: Specific Identification Sale of Mutual Fund

Dear Vanguard,

This is to inform you that for the following trade(s) placed today in my taxable joint account, I want to use the specific share identification method for capital gains calculation.

(A) Vanguard Total Stock Market Index Admiral Fund VTSAX, redeeming XXX.YYY shares from the following lots:

1) MM/DD/YY XX.YYY shares
2) MM/DD/YY XX.YYY shares

I understand that I am responsible for tracking my cost basis.

Please acknowledge that you have received this message.

Thank you.

Dated MM/DD/YYYY.

On the day of the redemption, I sent the above message via a secure email to Vanguard and then placed the sale of the specified number of shares online as per usual.

A few days later, I received the following confirmation:

Dear indexfundfan:

Thank you for your e-mail regarding your desire to use the specific share identification method (as defined in the Internal Revenue Code) for purposes of determining your cost basis. I am responding on behalf of your Flagship representative, XXX.

We acknowledge receiving your specifications, identifying the particular shares purchased on several dates to be redeemed from your Vanguard Total Stock Market Index Admiral Fund in the account #XXX. To assist you in making an adequate identification of such shares, we are confirming your specifications as outlined below in accordance with federal regulation section 1.1012-1(c)(3) of the Internal Revenue Code.

You are redeeming XXX.YYY shares from the following lots purchased on the following dates:

1) MM/DD/YY XX.YYY shares
2) MM/DD/YY XX.YYY shares

In the event you were using a different method to determine cost basis (for example, average cost method), you may need written consent from the Internal Revenue Service (IRS) to change to the specific share identification method. Consult your tax adviser if you have any questions concerning tax reporting methods or for additional assistance.

Please be advised that Vanguard’s recordkeeping systems support the average cost basis method of basis determination, not the specific share identification method. Therefore, it is your responsibility to keep sufficient records to support your basis determination under the method you have chosen, including but not limited to tracking the cost and related gain or loss of shares [exchanged, redeemed] for purposes of reporting that information to the IRS.

Additionally, since you are using the specific share identification method for tax reporting, any average cost basis statement that you may receive from Vanguard for this fund and account should be disregarded.

I have forwarded a copy of this e-mail to your representative. If you have any further questions, you may contact your Flagship Representative at 1-800-XXX, extension XXX. If your representative is unavailable at the time of your call, the next available trained representative will be happy to assist you. If you prefer, you may ask to be transferred to his voice mail. He will promptly return your call.

Flagship’s business hours are Monday to Friday from 8 a.m. to 10 p.m. and Saturdays from 9 a.m. to 4 p.m. Eastern time. You may also feel free to visit our website at www.vanguard.com, 24 hours a day, 7 days a week.

Sincerely,

XXX
Registered Representative
Vanguard Flagship Services

I printed a copy of the above to PDF and save it together with the secure email I had sent out a few days earlier.

That’s it. I now have a written confirmation that the brokerage had received my instructions to redeem specific shares of my mutual fund.

PS. The Fairmark article linked above has a brief section discussing the “legality” of whether an email confirmation (versus a paper confirmation) is sufficient. For my personal records, I am inclined to think that the secure email is sufficient, but another person’s situation could be different.

Reference

[1] Boglehead forum discussion.

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Here’s one article I read recently on the state of e-filing

We live in an age when everything is going electronic – credit-card bills, court filings, rent payments, even applications for Social Security benefits. We rent movies over the Internet and send e-mail from our cell phones.

Yet the federal government can’t seem to offer us an easy, online way to calculate and pay our income taxes.

…

The feds realize their position is somewhat ridiculous. Faced with a congressional mandate to cut processing costs by reducing the number of paper tax returns, the agency has worked with tax software providers to create Free File, which theoretically offers free federal online tax preparation and online filing to the 95 million taxpayers whose adjusted gross income didn’t exceed $54,000 in 2007.

I say “theoretically” because the IRS and the 19 participating companies in the Free File Alliance have structured the program to make it as difficult as possible to actually use it. Last year, just 3.9 million eligible taxpayers participated.

Free File is essentially a portal with links to special programs created by the 19 companies. But unless you already know about it, Free File is hard to find. It’s available only through the official IRS Web site, www.irs.gov. Participating companies can’t link to their own Free File offerings from their main sites. (To their credit, TurboTax and TaxACT offer free returns to a wide range of filers on their own sites.)

…

Why the crazy rules? Three years ago, some of the participating companies decided to offer free federal returns to everyone, without any income limits whatsoever. (Free File vendors typically make money from selling state returns and other extra services.) The literal free-for-all was great for taxpayers but costly to vendors. So they negotiated with the IRS to make sure such unbridled competition would never happen again

On a related note, I find it even more ridiculous that I have to pay additional to e-file using the tax software. You mean I have to pay additional money, so that an external vendor has all my sensitive information and the IRS has an easier time processing my return (as opposed to manual paper processing) and then take out cash from my bank faster?

Sorry, no thanks. I will rather send in my return through the good old USPS near the middle of April.

PS. I was made aware after preparing for this post that TaxAct appears to offer free federal filing for all. So it seems that I can file my federal taxes for free at TaxAct and file my CA state taxes for free at CalFile. The downside is that I would need to re-enter my information twice. As I have already bought the tax software, I might revisit this issue next year.

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A thought came to my mind — since unqualified distributions from the 529 plan are taxable, is it possible to tax harvest from the 529 plan?

I asked this question on the Bogleheads forum, and here’s a reply from LH2004 (who had previously demonstrated to have very good knowledge on tax matters):

Yes. See “Losses on QTP Investments” in Publication 970. You’ll be subject to the 2% of AGI floor, though, so you’ll need to have really extreme losses, or a big account, or low AGI, or other miscellaneous itemized deductions to reach that floor.

Alternatively, under the IRS’s new theory regarding wash sales, you could take the position that a sale of an individual portfolio in the 529 plan at a loss, followed by a purchase of a substantially identical fund in your taxable account, is a wash sale, increasing your basis in the newly-purchased fund, which you could then immediately sell at a loss; that would be an aggressive position to take.

Taylor Larimore kindly found the link to the relevant section in Publication 970 — http://www.irs.gov/publications/p970/ch08.htm :

Losses on QTP Investments

If you have a loss on your investment in a QTP account, you may be able to take the loss on your income tax return. You can take the loss only when all amounts from that account have been distributed and the total distributions are less than your unrecovered basis. Your basis is the total amount of contributions to that QTP account. You claim the loss as a miscellaneous itemized deduction on Schedule A (Form 1040), line 23, subject to the 2%-of-adjusted-gross-income limit.

If you have distributions from more than one QTP account during a year, you must combine the information (amount of distribution, basis, etc.) from all such accounts in order to determine your taxable earnings for the year. By doing this, the loss from one QTP account reduces the distributed earnings (if any) from any other QTP accounts.

At this point, it doesn’t look like something I would do.

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After I received the 1099DIV form from Sogoinvest, I noticed that all the dividends are classified as ordinary dividends, none of them are classified as qualified dividends. Also, for my VWO (Vanguard Emerging Market ETF) holding, the foreign taxes paid are not declared in the 1099DIV form. I know these are incorrect because the same ETF holdings held at Ameritrade had qualified dividends and foreign taxes paid declared in the 1099DIV form.

These incorrect figures are not good for me or investors in general because the tax rate for a qualified dividend distribution is typically only 15%, whereas the tax rate for an unqualified dividend can run as high as 35%. In addition, any foreign taxes paid by the fund can be claimed back as a credit in the tax return, dollar-for-dollar.

I requested Sogoinvest through their secure message system to issue me an updated 1099DIV. Here’s their “canned” reply:

We will look into this, the 1099 statements reflect what the IRS gave to us. So we will look into this and get it corrected if it needs to be as soon as possible.

Huh? I thought it is Sogoinvest who reports the dividend information to the IRS instead of the other way round? Anyway, I did not try to argue with them on this point.

I was not hopeful that I would get an updated 1099DIV on time, but there is nothing much I could do but to wait for an update. I also sent them a reminder some time after my original request. Then came April 14, but nothing. In the end, I filed my taxes without an updated 1099DIV, paying more in taxes than I actually need to. By my estimate, I probably paid about $50 more in taxes because of the inaccuracies in the 1099DIV form generated by Sogoinvest.

I do not know if this is an isolated case of an incorrect 1099DIV form, but if the qualified dividends and foreign taxes paid are generally not reported by Sogoinvest, then it will be a very big turn-off indeed.

Related links [1] [2] [3].

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You will be surprised by the amount of information covered. For a start, here is a list of topics in the library:

Table of Contents

I.References
A. Glossary
B. Investing: For Beginners
C. Books
D. Academic Research Links
E. About Vanguard and its Founder

II.Asset Allocation
A. Asset Allocation
B. Asset Location
C. Risk, uncertainty and behavioral pitfalls

III.Asset Classes

A. Equity
(a.) US Stocks
(b.) International Stocks
(c.) REITS
(d.) International REITS

B.Fixed Income
(a.) Bonds
(b.) TIPS
(c.) High Yield Bonds
(d.) Convertible Bonds

C. Alternative
(a.) Commodities

IV.Portfolio Management
A. Active vs. Passive Investing
B. Taxable account investing
(a.) ETF
C. Retirement and tax deferred investing
D. Rebalancing
E. Withdrawal Strategies

Random list of previous posts:

To use the new default method of HIFO, you need to sign up for the free Wells Trade’s Portfolio and Tax tracker tools. The following contains additional details which I am quoting from the sign-up agreement.

Highest-in, First-out Method of Designation (“HIFO”)

If a taxpayer holds more than one lot of shares of a particular stock or mutual fund purchased on different dates or at different prices and sells some of those shares without selling all of them in a single transaction it is necessary for income tax purposes to determine which shares were sold. Unless the taxpayer identifies the shares sold in accordance with applicable regulations and rulings or, in the case of a mutual fund, adopts an averaging method, the taxpayer is deemed to have sold the earliest shares purchased (the first-in, first-out, or “FIFO” method), even if a different selection of shares would result in a lower tax. If a taxpayer elects to use an averaging method for a mutual fund, the taxpayer must continue to use that method for that mutual fund all future years. In all other cases, the taxpayer may identify the shares sold at the time of the sale either by a communication to the broker relating to that particular transaction (“specific identification”) or by establishing with the broker that a particular method of identification will apply to all sales except as the taxpayer otherwise notifies the broker.

By using the Tools, I certify to WFI that I intend to establish with WFI that the equity and mutual fund sales in my Account will be identified by a method of identification under which the shares with the highest cost basis are sold first (highest-in, first-out, or “HIFO”) except as to (a) any mutual fund for which I elect (or have previously elected) an averaging method, or (b) any transaction as to which I have used a different specific identification in accordance with applicable income tax regulations.

I understand:

• The HIFO method will apply only to the equities and mutual funds sold through this Account.
• I can override the use of the HIFO method by making a specific designation at the time of a particular sale. This can be accomplished by placing my trade with an agent and informing the agent of the specific designation. HIFO will still apply to all other equity and mutual fund sales (except for mutual funds for which an averaging method applies).
• I can terminate the use of the HIFO method as to all subsequent sales by canceling my use of the Tools and notifying WFI of this intention in writing.
• It is believed that in many cases the HIFO method results in lower tax than the default FIFO method, but this is not true for all taxpayers or for all transactions of a particular taxpayer. In some instances, HIFO will result in higher tax than specific identification or FIFO.
• While the HIFO method is in effect for equities and mutual funds sold through this Account, this method of identification will be binding for federal income tax purposes (except in the case of a mutual fund for which I have elected an averaging method), unless I override HIFO with specific share identification. This is the case even if a different method would produce a more favorable result.
• The Tools will act as if the HIFO method applies to all equity and mutual fund sales, even those to which it does not apply because of specific share identification or the use of an averaging method for a mutual fund. It is my responsibility to deal with any resulting discrepancies.
• In some situations the Tools may fail to determine which shares have the highest cost basis for federal income tax purposes (e.g. due to capital changes or application of certain tax rules). I am responsible for dealing with any resulting discrepancy.

So, there you have it. You can sign up and let Wells Trade default to the more tax-friendly HIFO designation all the time. Personally I have signed up for this service but please be aware that I have not experienced first hand how well it works nor vouch for whether it works at all or not!

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The reason is because if the distribution is mostly long-term CG or qualified income, then by selling after the distribution, the investor can save on taxes, with the savings being attributable to the difference in tax rates between short-term CG and long-term CG (or qualified income).

The above obviously assumes no significant market price movements in the mutual fund. However nobody has a perfect crystal ball to predict future price movements; so with all things been equal, selling a mutual fund with short term capital gains after the fund distribution seemed to be a good strategy to adopt in such a scenario.

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For high income earners who are priced out of the Roth IRA, the 529 college savings account can become somewhat like a “giant” Roth IRA for you to sock away your savings, up to the limit of the estimated college costs. A Roth IRA is a great location for asset classes that have high expected returns but would otherwise be severely eroded by taxes due to high capital gains or dividend (especially the unqualified kind) distributions. This would include assets like the REITs, small-cap value and international small-cap asset classes.

Taking this view, one would then wonder why the 529 account should not be treated as part of the entire portfolio, instead of just treating it separately. When the 529 account is considered as part of the entire portfolio, an investor would have more freedom and less limitations as to where he/she can place the asset classes in the most efficient manner.

Conversation 54876 from the Diehards forum has a lively discussion on this issue. Personally I have not given serious thought into considering the 529 contributions as part of my portfolio but I believe it is an interesting idea that is worth exploring.

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• January 26, 2011 — Substitute Dividend Payments in Margin Accounts (0)
• March 27, 2010 — Reducing income during retirement to qualify for healthcare subsidy (1)
• July 30, 2009 — Squeezing out more tax efficiency from my portfolio (1)
• July 22, 2008 — Running out of tax-deferred space (2)
• January 31, 2008 — Tax harvesting from 529 plan? (0)

Section 415 of the Internal Revenue Code provides for dollar limitations on benefits and contributions under qualified retirement plans. It also requires that the Commissioner annually adjust these limits for cost of living increases.

Many of the pension plan limitations will change for 2007. For most of the limitations, the increase in the cost-of-living index met the statutory thresholds that trigger their adjustment. For example, the limitation under Section 402(g)(1) on the exclusion for elective deferrals described in Section 402(g)(3) is increased from $15,000 to $15,500. This limitation affects elective deferrals to Section 401(k) plans and to the Federal Government’s Thrift Savings Plan, among other plans.

The 401(k) limit increase of $500 from $15,000 to $15,500 represents an increase of 3.33%.

Deferring taxes is usually a good strategy since it allows your investments to compound faster; plus you will probably be at a lower tax rate during the retirement withdrawal phase. Personally, I would take advantage of this new limit as soon as the new year rolls in.

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The idea of placing equities in taxable accounts and bonds in tax-deferred accounts is not new. The reason for this recommendation is due to the differential tax treatment of capital gains and interest income. In a taxable account, capital gains (long term) are taxed at a maximum of 15% while interest income are taxed at the income tax rate of up to 35%.

Now consider the fact that tax-deferred accounts are always taxed at the income tax rate of up to 35% at withdrawal, regardless of whether the gains come from capital gains or interest income. What this means is that if we keep equities in the tax-deferred account, the more valuable capital gains rate actually gets “converted” into income tax rate, an undesirable situation. On the other hand, there is no such disadvantage if bonds are kept in the tax-deferred account since interest income is taxed at income tax rate anyway. Therefore, bonds are ideally placed in the tax-deferred account and equities in the taxable account.

Placing equities in the taxable account also has some other benefits, like ability to perform tax-loss harvesting, foreign tax credit, and the eventual stepped-up basis for the heirs

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There are many different types of money market funds; they are listed below in the following broad types:

1. Fully taxable at local, state and federal level, e.g. Vanguard’s Prime money market fund.
2. Taxable only at federal level, e.g. Vanguard’s Treasury money market fund.
3. Taxable only at local, state level, taxable at federal level if you are subject to AMT, e.g. Vanguard’s tax-exempt money market fund. (Note: The portion of the interest earned that comes from your state of residence is tax-exempt)
4. Taxable only at federal level if you are subject to AMT, otherwise it is fully tax-exempt, e.g. Vanguard’s California tax-exempt money market fund (for California residents).
5. Fully tax-exempt, e.g. Fidelity’s California AMT-free money market fund.

The following table summarizes the situation:

The reason why certain tax-exempt funds are subject to AMT is because they contain private activity bonds (e.g. bonds to build a shopping mall). Tax-exempt funds hold these bonds because they tend to have better yield.

Let’s calculate the net yield, with the effect of AMT considered, for an investor with the following tax situation:

State tax bracket 9.3% (California)
Federal tax bracket 28%
AMT bracket 32.5%

1) For a fully taxable fund, e.g. VG Prime MMF yields 5.10%
Net yield (no AMT) = 5.10% * (1 – 0.28 – 0.093*(1-0.28)) = 3.33%
Net yield (with AMT) = 5.10% * (1 – 0.325 – 0.093) = 2.97%

2) For a federal-taxable-only fund, e.g. VG Treasury MMF yields 4.69%
Net yield (no AMT) = 4.69% * (1 – 0.28) = 3.38%
Net yield (with AMT) = 4.69% * (1 – 0.325) = 3.17%

3) For a state-taxable-only fund, e.g. VG Tax exempt MMF yields 3.38%
This MMF has about 12.6% in CA and 17% subject to AMT
Net yield (no AMT) = 3.38% * (1 – 0.093*(1-0.126)) = 3.11%
Net yield (with AMT) = 3.38% * (1 – 0.093*(1-0.126)) * (1-0.17*0.325) = 2.93%

4) For a state-specific tax-exempt fund, e.g. VG CA tax exempt MMF yields 3.31%
This MMF has 100% in CA and about 18.2% subject to AMT
Net yield (no AMT) = 3.31%
Net yield (with AMT) = 3.31% * (1-0.182*0.325) = 3.11%

5) For a state-specific TE and AMT-free fund, e.g. Fidelity’s CA AMT-free MMF yields 3.19%
This MMF has 100% in CA and 0% subject to AMT
Net yield (no AMT) = 3.19%
Net yield (with AMT) = 3.19%

Interestingly, assuming my calculations are correct, Fidelity’s CA AMT-free fund turns out to be the best for an investor subject to AMT, despite the lower expenses of VG’s CA TE MMF.

The after-tax yields with and without AMT for the above scenario, and other scenarios for an investor in California are given below:

Note 1: The yields quoted are read from the respective website as of 2006-08-17.
Note 2: Most equivalent-yield calculators available on the web DO NOT take into account of AMT.

Update Nov 06, 2006
It appears that under California tax law, a mutual fund must have at least 50% of the income derived from California before that portion can be considered as state tax free. Under this scenario, the yield for the type 3 “state-taxable-only” money market fund is actually lower than the number shown in the tables above.

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Most people must have heard that the AMT tax brackets are ‘only’ 26% for incomes below $175k or 28% for incomes beyond $175k. This is not quite true. AlvinSch on Diehards forum has raised the issue a few times that AMT brackets are in fact regressive if your income is within the range of $150k and $400.2k (was $382k in 2005, see CNN article: “How the new tax law affects you”, May 17, 2006).

The reason why the effective AMT brackets are not 26% and 28% is because the effect of a phase-out of the personal AMT exemption for incomes above $150k by a quarter of a dollar for every additional dollar earned is ignored. The effect of the phase-out is to increase the tax rate by a quarter of 26% or 28% for incomes in the phase-out range.

Overall, the effective AMT brackets for a couple filing jointly for tax year 2006, taking the phase-out exemption into account, is as follows:

• below $62.55k : 0%
• $62.55k to $150k : 26%
• $150k to $220.04k : 26% + 26%/4 = 32.5%
• $220.04k to $400.2k : 28% + 28%/4 = 35%
• beyond $400.2k : 28%

As we can see, the AMT brackets are regressive and actually lower for the very rich with incomes beyond $400.2k.

Notes:

1) The income of $220.04k is the point at which AMT changes from 26% to 28%. This number, call this Y, occurs when your ordinary income, reduced by personal exemption, is $175k. The calculation to derive Y is as follows:

Y – E = 175000 where E is the personal exemption.

Y is above $150k and E is therefore subjected to the phase-out:

E = 62550 – 0.25(Y-150000)

Combining,

Y – (62550 – 0.25(Y-150000)) = 175000, giving Y = $220,040.

2) The number of $400.2k is the point at which the personal exemption completely disappears. This number is given by $150k + $62.55k/0.25 = $400.2k.

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