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Live webcast replay: It's not what you earn. It's what you keep.

June 17, 2013

Replay and transcript from a recent Vanguard webcast

Should you minimize your taxes or maximize your after-tax returns? It may sound like two sides of the same coin but the distinction is critical as it pertains to your portfolio.

In this live webcast aired May 23, 2013, Maria Bruno and Joel Dickson of Vanguard's Investment Strategy Group had a spirited discussion on how to be a tax-efficient investor, including using tax-advantaged accounts, locating your investments in certain funds, and even how your investment behavior can play an important role to keep more of what you earn.

Watch the full replay »


Rebecca Katz: Good afternoon to you and welcome to this live Vanguard webcast. I'm Rebecca Katz and whether you're joining us today from your computer, your smartphone, or your tablet, we're thrilled that you could be here today. We are going to be talking about tax-efficient investing, and this is really how to maximize your after-tax returns. Now, that's a really timely topic, because some of us are still smarting from paying those tax bills last month and because maximizing after-tax returns has been in the headlines this week. With us here to explore and explain this topic, at least how it pertains to you and I as investors, are two of Vanguard's experts in this area, both from Vanguard's Investment Strategy Group: Joel Dickson and Maria Bruno. Thanks for being here.

Joel Dickson: Thanks, Rebecca.

Maria Bruno: Thank you.

Rebecca Katz: It's been said that people who complain about taxes can be broken into two groups: men and women. None of us like having our investment returns eaten away by taxes, but how many investors deal with this is they try to minimize taxes rather than maximize after-tax returns. Now I know this may sound like semantics to you, but actually these two approaches are very different and can have different consequences on your portfolio. So Joel and Maria will explain this concept to us. They'll also share their perspectives on the current tax landscape. They'll talk about tax-efficient spending and retirement, and also the importance of maximizing your tax-deferred options.

But really this webcast is not about my questions to them: it's about your questions to them. So you can send questions our way. We've gotten many in advance, but you can also send them through your computer or you can tweet them to us using the hash-tag VGLIVE and I will see them here on my tablet.

Joel and Maria, what we usually do is we take the pulse of our audience by asking a polling question. So I'll do that and then come back to you. Our first question should be on your screen, and what we would like to know is "how confident are you that your investment portfolio is tax-efficient?" Very confident, somewhat confident, not at all, maybe you're unsure. So vote now and in just a few seconds we'll have those responses.

Joel, we'll come to you first with a question. Let's talk about this concept of maximizing after-tax returns. What does that really mean for us as investors?

Joel Dickson: Well, actually I want to describe that by, if we can, putting up a visual that we have describing different ways that people think about building portfolios from an after-tax basis. And I think the most important thing to consider is that it's not about minimizing taxes necessarily: it is, as you said, Rebecca, about maximizing after-tax returns. And the key way or the best way in many cases to maximize after-tax returns is actually to maximize your tax-deferred account contributions and opportunities. It might be an IRA or a 401(k), a college savings plan, but tax-preferenced accounts—even though you're not paying taxes and people don't necessarily think about it as "I'm being tax-efficient because I'm not worrying about the tax piece of my portfolio"—but in fact, having as much in tax-deferred opportunities as possible is a really good way to maximize that after-tax return. As this example shows there's—and just to set it up a little bit, the example assumes a $5,000 annual contribution on a pre-tax basis over a 30-year period with a 7% return, 25% tax rate—and you can see that the biggest difference in the height of the bars comes from the tax-deferral options of the IRA, versus non-deductible contributions or taxable account investments in the other three cases.

Rebecca Katz: I see. Well, we're going to come back to that topic in a little bit with a polling question, but let's see if we have the results of our first poll. Let me take a look. We talked about "how confident are you that your investment portfolio is tax-efficient," and actually a good number of our viewers are fairly confident. We have 51% of viewership saying they're "somewhat confident" and another 18% saying they are "very confident," so the majority feels pretty good. Hopefully we'll be able to give you some further tips during this webcast, or at least test whether or not you are, in fact, tax-efficient within your portfolio.

So Maria, Joel touched on this idea of maximizing IRAs, 401(k)s; I didn't know if you wanted to talk about that a little bit further or if there are other ways of being tax-efficient within your portfolio.

Maria Bruno: I think Joel's point was very relevant. I mean, you can't avoid taxes, right? We can't. The best you can do is manage that, and I think you can do that in one of two ways. One would be to think about what type of accounts to invest in. As Joel had mentioned, one way to do that is to maximize tax-advantaged accounts. And then—I think we'll talk a lot about this today—is once you establish your accounts, how do you allocate? So, you know, how do you put the puzzle together in terms of investment selection? Those two decisions come together and really serve as the basis for tax-efficient investing.

Rebecca Katz: I guess I would put this question to you. We talked about not trying to avoid taxes; what are some of the big mistakes that investors make when they do seek to do that first?

Maria Bruno: Sometimes it's "kick-the-can-down-the-road" with taxes, right? I don't want to pay taxes today; I'll defer this and pay it later. Because it's natural not to want to pay income taxes today. It's human nature; none of us enjoys paying taxes really, but that's not necessarily the best thing. So it's really trying to understand: okay, the reality of it is there are going to be either capital gains taxes or income taxes at some point on some of this, so how do I manage my current tax liability, understanding what the implications are down the road?

Again, we don't have a crystal ball; we don't know what the future tax regimes will look like. But what we can do is look at what the current tax structure looks like and try to have balance, for instance, between accounts. We'll probably talk about this today in terms of tax diversification. Much like [with] asset allocation, we hold different types of asset classes to try and weather out the different market cycles. The same thing with tax planning and accounts; holding different types of accounts so that you have the most flexibility down the road, regardless of what the tax regime looks like. Having that dual lens is really a good approach.

Joel Dickson: I think the other thing that people really have to think about, in tax-efficient investing in their overall portfolio, is [that] it's just as important to focus on your own behavior as well as the behavior of the portfolios or the funds that you're using. And the way I like to talk about it is [that] it's not enough to just select tax-efficient investments. You also have to be a tax-efficient investor. And so if you have these tax-efficient investments, and then you sell out of them three years down the road, well, okay, maybe you didn't pay capital gains from the underlying investments, but then you generated possibly capital gains in your own activity and undid all of the tax effects that you were trying to capture. And tax effects, like other cost-type issues, tend to compound or have a better chance at seeing greater value over longer holding periods, longer periods of time.

Rebecca Katz: Right, especially when tax rates decline for holding them longer.

Maria Bruno: And it's important to be tax-sensitive throughout. So when you're rebalancing, for instance, if you're drawing assets, even tax-loss harvesting, to the extent that you need to sell items, you can be tax-savvy as best as you can with these types of implementations.

Rebecca Katz: Okay, great. I think we'll get into some specifics when we start taking viewer questions. But why don't we take a second and ask our viewers another question. On your screen you should see our second polling question. We were just talking about things like IRAs and 401(k)s, so we would like to know: do you contribute regularly to one of these tax-advantaged accounts, whether it's an IRA, 401(k), 403(b), something like that? "Yes;" "yes, but I don't max out, I don't contribute the most that I possibly can;" or "no." So respond now and we'll come right back with the results.

If you'd like, we have a lot of questions to answer. We could jump right in.

Joel Dickson: Great.

Maria Bruno: Let's do it.

Rebecca Katz: Okay, let's take a look at what we have here. Can we queue up the questions? Thanks. Our first question is from Kathleen in Stillwater, Minnesota, and Kathleen asks, "How do I even begin to navigate this seemingly limitless, complicated web of taxes? I'm planning for retirement in a few years." So she has a shorter time horizon; it seems really complicated. Maria, do you want to take this one?

Maria Bruno: You know, I think [we should] start to break it down a little bit. One thing that I took from this question is that you're retiring in a few years. So that gives you some flexibility during your working years to look at your tax situation. As you're contributing to your accounts, really think about which type of account. Perhaps you might be short on Roth accounts; then you might be able to direct these cash flows into a Roth IRA, or a Roth 401(k) if your employer offers that. So you have some flexibility to think about. You may not know exactly what your future retirement tax picture looks like; you might have a sense, and if so you can maybe have some strategies now in terms of where to direct flows. One thing might be: maybe if you have a lot of traditional assets, think about a Roth conversion, either now or maybe later when you retire, if your tax picture might change.

Rebecca Katz: And just in case any of our audience doesn't know what the difference is between a Roth and traditional IRA or 401(k), could you define that?

Maria Bruno: Oh, sure. With a traditional 401(k) or IRA, the contributions are made on a pre-tax basis. Typically you'll make the contributions, get a tax deduction in the year of contribution, and the account grows tax-deferred. Later when you take withdrawals, they would be taxed as ordinary income. With a Roth IRA, the contributions are made with after-tax dollars. So you don't get the tax deduction upfront, but the account grows tax-free. Assuming that it's a qualified withdrawal in retirement, for instance, the proceeds would not be taxed. So it's really just [a question of] when the taxes are paid. Just like the tax situation is different when you make contributions, likewise on the withdrawal.

Joel Dickson: And I would just highlight that part of the question about this—what was it, "seemingly maze of uncertainty" around taxes—and that goes to, I mean, you could make that same argument around investments. What's the return going to be on this asset class versus another asset class? I don't know. How should I allocate my portfolio? And this brings up the concept of uncertainty with respect to what the tax situation will be. There might even be a maze now, but what will it be when you're actually withdrawing in retirement? Will the tax rates be different? Will there be different types of accounts? Will there be different types of taxation and so forth? And so that gets into this concept of how do we deal with that on the investment portfolio; we diversify, right? We have small-cap stocks and large-cap stocks and international and U.S. and bonds and so forth. [The] same type of principle can actually apply with respect to tax issues, which is that they're—as Maria was explaining around the traditional and the Roth—there are different types of accounts that have different tax treatments.

With the traditional IRA, you're taxed in the future at withdrawal. With the Roth IRA, you're taxed today. And assuming rules don't change—which, of course, is an assumption—you will get tax-free withdrawals assuming certain conditions are met in the future. Well, now you have a tax today versus tax tomorrow, which is a natural diversification, which you can do on a tax basis because there is uncertainty about what your tax situation will be in the future; and so you can balance those types of accounts.

Rebecca Katz: Right, and you have options when it is time to withdraw.

Joel Dickson: That's right.

Rebecca Katz: So we actually asked our investors what types of accounts they have, and if they're using them, and we have those results in. We asked if you contribute regularly to one of these tax-advantaged vehicles and, again, we have a smart audience today. We have 61% or almost 62% [who] say they do contribute regularly; 6% percent say they do but they don't max out; and only about a third either don't have opportunities to invest in them or don't use them. I should say we make an assumption that everybody has access to these, and a lot of people have 401(k)s, but not everyone, especially if you're something like a small-business owner, although you could have some types of IRAs.

Joel Dickson: And also with either IRAs or 401(k)s, you need to have earned income.

Rebecca Katz: That's true. So if you're a retiree, you really can't, right.

Joel Dickson: Right.

Rebecca Katz: Great. Let's jump back into questions. Our next question is from Robert, and Robert says, "What is the hierarchy for spending sources for living expenses during retirement?" So basically, in what order should you take money out to use for retirement spending: cash first, then tax-exempt sources, then taxable accounts, then IRAs? Is there a one-size-fits-all solution to this?

Maria Bruno: Well, there's a general guideline on this, and it's a really good consideration because taxes are like a cost. Much like investment costs, taxes will, at the end of the day, eat into what the net income would be from these accounts. So tax-savvy withdrawal is really one great way to think about retirement withdrawals and to maximize the longevity of the portfolio.

That said, generally speaking, if you have different buckets, you'll want to spend from taxable accounts first and let the tax-advantaged accounts—the 401(k)s, the IRAs—grow tax-advantaged as long as possible. There are two reasons. One reason is to enjoy the tax deferral. The other thing is, in the current tax environment, distributions from taxable accounts are taxed at lower rates. Capital gains rates are lower than ordinary income tax rates. So if you do take withdrawals from the portfolios and taxable accounts, it's more tax-advantageous, generally speaking.

Then when you start drawing down from tax-advantaged accounts, it becomes, well, do I take from the Roth or the traditional? And that sometimes is really looking at tax expectations. So if you think you might be in a higher tax bracket later, then you may want to take from traditional assets first—the deferred assets—because again, they'll be taxed at ordinary income tax rates. So you're paying, presumably, at a lower rate today.

And if you have reverse expectations, then the order would be reversed. Most people don't necessarily know what the future tax rate will be or [what] their situation would be; so if you do have the different types of accounts, really take a look at what the tax situation is this year. Maybe there's a way to manage the brackets. For instance, if you're in a certain bracket, you might be able to take additional—or generate additional—income without increasing your tax bracket. Really look at it—maybe on an annual basis—look strategically: do I have a normal or abnormal tax return situation that might warrant changing that order?

Rebecca Katz: So it's important to think through this before you take action.

Maria Bruno: Oh absolutely, yes.

Joel Dickson: And I think, a couple of tips too around making sure you don't end up paying taxes on taxes. What I mean by that is there are going to be some tax situations that might occur naturally. So for example, when you're rebalancing, you might be rebalancing those investments that did better than other investments, right? So you might be realizing gains if you have a regular rebalancing plan, all else equal. Or, you do get distributions from funds and other investments occasionally, whether it's income distributions or dividends or even sometimes capital gains distributions. If you are reinvesting those distributions and then you sell the fund or the investment at some additional gain, there might have been a way to manage the cash flows in a more tax-efficient way.

For example, especially in retirement, where you might be spending income out of your portfolio, there are certain things that you might think about doing that might be a little bit different. So in an accumulation phase, if you're growing your portfolio and so forth, reinvesting distributions may make sense from that standpoint. But you might consider in retirement having the distributions go to a money market account or a bank account—your spending account—as a way either to rebalance your portfolio if you don't need it to spend, because you then aren't going to incur additional taxes through your rebalancing because you've already paid the taxes (because those are taxable distributions), or as actual spending, as income. Because again, there's nothing you can do about those distributions in terms of a tax standpoint. You're already going to be taxed on them.

Maria Bruno: In taxable accounts.

Joel Dickson: In taxable accounts.

Maria Bruno: Exactly. Joel's really talking about the taxable accounts.

Joel Dickson: That's right.

Rebecca Katz: Right; within tax-deferred accounts, it all gets taxed at the time it all comes out.

Maria Bruno: Exactly.

Joel Dickson: Right.

Rebecca Katz: Great. All right, our next question is from Erica in San Marcos, California. Thanks, Erica. And she asks, "What types of investments—bonds, dividend-paying stocks, growth funds—should be held where, within an IRA, outside the IRA? Thanks for your help." So are there better places to hold different types of assets than others?

Maria Bruno: Of course there are, yes. Yes there are, and that's what we commonly refer to as "asset location," in terms of where do you place different types of investments in what type of accounts. The general rule of thumb is to place tax-inefficient investments, things that generate a lot of income that may be subject to taxes, within tax-advantaged accounts; and hold tax-efficient investments in taxable accounts. Things like broad-market index funds, for instance, or municipal bond funds—those that may be more tax-efficiently managed or are not subject to income taxation—in taxable accounts.

Rebecca Katz: Now, before we went on air we were having a little discussion about this, because I think sometimes we think about it as, you know, bond funds throw off a lot of income and so you should hold those in, say, an IRA where you won't get taxed on that.

Maria Bruno: Yes, that's an easy one. Right, yes.

Rebecca Katz: But Joel actually had a different perspective on this and I wondered if you'd share.

Joel Dickson: First, on asset location, I would just go back and say, as that first chart that we had up showed, the most bang for your tax buck, if you will, is by actually maximizing tax-deferred opportunities. So asset location is kind of like the frosting on the cake; it helps a little bit but it's not nearly as impactful as maximizing the tax-deferred opportunities. And where it matters most is the closer that you are to a 50-50 stock-bond split of your portfolio, and a 50-50 split between assets held in tax-deferred accounts and taxable accounts. That's where you maximize the benefits from asset location.

In the current environment, though, really the benefits from asset location come from deferring what would otherwise be a lot of taxable income, which is why you normally would have taxable bonds in tax-deferred accounts. In a low-interest-rate environment, though, where we have been recently and may continue to be going forward, you are actually not deferring that much in taxes because you have lower yields if, in fact, you are holding taxable bonds in tax-deferred accounts. So while asset location still matters—it's still helpful a little bit—its impact even right now in the current environment is less than what it normally would be.

Rebecca Katz: I see. Actually we have some similar questions along these same themes about where to put money, where to take money out. The first one is from David and he says, "When I withdraw money from a traditional 401(k), what's taxed? Is that entire amount taxed as ordinary income, or is it just the earnings?" That is important to talk about, when money is coming out, how taxes are applied.

Maria Bruno: Right. So with a traditional 401(k), pre-taxed, where you were able to enjoy the deductions on the contributions, the entire balance is considered a pre-tax balance, meaning the entire pool would be taxed upon withdrawals. If you make any type of contributions on an after-tax basis, like a non—

Rebecca Katz: A Roth 401(k)?

Maria Bruno: A Roth 401(k), right, so those contributions are made with after-tax dollars. Because they fall under the Roth rules—it is a Roth 401(k)—the withdrawals would not be taxed if they're qualified. But something like a non-deductible IRA, for instance, you don't get the tax deduction up front so, therefore, when you go to withdraw monies you're not taxed again on that basis—the contributions—it's really just the earnings. And that's where it's really important to track what are the contributions versus what are the earnings; that way you're not taxed again when you take withdrawals. And that's up to the investor, the taxpayer, to track that.

Rebecca Katz: I see.

Joel Dickson: And sometimes there are plans that are set up—even employer-sponsored plans—to allow after-tax contributions, that aren't necessarily Roth contributions. Typically they've been older plans established a while ago, but in those cases it would work much like the non-deductible IRA that Maria was talking about, where it would be a pro rata share of the earnings and the [cost] basis in most cases.

Rebecca Katz: I see. Okay. Our next question is from Glen in California, and he says, "I am retired, and if I believe the stock market will decline substantially, should I go to cash and avoid the drop, since I have a short time horizon to recapture losses?" So doing this type of market-timing in order to have a tax benefit.

Joel Dickson: There are a number of things that are within that. First of all, if you're going to go to cash right now, we don't know what the market's going to do. What we do know for certain though, most likely in anyone's portfolio recently, you've actually probably had gains if you're broad-based stock investing, so you're going to realize gains and pay taxes if it's in a taxable account, just from that type of transaction. And you can think of that as a fairly significant hurdle rate—that the market would have to go down significantly, if that's the case, for that to even pay off. Now that said, I think also what was embedded in that question was a strategy of potential loss-harvesting, which is if you have a loss on an investment, realizing that loss can actually help from a tax situation in many cases, because losses can often be used to either offset other gains in your portfolio, or even to deduct—usually up to about $3,000—off of ordinary income [for] tax purposes.

Rebecca Katz: I see. So you may, in fact, at year-end or as you're doing your tax planning, see some advantages in selling something that has lost ground.

Joel Dickson: It can. You can get some advantages from selling losers. Just like deferring taxes if you have gains is good, sometimes selling losers can be beneficial.

Rebecca Katz: Okay, great.

Maria Bruno: And the only caveat I would add to that is just remember your asset allocation, so don't do tax strategies and forego your asset allocation. So really, you need to look at both of them.

Rebecca Katz: Okay, great. Great tip. Louis asks a question about the bond market, [a] similar type of question: "In today's and future bond climate with very low returns, are tax-deferred accounts—" well, we sort of touched on this, the best place to hold taxable bonds. So Louis, I think we got to your question as we were putting it in the system. Our next question is from Thomas, who asks, "Can Vanguard help me with tax location advice?" So we do offer financial planning; is this one of the things that we cover in our financial planning services?

Maria Bruno: Yes, absolutely. With our advice services we do practice asset location and other tax-sensitive strategies. We'll work with our clients in terms of helping them determine, if they're making contributions, where to direct the flows; if they're taking distributions, how to take those tax-efficiently; how to locate assets; rebalancing; those types of strategies from an asset-allocation standpoint but also a tax-efficiency standpoint.

We also have a lot of information on our website, our tax center; there are a lot of good articles and tips that general investors might be interested in as well.

Rebecca Katz: Okay, great. Our next question is from Charles in Hardy, Virginia, and Charles asks, "Are there any strategies specifically for dealing with RMD requirements?"—and that's your required minimum distribution, that you are required to take when you are 70 and a half, from your IRAs. Maria?

Maria Bruno: Well, the RMDs are mandated by the IRS. So if you have deferred assets, traditional 401(k)s or IRAs, you do have to start taking distributions based upon IRS life-expectancy tables every year. So you can't escape them. What you can do potentially is, if you're not to the RMD stage, there are a couple [of] tax strategies. One of them might be, if you have large traditional assets, maybe look to see, does a conversion make sense to a Roth? And the reason is Roth IRAs are not subject to lifetime RMD requirements. The IRS doesn't mandate during the owner's lifetime that withdrawals have to come out. So if you're thinking about maybe passing those assets on to future heirs, then you're paying income taxes today; however, there's a benefit of tax-advantaged growth going forward. So there may be some tax strategies that you could take to try and minimize RMDs.

Rebecca Katz: So it depends what your actual purpose for that money is.

Maria Bruno: Yes, exactly. If the account's getting taxed, for instance, even with a conversion, it will get taxed with an RMD. It's just really—are you paying the taxes now in order to try to maximize this overall after-tax wealth of the portfolio?

Joel Dickson: Yes, and just to be clear, if you do a conversion, you do have to pay taxes on that converted amount. But it often does come down to what your tax rate is today versus what it'll be in the future, as to how to make that decision. I would just reiterate the point that I made about reinvesting distributions in a taxable account. You can think about that in the same way [for] your RMD. You're going to have to take it, if you have a traditional IRA and you're 70 and a half; you're going to have to pay taxes on it, assuming normal tax situations. So, consider that now as part of your spending account, if you're using it for retirement income purposes. If you don't and you're going to reinvest it, now it's being reinvested in a taxable framework, that is, in a taxable account, and so you might be thinking about your asset allocation somewhat differently, or you might be thinking about the types of investments somewhat differently, in that account.

It's also an opportunity, and Maria and I were talking about this just yesterday, about RMDs being a way to rebalance at the same time between your tax-deferred and taxable accounts, or the types of investments that are in your tax-deferred accounts. So you might have, for various reasons, both a stock and a bond investment in your tax-deferred account; you might want to take the RMD from one of those two in order to maintain an overall asset allocation, for example.

Rebecca Katz: That makes a lot of sense. Well, we have a question about that taxation of doing conversions, so why don't we talk about that in a little bit more detail. Theresa from Sunnyvale, California, says, "What are the tax consequences of converting a traditional IRA to a Roth?" So you mentioned that when you do a conversion you pay tax. Do you want to expand on that a little bit? Do you pay all the tax? Is it on the whole amount? Does it have to be outside money?

Maria Bruno: The way to remember it is, it is the pre-tax balance of the IRA. So pre-tax means if it's a tax-deferred IRA—so if I got the deduction in the year of contributions—the whole amount is taxed. And what happens is you take the distribution and then you have to report that income when you do your tax return. At that point it increases your adjusted gross income. So it is an income item that you then have to pay income taxes on. So you need to think about the conversion in light of what your entire tax picture looks like.

Specifically, what will this conversion do to my overall income? Could it push me into a higher income tax bracket, a higher marginal bracket? I want to be sensitive about that. If so, you could do a partial conversion. It's not an all-or-nothing decision. So you could do a partial conversion, maybe stagger it over a couple of years. There's a lot of flexibility to deal with this conversion decision if that's something that is deemed advantageous.

Rebecca Katz: What happens if you do this conversion? Let's say you convert, I don't know, a $50,000 IRA into a Roth IRA and then you realize at year-end, that was a mistake, I probably shouldn't have done that, it pushed me into a much higher tax bracket, then what?

Maria Bruno: Well, there is some flexibility with Roth conversions, and this doesn't happen very often with the IRS: they do allow a do-over. So you can, if you realize you don't want to do it or maybe you don't have the income to pay the taxes, you can undo the conversion by re-characterizing it back to a traditional IRA. You do have some flexibility. There are some time constraints to do that, but you have, typically, if you file a timely tax return or file for an extension, until October of the following year to actually do the re-characterization. So there's some flexibility there for a do-over. It can get a little complicated in terms of deciphering what the earnings might be and what-not, if you're doing a partial re-characterization, so you might need a little bit of help, but absolutely you can undo it if that's something that you feel you need to.

Joel Dickson: And actually there are a whole host of strategies around re-characterizations. For example, not just if you found yourself maybe not able to pay the tax or not wanting to pay the tax, but even after you did the conversion, if the value of the assets fell. Let's say it was in a stock fund and the stock market fell. There might be a strategy to re-characterize back to pre-tax, because now if you were to do the conversion you would actually have less of a tax bill, because what matters is the value of that account at the time of the conversion, in terms of your income.

Now there are rules around this, when you can and when you can't, but there's certainly a lot more flexibility that's allowed with this do-over.

The other thing that I would just highlight with traditional-to-Roth conversions is that the value of those conversions is often higher if you can do it at lower tax rates today—and especially relative to the future—and/or if you can pay the tax using non-tax-deferred proceeds, that is, if you have value in a taxable account that you can use to pay the taxes, because effectively what that means is you're sheltering more in tax-advantaged accounts. Think of it this way: $5,000 of pre-tax money is different than $5,000 of after-tax money. That might seem a little strange to people: "What do you mean? I have $5,000."

But in the pre-tax money case in an IRA, there's also an embedded tax liability in the future on that $5,000; whereas, in the Roth IRA, assuming you meet the conditions for withdrawal from a Roth IRA, that $5,000 is worth that full $5,000. So the more that you can shelter within a tax-preferenced vehicle, and in this case by converting to a Roth and taking taxable money out of your taxable account and effectively using it to pay the taxes to not lower the value of your account in dollar terms, you've effectively put more to work in tax-deferred accounts.

Rebecca Katz: That makes sense. I know that now there are Roth 401(k)s and there is a provision—it depends on the plan—to allow conversions from a traditional 401(k) to a Roth 401(k). And you actually cannot use—if I understand correctly—cannot use the money in your 401(k) to pay that tax bill; you have to have that outside of the plan, is my understanding.

Maria Bruno: Yes, and the only comment I would have around that, Rebecca, is, one, the plan has to offer the Roth 401(k) feature. The good part about that is more and more plans are offering Roth 401(k)s for contributions. Then secondly, some plans may offer the ability to convert in-plan. That number is very, very low, because there's a lot of administrative work that the plan sponsor needs to do to allow that. It's probably a very narrow window of viewers today who can actually do that. Check with your plan administrator absolutely, but what you'll find more common is the Roth 401(k) contributions.

The nice part about that too is if you are making contributions to a Roth 401(k), employer match will be done in the traditional tax-deferred 401(k), so that really gives you instant tax diversification. So I might be directing part or all of my contributions to the Roth 401(k), but my match is going into the traditional [401(K)], so I'm getting diversification right there.

Rebecca Katz: Great.

Joel Dickson: One other thing I would add: there's a lot of nuance to the Roth and the traditional stuff. This is oftentimes where, if you don't have a lot of interest doing it on your own, [you would] seek out an investment advisor or tax advisor to help with whether this might make sense. But the other thing to keep in mind is, even if you think a Roth conversion might be advantageous in your situation, you don't necessarily have to do it today. You might wait until your tax rate is lower for some reason; if your income is variable, for example; or if you're near retirement. Actually a really good time to think about possibly doing a Roth conversion is after you've already lowered your income, and retirement, because now you have lowered your tax bracket and it's more likely that your future tax rate is going to be the same or higher than what it is today—now that I'm already in retirement. Because a lot of folks that are pre-retirees, they're often at their highest income level and highest tax bracket, and this conversion decision really—although there are a number of considerations to it—often the largest consideration is tax rate today versus tax rate when I withdraw the money. And if those are wildly different, if they're going to be a lot lower, you want to stay with the traditional [401(K)] most likely. If they're going to be higher or the same, you might think about the Roth [401(K)] as being an appropriate option.

Rebecca Katz: Okay. That's a great way of thinking about it. Now I want to come back to the RMD issue, because we've received a number of questions asking if you can reinvest your RMD into a Roth IRA.

Maria Bruno: Well, you need to have earned income. Many retirees, unless they have earned income, can't make contributions to a Roth. So really the option there would be to make the contributions into a taxable account, but pick tax-efficient investments. That's the key there. Many people don't need their RMD to spend and they'll reinvest it.

Rebecca Katz: Right, but in theory if you're still working at 70 and a half, you could.

Maria Bruno: With the Roth, yes.

Joel Dickson: But you're still going to have that RMD count on your income tax.

Rebecca Katz: I see.

Maria Bruno: Yes, absolutely. You'll still need to pay income taxes on the distribution, yes.

Joel Dickson: That's right.

Rebecca Katz: Okay. Our next question is also about converting Roths, from Richard, who asks, "Is the back-door IRA always available each year?" So explain what a back-door IRA is, or I think it's [a] back-door Roth conversion; what does that mean and is it—

Maria Bruno: It almost sounds seedy, doesn't it?

Rebecca Katz: Doesn't it, yes.

Maria Bruno: It's often called also a contribute-and-convert strategy. So you make a contribution to a traditional IRA and then you immediately or soon after convert that to a Roth IRA. There are no income limitations on conversions. There are on contributions or deductibility of contributions. There are income limits on who can contribute to a Roth, and there are also income limits to who can qualify for tax-deductible contributions on a tax-deferred IRA. You can always make a non-deductible IRA contribution; you don't get the tax deduction on the contribution, but the account grows tax-deferred. So this strategy comes into play where, if someone wants to invest in a Roth IRA but can't do it directly—

Rebecca Katz: Because they make too much money?

Maria Bruno: Because they exceed the income limitations, yes. So they can contribute to a traditional IRA—it's not tax-deductible—then they shortly thereafter convert to a Roth. Presumably the account does not accrue any type of earnings, so there are no tax consequences, and essentially you funded a Roth for that year. So it's a neat little way to do it. You can do this strategy and it's a great way to actually make a Roth contribution if you couldn't otherwise.

Joel Dickson: One—again—caveat to that.

Maria Bruno: The aggregationals; go ahead.

Joel Dickson: The aggregationals, exactly, you have to be very careful about. You can't just designate certain portions of IRA accounts that you hold and say "that's what I'm going to convert." You have to aggregate all of your IRAs. So, for example, if you make a non-deductible contribution to an IRA, but you also have pre-tax IRAs, then any amount that you take out to convert to a Roth IRA is pro rata from the pre-tax and the non-deductible portions and, therefore, may be taxable. So actually—and this gets to yet another potential nuance—one strategy to take advantage of back-door Roth IRA contributions is if you don't have a traditional IRA or if you're able to—maybe you have converted a traditional IRA in the past to a Roth, now you can do this back-door contribution, often without additional tax consequences, as Maria was describing, because you don't have any pre-tax IRA dollars left. You're just now making a non-deductible contribution and then shortly thereafter converting it to a Roth.

Rebecca Katz: That's interesting.

Maria Bruno: So to break it down: one, "is my income too high to contribute to a Roth outright?" If the answer to that is yes, then the other next question, I think, is "do I have other traditional IRAs that I'm not converting?" If the answer to that is yes—

Rebecca Katz: No.

Maria Bruno: Well, if no, then this strategy can work pretty cleanly, I think. But if you do have those large IRA balances, really look at it closely before doing it, because you're basically—some of that will be subject to income taxes because the IRS doesn't allow you to cherry-pick for calculation purposes for taxes.

Rebecca Katz: Okay, very important. And it does sound like it might be good to get some professional help with some of this. Our next question is from Harbo in Novato, California. Oh, this one, I know Joel will really like this question. "The threat and complexity of AMT, alternative minimum tax, makes tax planning difficult. Is there a simple method or tool to help work through whether a tax strategy would throw me into the AMT, alternative minimum tax?"

Joel Dickson: The alternative minimum tax basically comes into play—I mean, it can come into play from lots of sources—but at a high level it comes into play if you have effectively too many deductions for the amount of income that you make, as long as you're over a certain amount of income. And that can add to the additional tax as your baseline; your bottom-dollar tax bill is going to be the tax that you would calculate from the normal marginal tax rate tables and this additional AMT amount. And there are lots of potential strategies for dealing with AMT-type issues, but they basically come down to "am I raising or lowering my income," "am I raising or lowering my deductions." And I actually think the simple way to do scenario analysis is honestly to get some tax planning software. If you have used tax software to file your own returns, you can play with some of the different categories of where it might occur and you can see at a bottom line how much difference it'll make in terms of AMT or your total tax bill. And I think that's, in many ways, the best way—to just get a tax software and play with different approaches.

Maria Bruno: And that's [true] with [much] of this too, not just AMT. Like if you're thinking about a Roth conversion and you don't know how much additional income you could generate before getting bumped into a higher tax bracket, for instance. If you use tax software, you can go in and do some scenario analysis. It's a great way to get a sense of "is this a viable alternative?"

Joel Dickson: And here we go again with another Roth conversion nuance.

Maria Bruno: Oh, what have I started?

Joel Dickson: Roth conversions might actually not cost you the full amount of your marginal tax rate, and the reason is that if you're currently subject to AMT, by increasing your income through a conversion, you haven't changed your deductions, you've increased your income; you're actually improving your AMT situation in that scenario. So you may not have to pay full freight of your marginal tax rate because, yes, your income has gone up and you're paying marginal tax rate, but now you might be paying less AMT, and so there's a bit of an all-else-equal offset.

Rebecca Katz: It sounds like you really need to do a lot of homework before making these decisions. We have another question; this is more about investments and portfolios. Lee, from The Villages in Florida, asks "How are ETFs more tax-efficient than index funds?" We talked about bond funds perhaps in certain environments being less tax-efficient than some other types of funds. Maybe we should talk about that more broadly, like what are considered tax-efficient investments, and then get back to Lee's question.

Joel Dickson: Yes, generally when we think about the investment itself being fairly tax-efficient, it would be something that either throws off tax-preferenced income, like qualified dividends [which] are taxed at a lower rate than ordinary income, for example, or minimized as capital gains and so forth. In the general hierarchy of asset location that we were talking about earlier, normally you would think about putting taxable bonds, which are subject to ordinary income tax rate, typically on the distributions. You know, tax-inefficient equity investments—whether it might be a very active actively managed fund that might realize a lot of gains on an annual basis, or something that throws off a lot of yield, like even high-dividend stocks relative to the broad market—might be a candidate for tax-deferred vehicles.

And then in your taxable account, oftentimes investments like municipal bonds, as Maria had mentioned before, or more tax-efficient equity investments, where maybe there's not a lot of capital gain or dividend on an annual basis, are more appropriate from an asset location basis in the taxable account.

Now with respect to the ETF-versus-index-fund question, exchange traded funds by and large—the majority of them in the industry and all of them at Vanguard—are index funds. Now we can't say they're actually mutual funds because there are some different features of them, but they share the same underlying investment portfolio as the share class of the mutual fund that they exist with. All of Vanguard's ETFs have a share class with traditional mutual funds like the Investor Shares or the Admiral Shares, that all feed into the same portfolio of securities. And oftentimes ETFs are talked about as being tax-efficient, but a lot of times that tax-efficiency that is realized may just come from the fact that it's an index-type investment. Index funds, while it's certainly not guaranteed, relative to actively managed peers have seen less capital gain realizations over time; they may be less income but often it's more on the capital gains piece.

Rebecca Katz: Because they're not buying and selling the stocks as often.

Joel Dickson: Typically not. That's not true with all funds, and you have to look at it, but certainly broad-market equity funds have historically been pretty tax-efficient from the standpoint of not having a lot of capital gain realizations, because of the way they manage their portfolios.

The difference between traditional funds and ETFs really is not much, because they're subject to the same tax rules. In Vanguard's case they have the same underlying portfolio. There might be different expenses on different share classes, but the distributions themselves are the same. There is a little bit of a difference in that exchange-traded funds use a mechanism called an in-kind redemption, where basically there are only very large institutional investors, called "authorized participants," that are allowed to actually directly interact with the fund. And their transactions are often done in the form of the underlying securities—so, stocks for a stock fund, for example. And when you engage in an in-kind stock transaction, and you give stock instead of cash, you take it from a traditional mutual fund; quite often you get cash when you redeem. If instead the redemption is paid in stock, then there are certain ways that you don't have to realize the capital gain that would otherwise have realized from selling those securities, and therefore not have to distribute it. So it's a more efficient mechanism to be able to get low cost basis or high unrealized capital gain securities through the portfolio in the ETF structure.

Rebecca Katz: So just to be clear, the people who are receiving the actual stocks in the underlying index, it's not you and me buying ETFs, it's these authorized participants, these market makers that are doing that. I just don't want anybody to be confused.

Joel Dickson: Yes, well, we'd have a lot of upset shareholders if, from their S&P 500 Fund, we gave them 500 securities instead of cash, yes.

Rebecca Katz: That's right. All right, we have another question. Marvin's asking you to be even more specific in talking about different types of tax-efficient investments in a non-retirement account. So we talked about index funds potentially being more tax-efficient; [are there] other types of funds that tend to be tax-efficient? Can you think of any others?

Maria Bruno: The one thing that I would probably just clarify is that index funds are not all created equally. So more narrow-focused or sector-type index funds typically are less tax-efficient than broad-market index funds. I just want to be careful when we talk about index funds. Broader is generally more tax-efficient than narrow.

Rebecca Katz: So as an investor is trying to figure out whether or not a fund is tax-efficient, what should they be looking at? Is there something on the web that they could look at to have some sense of that?

Joel Dickson: As much as I hate to say this: read the prospectus. And the reason that I say that is the prospectuses for many of Vanguard's actively managed funds, both stock and bond funds, actually say in [them] "this fund is generally not managed with regard to tax consequences." So even if it has been tax-efficient in the past, it's not because there was necessarily an eye towards that, whereas in the prospectus of—sometimes in index funds, certainly in the Vanguard Tax-Managed Funds prospectus—there's actually discussion of how the fund and tax considerations are taken into account in the portfolio management process. And while, again, [there is] no guarantee, that's the way that you want to think about "do I have some sense that the portfolio is being managed on an after-tax return basis." Because one of the big things about—let's take an actively managed fund for a moment—one risk even if it has been very tax-efficient in the past, if the manager changes and you have a new manager come in, even if that manager is going to be very tax-efficient in the future, they may have a different view of which securities they want in the portfolio, and you sell the old, buy the new, and any past tax-efficiency might be negated.

Rebecca Katz: I would also assume market environment can have an influence on that, if we've had a few bad years in the markets. I would assume a fund is a little bit more tax-efficient, isn't it?

Joel Dickson: It certainly can be and, in fact, through much of the 2000 period, relative especially to the 1990s, capital gain distributions from U.S. equity funds were a lot lower than in the 1990s on average. In part because with the 2000-to-2002 bear market, so many losses were built up and realized that it made future gains, that were realized as the market recovered, not necessarily have to be distributed because they were just offsetting these capital losses that had been realized in large scale in the downturn.

Rebecca Katz: Okay. Good. Some good pointers there. Let's take another question. We're actually creeping up on time so let's see how many of these we can get through. Our next question is from Johnny in Walnut Creek, California, and Johnny says, "What would the impact of new Medicare taxes on higher incomes be? Are there any tax-avoidance strategies?" I'm not sure this has direct correlation to investing, but do we have any thoughts on this?

Maria Bruno: I think it makes sense for us just to touch upon what the Medicare surtax is. So that went into effect with the recent legislation this year. Above certain income thresholds, there's a 3.9—

Joel Dickson: Eight.

Maria Bruno: A 3.8% Medicare surtax on net investment income. The threshold is $400,000 single, $450,000 for joint and married?

Joel Dickson: This was part of the healthcare legislation, so there are all sorts of different thresholds. As a matter of fact, taxes have gotten a lot more complicated in 2013 just from the break points. For the Medicare one, I believe it's $200,000 single and $250,000 for joint.

Maria Bruno: Oh yes, I'm sorry, I'm mixing that up with the higher tax brackets. Our tax brackets went up.

Rebecca Katz: But just to be clear, everyone should check. I'm sure you can find this online.

Joel Dickson: You can.

Maria Bruno: Oh yes, actually, yes. I'm thinking about—in addition, the marginal income tax brackets went up and that's the highest—

Joel Dickson: And that was $400,000.

Maria Bruno: Yes. Thank you for keeping me honest there. With the Medicare surtax, it's above the income thresholds and it looks at which is less—above the threshold—is that your modified adjusted gross income or net investment income? So you're subjected to this Medicare surtax for this amount of income above the threshold. And we should probably touch upon what, generally, constitutes net investment income. So things like interest dividends, capital gain distributions, distributions from non-qualified annuities, for instance; municipal bond income is not. There are certain stipulations as far as what constitutes net investment income versus what doesn't. The ramification of this is, okay, I might be in the highest tax bracket or a high tax bracket. I then need to layer this potential tax on, and I may or may not be subject to it based upon what my income looks like.

Joel Dickson: And I would say it makes two things relatively more attractive. One is tax-deferred accounts, again, because to the extent that you don't have it in the taxable account, it's most likely not going to be subject to this 3.8%. And because you have it on investment income that is realized, whether it's capital gains or dividends or so forth, deferral strategies become a little bit more advantageous. So if, for example, you can defer a capital gain realization instead of realizing that capital gain, whether it's rebalancing or selling for another purpose, you can further delay that potential 3.8%, all else equal in that standpoint.

Rebecca Katz: Okay, great. Our next question is from Amy in Rochester, Minnesota, who says, "How would you invest emergency funds in a tax-efficient manner to earn interest to at least keep pace with inflation?" So right now we know that cash accounts, which is where we would normally think of putting emergency assets, have very little interest if any, so how do you do this in a way that you actually earn interest but don't create a tax situation?

Maria Bruno: That's a tough one in this environment; I mean, yields are at historic lows. You need to think about what the emergency funds are meant for—emergencies, rainy day funds, the what-ifs. So it is important to have a certain amount of cash set aside for emergencies or unanticipated expenses, good or bad. And the reality of it is that principle-preservation really is the priority. The one thing you could potentially look at would be maybe going into short-term bond funds—very short-term, I would say—if you're looking at emergency funds—or municipal bond funds short-term. It gives you some duration risk, so it does give you some potential principle fluctuations. It might give you a little bit of a yield but, again, given the yield situation today, probably not much.

Just be careful stretching out longer for yield in this environment, because it will subject you to some interest rate risks—price volatility when interest rates do change.

Rebecca Katz: Generally if a fund has a higher yield today—a bond fund—it means that there's typically greater risk in that fund?

Maria Bruno: From an interest rate standpoint. There's an inverse relationship between interest rates and price fluctuation. So the yield comes with a risk and you just need to understand what that risk is. And it may not manifest itself today but the bottom line, and generally speaking, I mean, there are other strategies in terms of, for instance, if you have Roth accounts you might be able to pull out—not might, you can pull out contributions. But again, that's not meant for an emergency fund, that is meant for retirement, so there are trade-offs to doing that. There are ways you can do it but there are trade-offs.

Joel Dickson: But to Maria's point, it's really hard, when you think about cash essentially being at zero, which really means that from an inflation-adjusted basis, it's about negative two or negative two-and-a-half, right? So either you have to—if you're trying to get some sort of inflation-adjusted yield—you could look at treasury inflation-protected securities, but they have negative real yields on them right now. I mean, you get an inflation adjustment but you're sort of getting a haircut, if you will, because you're starting from a negative real yield standpoint. Either you have to stretch for yield on terms of longer maturities, as Maria was talking about, or in terms of lowering the credit quality of the bonds.

But sometimes short-term high-yield bonds—that's not really what you're trying to accomplish with an emergency fund. Again, you want it to be there if you need it.

Maria Bruno: Right, any [inaudible] TIPS or bond funds. TIPS do have duration risks, so they can experience loss both on a real and non-real basis.

Rebecca Katz: Yes, their share price is going to go up and down on that fund; you should be prepared for that.

Joel Dickson: Correct. That's right.

Rebecca Katz: Great. Our next question is from—we have just a few minutes and we have so many good questions here—let's take this one from Jerry from Iowa. He says, "I use the Total International Stock Fund as part of my portfolio and I intend to use the new international bond fund. How can investors understand the tax implications of international investments?" So the underlying stocks and bonds are derived from international—from other countries—does that create different tax issues for investors here?

Joel Dickson: It can. We don't have enough time to go through all of the differences. But at a high level, we're talking about one portfolio—if we're talking Total International Stock—that is a broad international equity portfolio, index portfolio. Another is a broad taxable bond portfolio. If you go back to general principles of asset location, your starting point is to think about maybe that bond portfolio could be used in a tax-deferred account; that total international equity—your stock fund—in a taxable account.

Again, there are different considerations that can come into play. You may have what's called foreign tax-paid credits—that you get from, for example, if there was, due to tax treaties, the fund had to effectively pay some taxes on its holdings—that will flow through to investors. If you're in a taxable account you might get a bit of a credit back at the end of the year on your tax form. The Total International Bond [Fund] has all sorts of complications to it because that portfolio is expected to hedge its currency risk. So you'll hold a bond from, let's say, Europe—it'll offset that currency risk in terms of Euros. Depending on how the currencies move, you may increase the income or decrease the income that's actually distributed from the portfolio. So the tax situation is somewhat uncertain in those cases.

Rebecca Katz: But from an investor's perspective, you mentioned the foreign tax credit. We send you forms that tell you everything you need to know—

Joel Dickson: Correct.

Maria Bruno: Yes.

Rebecca Katz: In order to fill out your tax forms in April.

Joel Dickson: That is correct.

Rebecca Katz: Okay. Well, unfortunately we have lots of questions left, but no time left, so I think we're going to have to leave it there. Would you like to share any closing thoughts with our viewers?

Joel Dickson: I would just highlight that we've talked about a lot of different things here from a tax-efficient investing standpoint. There are lots of tools that people can use. It's kind of like—and Maria's big into gardening—it's kind of like having a spade and a hoe and pitchfork, and which do you use for the right situation. But it is important to prioritize how you think about the different asset location, the use of tax-deferred accounts, what types of accounts, and what types of investments that you use. And when it comes to maximizing that after-tax return, I would just highlight again: to the extent you can use tax-deferred accounts, that's where you're likely to get the biggest bang for your tax buck.

Rebecca Katz: Okay, great. And Maria, based on the number of Roth questions we had, I think we have to do a repeat of our Roth webcast.

Maria Bruno: We're due for another webcast.

Rebecca Katz: That's right. So thanks to both of you for all your time and the great suggestions and information today. And from all of us here, thanks to you for sharing your afternoon with us. Look for an email from us in the near future with a link to a replay of this broadcast and a transcript. And if you could, we'd really appreciate your feedback on a survey that you'll see on the right-hand side of your screen. It'll take you just 15 seconds but we would love to know what you'd like to see more of, what you liked, what you didn't like.

Come visit us on our Facebook page. I am sure we can get Maria and Joel to answer a few more questions out on Facebook since we had so many left. Let's keep this conversation going.

That's it from us here in Valley Forge. We hope you have a great afternoon and we'll see you again next time.


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