The “Three Fund” Portfolio Part 5 – Tax Considerations

My friend Frugal Professor asked me about the tax consequences of my portfolio choices. So let’s discuss those in the context of a standard Vanguard portfolio of VTI, VEU and BND.

Qualified Dividends

VTI pays a dividend of approximately 1.8% per year. 94% of those dividends are qualified, meaning they count as investment income taxed at long term capital gains rates. The other 6% count as ordinary income. In 2019, the long term capital gains rate depends on your income level:

  • 0% on the first $39,375 for individuals and $78,750 for married couples
  • 15% on the next $395,175 for indivduals and the next $410,100 for couples
  • 20% over $434,550 for individuals and $488,850 for couples

By comparison, DGRO pays about 2.5% per year in dividends, with 100% qualified for capital gains rates because the methodology excludes REITs from the investment universe.

Overall, a combination of 75% domestic consisting of DGRO and sector equalization positons and 25% foreign with DNL has a blended yield of 2.26%. Compare 75% VTI and 25% VEU with a blended yield of 2.22%.

Tax Cost Ratios

In addition to dividends, funds can also distribute true long and short term capital gains from trading activity within the fund. Most ETFs avoid or postpone these distributions with unique trading structures, but many mutual funds distribute capital gains. Short term gains are taxed as income, while long term qualify for the rates noted above.

Morningstar factors in qualified dividends, unqualified dividends and long/short-term capital gains from trading activity to estimate a three-year “tax cost ratio” for each fund. For example, if a fund had a 2% tax cost ratio for the three-year time period, it means that on average each year investors in that fund lost 2% of their assets to taxes. If the fund had a three-year annualized pre-tax return of 10%, an investor in the fund took home about 8% on an after-tax basis.  YMMV depending on your income level, but I will use the Morningstar three-year tax cost ratios for comparison:

  • DGRO 0.65% vs VTI 0.64%
  • DNL 0.62% vs. VEU 0.97%
  • AGG 1.07% vs. BND 1.11%

For the final Aggressive portfolio, the blended tax cost ratio is 0.67% compared to 0.75% for the Vanguard portfolio.

Conclusion

DGRO is the only laggard, and it trails by one basis point. When I go through the sector equalization exercise, the blended tax cost ratio falls to 0.64% to tie VTI. Meanwhile, DNL is a significant improvement over VEU, and AGG is a slight improvement over BND. The blended tax cost ratio is lower.

Accordingly, I am confident that the tax consequences of the Aggressive model are not materially more burdensome than a standard Vanguard portfolio.

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Frugal Professor

Good analysis!
 
What doesn’t make sense to me is how DGRO’s tax burden can be so low when it’s turnover ratio is 26% whereas VTSAX’s is only 4%.
 
If the fund is turning over that often in its desire to pick the “best” stocks (whatever that means), it’s bound to a huge capital gain penalty.
 
In any regards, I enjoyed the analysis!