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.
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!
Thanks for checking it out, FP. For those who haven’t seen, Frugal Professor runs a great site about his personal finance journey. It’s linked above and in my Resources collection. I stumbled across FP’s blog when searching for information on the BOA Cash Rewards card, as I could not believe how good it was. Lo and behold, FP was blogging about the very subject! In many ways, his blog was an inspiration for this one as I start my CFP journey. I am only embarrassed that I seemed to have unconsciously selected a very similar theme that… Read more »