Saturday, November 03, 2007

Tax planning II

Hoisted from the comments, Brad Delong style:
i was just thinking about your "tail wagging the dog" thing and wondering if that is true, why does it makes sense to put money in tax-exempt funds?

I have been slashing my savings in CA tax-exempt MMF but I am confused if that is the right thing to do. Any suggestions?


Thank you for your question.

There's a difference between tax aware investing and "tax tail wagging the investment dog" thinking.

Here's a good example of tax aware stock selling. The author clearly has thought through the issues and understands the risk of selling late. An example I can think of is the "tax tail wagging the investment dog" thinking is that of a conversation I had recently with someone who had a majority of her wealth tied up in her company stock options, which had hit a record high. Despite her awareness of that, her reason for not selling was: "I don't want to pay the capital gains tax." Given that a majority of her assets were in the form of NSOs, she would have to pay those taxes sooner or later, while the consequences of a 50% drop in a high flying stock on her wealth would be substantial.

Back to the your question. Putting money into a CA tax-exempt fund makes sense when your marginal tax rate is high enough that the reduced yield of the CA tax exempt fund after taxes is higher than that of the best non-tax exempt fund you can find.

To do this, first find your marginal tax rate, then visit the Vanguard after-tax equivalent yield calculator. You probably already know your marginal tax rate for your state (CA), but in case you don't, here's the table.

Here now is a puzzler for you financial gurus: A person I know just quit his job to move to another (income-tax free) state. His reasoning: "I have enough money in my stock stash to retire (barely), but my margin of safety goes up by about 9.3% if I move to a state with no income tax when I sell. So I'll change residency and do my selling then." Note that again, his portfolio is highly concentrated in one stock. Would this be considered tax-aware stock selling? I have my opinion, but I'm interested in what others might think.
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