kodokan

Now the dust's settled on our recent house purchase, I'm onto my next project: investing.

In the first instance, I want to take some spare money out of cash (lowish 5-figure sum) and set up a simple, balanced portfolio of US equities, international equities and bonds. I am planning to use somebody like Vanguard for this and, to keep costs as near to zero as possible, I will probably use index tracking funds.

Before I do this, is there anything I should be aware of from a tax reporting angle, that'll cause me trouble down the line? I tried looking this up, but got a bit bogged down. I understand that the broker will send me a statement once a year with details of dividends and capital gains based on sales within the fund, and that there will be some numbers I copy into the relevant box on the 1040 or wherever, and pay the relevant tax (would this be income tax, at my marginal rate?).

But what happens when I come to sell any shares? I will be buying over time, so the shares will have a range of purchase prices. How will I then work out capital gains upon selling, and what sort of tax rate will it be at? (Assume they're all long-term held, upwards of a year.) What records am I likely to need to keep?

Could someone kindly explain how this works and what I'd need to report/ pay, or point me somewhere that lays it all out for US investing beginners? Many thanks.

Michael

Each time you make a purchase, there is a confirmation that can be printed. I print all my confirmations and put them in a folder. When I sell, I print that confirmation and staple it to the buy confirmation. I'd advise that you do not have dividends reinvested back into the fund unless it is an IRA or 401K since that can really create massive headaches calculating the capital gains (short or long and price bought of each share) when tax time comes and you sold the fund. You could have purchases for every month if dividends are paid monthly. Just save your dividends and purchase a new fund or more of the fund when you have enough money.

Long term capital gains (shares held for a year or more) are taxed at a maximum of 15% for incomes below $400,000 and 20% above $400,000. Securities held for less than a year are short term capital gains and are taxed as normal income.

The biggest concern should be how dividends are treated. US dividends for common shares, ETFs, and mutual funds are almost always qualified. Qualified means that they are taxed the same as long term capital gains. For them to be qualified, you must hold the security for 61 days in a 121 day window around the ex dividend date. Simply put, if you hold any security for 61 days, it will always produce qualified dividends.

About 50% of European stock are qualified and only about 10% of the rest of the world's stock are qualified. Therefore what you like to see at the end of the year on your 1099-DIV is the amount in ordinary dividends equals the amount in qualified dividends indicating that all dividends are qualified. If you own foreign stocks or funds with foreign stocks, you will likely see a difference in the two numbers and the difference is taxed as normal income.

I believe most American Depositary Receipts (ADRs) are qualified dividends but I'm not sure. ADRs are foreign stocks bundled (may be 1-20 stock certificates in the bundle) and sold on the US exchanges.

Also some foreign stock withhold tax at the source for that government. This may or may not be an issue since normally you can use those foreign tax credits to offset US taxes owed for those stocks. As an example, Royal Dutch Shell has 2 ADRs on the US exchange (RDS.A and RDS.B). I believe that RDS.A is from Amsterdam and RDS.B is from London but RDS.A withholds tax on dividends but RDS.B does not.

Dividends from preferred shares could be qualified or non qualified but many are qualified for the US and Europe.

I only own two foreign ETFs (one for European large companies and the other for worldwide large companies) and I'm selling them both since they haven't performed very well (actually poorly) and most of the dividends are taxed as non qualified dividends. Who would have thought that companies such as Total, Bayer, Siemens, Basf, Allianz, SAP, Daimler, and BNP Paribas would perform so poorly as the US market rose significantly over the past three years?

kodokan

Brilliant Michael, that's very helpful. You've answered lots of my ponderings and have given me useful vocabulary to hunt down more information, and your point about reinvesting dividends in taxed funds is exactly the kind of 'world of pain if I don't know about' thing I had in mind! (Can't use tax-free, as we're already maxing out the 401(k) and Roth IRAs aren't applicable.)

So... if I buy a plain vanilla Vanguard index fund tracking a standard US index, and hold it for more than 61 days, and don't have the dividends reinvested on the fly but let them build up - in some sort of cash account at the broker's, I guess - into a useful 'all at once' buying lump, then my life will be relatively simple?

And if I do the same, but with a Vanguard fund tracking an overseas index or indices, and just check it's one where the dividends are qualified, again, simple life?

And presumably the same goes for whatever is Vanguard's most boring, standard bond fund.

My plan is to just do this for a couple of years, to get my feet wet and make sure I understand all the paperwork; I'm not planning to cash out in that time, but will do a portfolio rebalancing buy/ sell between the asset groups perhaps once a year. After that, I might get adventurous and move onto individual shares (in the UK, I had a small High Yield share portfolio, for fun).

Thanks a lot.

Michael

Use a discount brokerage instead of buying directly from Vanguard. Generally there isn't any commission on no load funds. Also I'd recommend that you open the checking account at Capital One 360 (pays about 0.8% interest compared to 0% for brokerages) and transfer money between the two. If you open a margin account, you can buy shares and initiate a ACH transfer that day and not pay margin interest rates since settlement takes 3 days. You can also use the Capital One 360 brokerage instead of using one of the more popular brokerages and then you will have instant transfers between accounts.

It is really difficult to determine if a stock or fund has qualified or non qualified dividends if foreign stocks are included. Even the brokerage sometimes gets it mixed up when they post the dividends (indicating non qualified when they are qualified) but by the time you get your year end statement, everything is all cleared up. I checked my last TD Ameritrade year end statement and all my US stocks and ETFS were qualified but only part of my foreign ETFs were qualified with almost all of my worldwide fund as being non qualified.

What defines whether a dividend is qualified is how corporate taxes are paid. If corporate taxes are paid prior to distributing dividends (US law for common shares), the dividends are qualified but if corporate taxes are paid after dividends are distributed (varies from country to country and company to company in some countries), then the dividends are non qualified.

Michael

If your 401K is managed by Fidelity and possibly other companies that have brokerages, you can normally use their brokerage for $50 per year instead of investing in the predefined funds (if your company allows it).

Michael

Bonds do not pay dividends but interest and that is taxed as normal income. The gains or losses when sold are taxed as capital gains.

I don't invest in bonds but instead invest in large banks preferred shares that pay 6%-8% dividends and only invest in shares that are qualified.

You can use the following link to search for preferred shares that are qualified.

http://www.quantumonline.com/

First register (it's free) and then under "Income Tables", click on "Preferreds Eligible for the 15% tax Rate" and then look for very large banks (HSBC, JPM, BOA, ING, Deutsche Bank, Wells Fargo, Barclays, etc.). Then click on the symbol and a new screen will appear and then click on "MW ExDiv Date" and you will see the current price and current yield.

You may want to use the msn portfolio manager to track shares to get used to what is happening on funds, ETFs, common stocks, and preferred shares. This portfolio manager is the only one I know that allows you to track dividends and interest. Usually I enter the dividend on the ex dividend date since it is owed to me but will be paid days later into my account even if the shares are sold. When the ex dividend date occurs, at about 3 am in the following morning the share price falls by the amount of the dividend so the following day that is the starting point of trades.

http://money.msn.com/

You should read the following link where preferred shares are discussed both pro and against. It may also give you some ideas of the risks involved.

http://britishexpats.com/forum/showthread.php?t=802643

Michael

Final thing about Capital One 360, they have Person to Person money transfers via ACH or by check whichever your prefer. I don't know of any other bank that has Person to Person ACH transfers. All you need is the last for digits of the person's account number and email address and when you initiate ACH transfers, the person will receive an email asking them to enter their routing and account number and then the transfer will start.

Also if you are primarily going to trade mutual funds, the Capital One ShareBuilder brokerage account will likely be all you need since the mutual fund is bought and sold at the end of the day and prices will be the same for all brokerages. It also has a $5.99 commission for shares traded which is lower than most of the other discount brokers. The only thing I don't know is how much they pick up on the selling and asking prices on the massive number of exchanges that the shares are traded on in the US. Even TD Aneritrade doesn't pick up all of the trades since sometimes I watch Level II quotes (shows the outstanding ask and bids for shares) and a sell or buy bypasses what I am seeing. That may be caused by high frequency traders that finds a sucker that has a market sell outstanding on some obscure exchange that most brokerages don't see and initiates a trade within milliseconds. I see the trade occur but it is higher than the ask or lower than the bid on my screen.Therefore limit orders are best especially on low volume stocks. Also I'm not sure which types of tools they have (do they have Level II quotes?) and how well their web site is designed. Although I have a Capital One 360 account, I never signed up for ShareBuilder so I've never seen the screens.

Although all orders eventually go through the major exchanges, there are many smaller exchanges in the US so unless the brokerage can constantly monitor all the exchanges, occasionally a bid or ask will be missed. High frequency trades are sneaky and can get at any exchange since they are looking for specific stocks to arbitrage (differences between exchanges) where brokerages have to try to monitor all stocks simultaneously. Since nothing occurs instantaneously, a sell placed on one exchange may not get updated on other exchanges for a 1/10 of a second and if a high frequency trader can spot it before it gets to the other exchanges, he can make the trade. I believe that most brokerages monitor approximately the 10 largest exchanges and wait for the smaller exchanges to send them their buy and sell orders.

In fact it gets so crazy that the current high speed line from New York to Chicago (CME exchange for futures and options) currently takes 12 milliseconds round trip for high speed traders. To speed that up to 9 milliseconds, a company is installing microwave towers (about $1 billion) about every 60 miles between New York and Chicago and will be charging a minimum of $20,000 per month to use that line. Most of the high speed traders are hedge funds and investment banks. So hedge funds and investment banks make money by stealing other people money.

https://home.capitalone360.com/

kodokan

Thanks Michael, a lot to read, digest and decide about there! I appreciate you taking the time to be so thorough. Sorry I didn't come back earlier; had a sick pet who needed a vet visit (but turned out to be fine, thankfully).

I shall carry on reading my Bogleheads book on investing, and look into it further once the kids are back at school in a week or so.

Michael

What most investment advisors don't tell people is that bonds and bond funds can be more risky than common stocks. Some investment advisors may try to tell people that but most people don't believe it. Over the past 30 years, bond funds have performed very well and that is only because interest rates have dropped continuously for the past 30 years. As long as interest rates drop, bond funds will do OK. If interest rates don't move, you'll get a small return. If interest rates rise, you'll probably lose money. If interest rates rise significantly, you'll probably lose a lot of money.

The reason is that bond funds purchase bonds at their current yield and if other investors purchase bonds in the future at a lower yield, the market value of the bonds in the fund will rise to equalize the yield between the bond fund and the current yield on the bond market. The opposite occurs if investors purchase bonds in the future at a higher yield.

Example:

A bond fund purchases 30 year treasuries with a par vale of $1,000 with a the coupon rate of 3.60% for $1,000 per bond. In this case, the current yield is 3.60% and the yield to maturity is 3.60%. If the interest rate for 30 year bonds drops to 2.60%, that means that the bonds in the bond fund are more valuable since they are paying 3.60% or approximately an additional 30% over the next 30 years then the bond that was purchased on the market that day. If the market value of the bonds in the bond fund remained the same, everyone would want to buy that fund since it is paying a higher interest rate than the current market for 30 year bonds. So therefore to equalize the two, the market value of the bonds in the fund must rise and therefore the market value of the bond fund will also rise. Now how much would the bonds in the fund rise? They would rise to approximately $1,200 each so you would see a capital gains of 20% if you sold that fund at that time.

However now that the interest rate is at 2.60% and if you purchased that bond fund, you would be paying $1,200 for each bond in the fund and if interest rate rises back to 3.60%, each bond in the fund will return to $1,000 and if you sold the fund at that time, you would have a capital loss of 17%.

Why aren't the percentages the same? Why was there a gain of 20% and only a loss of 17% and yet the value of the bond and interest rate returned to the same place where it started? That is because a 100% gain means you double your money but 100% loss means you lose all your money. You can not lose more than 100% of your money but you can gain 200%, 300%, 400%, etc. In fact if you have a gain of 100% and then lose 50%, you have a net gain of 0% (a 100% gain on $1,000 in a bond fund means your bond fund now has $2,000 but a 50% loss on $2,000 means your bond fund is now worth $1,000).

The above example assumes that all bonds in the bond fund are 30 year treasuries with still 30 years to maturity. However bond funds are long bond funds (holds bonds with 15-30 years to maturity), intermediate bond funds (holds bonds with 7-15 years to maturity), short bond funds (holds bond with 1-7 years to maturity), and ultra short bond funds (typically holds bonds with less than 1 year to maturity).

The longer the maturity of the bonds in a bond fund, increases the possibility of higher capital gains and bigger capital losses. So if you invest in a long bond fund, your potential rewards and losses are the greatest. If you invest in an intermediate bond fund, the potential rewards and losses become less. If you invest in a short term bond fund, the potential rewards and loses even become less. If you invest in an ultra short bond fund, you'll likely not have any capital gains or loses but only get the interest rate of the bonds in the fund (probably currently less than 1%).

Bond funds are usually a combination of treasuries and corporate bonds. If it is a very solid bond fund, they will only have AAA, AA, and A rated corporate bonds in the fund along with the treasuries. If it an intermediate bond fund, they may have 10 year treasury and corporate bonds in the fund. As you can see from the following link, currently 10 year treasuries are yielding 2.58%, 10 year AAA rated corporate bonds are yielding 3.25%, 10 year AA rated corporate bonds are yielding 3.33%, and 10 year A rated corporate bonds are yielding 3.56%. See thumbnails at bottom for different bond ratings.

http://www.bondsonline.com/Todays_Ma...elds_table.php

Depending on how they mix the bonds in the fund, the current yield of the fund could be anywhere between 2.58% and 3.56% (less than those figures since mutual fund fees will take it's cut). If the bond was classified as a high yield bond fund, they then will be holding BBB, BB, and B rated bonds and the current yield of the fund could be as much as 4.5%.

Now imagine if 10 year treasuries went up by 2% to 4.58%. That means that all the other bonds in the fund would also have to produce about an increase of at least 2% yield in order for anyone to want to buy that fund. With that big of an increase in yield, the price of an intermediate fund (the NAV or net asset value) could drop by 15% or more and a long bond fund could drop by 30% or more.

Over the past couple of years, analysts have been talking about the bond bubble and that is what they are referring to that rising interest rates cause the current outstanding bonds market value to drop and that large losses will be felt by people holding bonds or bond funds. Unfortunately it is going to be the unsophisticated investor that is going to be hurt the most. For the past 30 years, 30 year treasury interest rates dropped from it's high of 16% in the early 1980s to as low as 2.50% recently and nearly every year their bond fund's price would rise and they would also receive interest and many now assume it is risk free not understanding that that the only reason that the bond fund's price has risen is that interest rates have constantly dropped.

You can see from the following link that most bond funds have lost money YTD this year. The long bond funds have lost the most as interest rates have begun to climb.

https://personal.vanguard.com/us/fun...ssetclass=bond

For that reason as well as interest is taxed as normal income, I don't like bond funds but instead prefer large bank preferred shares. In my personal opinion, large bank preferred shares are less risky than bonds even though they are junior to bonds but they pay a 6%-8% qualified dividend and are not as sensitive to interest rate movements.

So if you were holding 7.50% yield preferred shares and 30 year treasuries rose from 3.50% to 5.50%, you would still be getting 2% more than 30 year treasuries. Although the price for preferred shares may possibly drop by 20%, in about 3 years you would receive enough dividends (including taxes paid on the dividends) to break even. If you were holding a bond fund that dropped by 20% and the yield when you purchased the fund was 3.5%, it would take you over 7 years (including taxes on the interest paid) to break even.

The following thumbnails are how bonds are rated. AAA bonds have a very low risk of default but that does not mean that those bonds cannot drop significantly in value due to rising interest rates.

nun

Your questions have been well answered. If you invest in mutual funds with someone like Vanguard all your paperwork will be taken care of. You'll get all the required forms and figures from the company and you can just plug the numbers into your US taxes.

I applaude you thinking of investing through Vanguard and following the Boglehead philosophy. However, don't think that you need to invest in individual shares or that share investing is in anyway better or more sophisticated than index investing.

I won't go on about my distain for market timing or individual share investing anymore, but I will mention taxes on investments. These are going to depend on your citizenship, residency and the type of investments you own. For example if you ever became UK tax resident it would be a bad idea for you to own Vanguard mutual funds......however the equivalent ETF would be ok. This is because the ETF is recognized by HMRC as a "distributing fund". HMRC taxes the capital gains in non-distributing foreign funds at your income tax rate. So as well as learning about investing you should arrange your investments and pensions to be efficient from a domestic and/or international tax perspective.

Michael

I didn't know that mutual funds and ETFs have different tax treatments in the UK so that sounds like good advice. Although Vanguard has some of the lowest expense ratios in the mutual fund business, ETFs generally have lower expense ratios then it's equivalent index tracking mutual fund (especially SPDR EFTs such as SPY and DIA). If your investment is small (about $3,000) or your time frame to hold the index is relatively short, it is probably better to purchase a Vanguard index tracking fund then an ETF since you pay a commission when you buy and sell ETFs and the commission may exceed the extra expenses charged by a index tracking fund. However as size of the investment increases or the time frame you plan to hold the fund increases, it is likely better to purchase ETFs.

Another couple of issues with mutual funds is that you must give the brokerage several hours notification prior to the end of the day to buy or sell mutual funds but ETFs can be bought and sold at any time during the trading day. Also most brokerages charge a fee (typically about $25 per trade) if you trade too many mutual funds during a short period of time. Normally that is not a problem if you hold funds for a long time but if you rebalance at the end of the year, there is a possibility that you could get hit with the fees.

I only hold ETFs (and stocks) since my investments are larger and I hold them for a long period of time so the commission that I pay will be less than the additional expenses paid for an index tracking mutual fund.

Michael

I just opened an account with Capital One 360 ShareBuilder brokerage account to see what it offers. At $6.95 per trade and instant transfer from my Capital One 360 accounts, I thought it might be worth looking at compared to my current TD Ameritrade account at $9.99 per trade and 3 day ACH transfers from my Capital One 360 accounts.

After I open the account and make a trade within 45 days, I get a bonus of $50 and if transfer my TD Ameritrade IRA account to a ShareBuilder IRA account, I get up to a $600 bonus (amount depends on size of account to be transferred).

Unfortunately Sharebuilder is pretty vanilla compared to TD Ameritrade with no Level II quotes, multiple real time quotes, and multiple real time charting (maybe they provide those features if I would pay for the premium package but everything is free with TD Ameritrade if I maintain a minimum balance in securities or cash), preferred symbols require a "PR" following the symbol ("JPM-I" is entered as "JPM-PRI"), and overall it appears limited to me. Maybe for a novice it would be easier to use than TD Ameritrade.

I may never use the account or possibly may make one trade to get the $50 bonus and transfer my TD Ameritrade IRA account to get the $600 bonus since I don't trade much in my IRA account.

It would save me money if I could use it for my preferred shares since I normally purchase new preferred shares when shares are called but I really need Level II quotes, multiple real time quotes, and multiple real time charts to buy or sell preferred shares. For high volume common stocks or ETFs, Level II quotes and multiple real time quotes aren't as necessary.

So now I have to think if I have any use for Sharebuilder.

Edit: After checking, Sharebuilder doesn't appear to offer any of the above (Level II quotes, etc.) even with the premium service. The premium service ($10 per month) only upgrades to real time quotes when researching which is standard with TD Ameritrade. To get real time quotes when trading a security (premium service not required), you have to go into one of the menus to enable that. If I transferred my IRA account, I guess I could use TD Ameritrade's Level II quotes when trading in the Sharebuilder IRA account.

Orangepants

Wow - this is all great information. I am moving money onshore now I know I am going to be staying a while and looked at investing myself - spent weeks reading books and tracking stocks I liked etc. tracked them using Seeking Alpha, really got into it but in the end decided to go with a managed portfolio - a bond fund, some stock funds and a couple of index ETFs.
Thanks you are both so knowledgeable.

Michael

If you invest in mutual funds, if possible, go with Vanguard since they won't eat you alive as badly as many other companies with fees. If you haven't traded before, then your plan sounds pretty good. However, if you haven't read my post on bonds, please read it since I suspect there will be a bond bubble within the next couple of years. In fact a bond bubble started about a month ago which may or may not reverse. If economic indicators keep pointing positive, it is very likely that a major bond bubble will occur.

On the surface European stocks look like a good value since they are overall about 30% below their 2007 highs but Europe has had 6 consecutive quarters of negative growth, many European companies are hurting (car sales are at 30 year lows and growth for many companies has been dismal), the European banking system is still not in good shape, the sovereign debt is still a problem, and the EU is slow to react to crisis. The gdp growth rate for the BRIC countries (Brazil, Russia, India, and China) is still very high but there is so much pressure to keep prices down that companies haven't been increasing profits and the markets have reflected that (Chinese markets are still about 60% below it's 2007 high). Canada and Australia were not hurt much by the recession due to their natural resources but their stock markets haven't gone anywhere in the last 5 years. Recently the Japanese market has finally become hot but from past performance, it is likely a "bear trap".

If the US economy can start growing at a continuous healthily 3% real gdp growth rate, I suspect that will start to pull Europe out of it doldrums but every time US growth seems to start producing high growth rates, headwinds occur. Either there is another European crisis, congress does something stupid, or oil prices skyrocket all putting a squeeze on the US economy.

Orangepants

After I signed on the dotted line and funded the account which would have been just over a month ago - two days later I saw a 2% drop in the bond fund! After what you said I think I will move out of the bonds - maybe tomorrow. Definitely tomorrow! I am planning my next round of investing in about 4 months after I had a chance to see performance on this lot!

I read all your excellent posts abut 2 years ago about futures, indexes, stocks etc when I was studying for my CAIA exams - I swear you helped me pass - not sure if I said thanks at the time. But Thanks!