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My children received significant gifts from grandparents, both to be their college fund and also nest eggs/etc. if they don't go to college for some reason or post-college. The gifts are in UTMA accounts; they're not in 529 accounts or similar, and I don't think we want them to be (as the money isn't just for college).

The accounts are big enough that they incur significant income taxes, and since the kids are young, they will be growing and paying taxes at our rate for quite some time (over ten years in both cases).

What kinds of investment choices are most sensible for this kind of capital? Right now they're just sitting in index funds, but those have typically generated ~2% in capital gains annually from what I've seen the last few years. That 2% is taxed at 25% federally plus 4% state after the first $2k, meaning we lose ~0.5% of the investment to taxes each year.

Are tax-managed funds like VTMSX or similar a good strategy for accounts like this? Or are we better off sticking with the very low overhead index funds and just accepting the taxable gains? And are we entirely wrong to consider 529s inappropriate (given the amount already is over what we expect college to cost, and we and the grandparents making the gift specifically didn't want to require it to pay for college if they choose otherwise)? Finally, are there other strategies that make sense for this kind of long-term investment?

  • 2% seems very low for index funds unless there very low-risk. One option might be to consider better performing index funds, especially if you can afford to take some short-term risk for more long-term benefit. – D Stanley Apr 17 '17 at 16:54
  • 2% is not the overall change in value of the fund, but is just the realized capital gains and dividends (i.e., what we have to pay taxes on each year just holding the fund). We're holding VFIAX and another similar fund; VFIAX for example had about $4 in dividend distributions in 2016, on a share price of a bit over $200/share, for 2%. – Joe Apr 17 '17 at 17:28
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In your case I think you are doing just fine. Index funds, by their nature, have lower transaction costs and fewer taxable events than actively managed funds, good work.

Index funds do not preclude the generation of dividends, and by their nature they probably generate slightly more than actively managed funds.

You could take capital gain or dividend or both distributions, rather than reinvest them, if paying the taxes are a hardship. Otherwise look at the taxes you pay as your contributions to these funds. It stinks, but this is why 401K/IRA were rather revolutionary when they were formed. It was a really good deal to not have people's capital gains eaten by taxes when they occurred. Now its old hat, but it was pretty darn cool at the time.

Should you prefer VTMSX rather than VFIAX? We can't really make the call on that one. Which one will perform better after taxes? Its anyone's guess.

It is kind of a good problem to have.

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    Good problem to have, sure, and I'm not worried about paying the taxes ourselves from a cash flow point of view (they're not that much ultimately); I'm just thinking from an overall ROI point of view. I'm not asking about the specific funds, but about general strategy. If a 0.5% (or so) drag on gains is just what we have to live with I'm okay with it, but if there are strategic ways to avoid that, it seems like that would be preferable... – Joe Apr 18 '17 at 18:00
  • @Joe sorry I did not make this clear, but .5% is unbelievably good, especially considering historical nature of taxes and investments. This promoted the "good work" at the end of the first paragraph. Buffet in many of his writings talks about the unaccounted for drain taxes play in investment returns and he would be proud of your work from what I have read. – Pete B. Apr 18 '17 at 18:51

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