I'm trying to decide between investing in Vanguard Tax Managed International vs. investing in both Vanguard European Index and Vanguard Pacific Index in a buy and hold taxable account. Given that both the Vanguard European and Pacific Index funds seem to be rather tax efficient index funds, is the gain from investing in the tax managed fund enough to overcome the loss of the ability to rebalance between the Europe and Pacific funds with new money? My top tax bracket in last year was 31 percent, and I intend to hold my funds for 20 or more years.

Paul's Answer:

You have figured out the tradeoff pretty well, I think. Vanguard's Pacific and European index funds are very tax efficient, and they aren't likely to leave you with big tax bills. However, in your income bracket, taxes are a major consideration.

Over 20 years, the taxes from any capital gains distribution will erode your performance in one of two ways. Either you will have to sell some shares to pay the taxes or you will have to pay taxes from some other source. Paying taxes from another source has the same effect as adding to your investment without getting any additional return.

I think long-term investors should try to cut their expenses, including taxes, any way they can. Over 20 years, little differences become big ones. Why not give yourself the advantage of Vanguard's specific tax-averse management?

A tax-managed fund is run very similarly to an index fund. But one of the manager's specific jobs is to avoid or minimize capital gains distributions. So when a position is sold with a capital gain, the manager will look for other positions to sell at offsetting losses.

Vanguard has several good tax-managed funds. The one you're considering is too new to have a three-year or a five-year tax efficiency ratio. But I think its tax management discipline will give it at least a modest edge over the indexed funds that are not specifically managed to minimize taxes.

As for rebalancing, Vanguard will do that for you within the Tax-Managed International Fund. That's the choice I recommend for your situation.