Asset Allocation for drawdown phase: Keep "cash" in IRAs or taxable?

[samclem]

I'm helping my MIL with her finances and working through her AA and the mechanics of where the assets should go. She has no Roth accounts, just her after-tax accounts and a traditional IRA. She's 73, so she's taking RMDs. 82% of her funds are on the IRA side of the fence now. I'm struggling with where to put her "cash" (right now it looks like it'll be CDs at Ally Bank). The cash portion of her portfolio will be about 18%, these are taking the "normal" place of most of the bonds I'd normally recommend that she include (bonds just seem risky due to possibly higher rates, I'm not seeing much reward for that).
Would it be best to keep these CDs outside her IRA, or put them in there? What I've thought:
- The CD's are likely to grow less than the equities, let the equities stay in the IRA and grow tax free.
- She has to take her RMD from the IRA every year. If the market goes down and if she's got CD's in the IRA, she'd be able to sell those to meet the RMD rather than sell stock that is at a beaten-down share price.
- Putting equities outside the IRA would give the opportunity to do tax loss harvesting (if necessary), which can't be done in an IRA.

- Right now I'm leaning toward keeping the CD's out of the IRA. If she has to sell depreciated equities to meet her RMD, we can just sell a corresponding amount in CDs and replace the equities (or buy similar ones) in the after-tax account.

I know this is Retirement 101, so just point me to a good source of info and I'll go read it!

[LOL!]

Equities grow tax-free in taxable as well, don't they?

What is her marginal income tax bracket? Is conversion to Roth something to do?

This describes some things to consider: Placing Cash Needs in a Tax-Advantaged Account - Bogleheads

[samclem]

Quote:

Originally Posted by LOL! Equities grow tax-free in taxable as well, don't they?

No, the dividends paid out would all be taxable, as well as any cap gains. I could choose a Tax Managed account to minimize the problem with capital gains. For 2012 she wouldn't have to pay cap gains and dividends would be taxed at 10% (she's in the 15% bracket), but starting in 2013 the cap gains go to 10% and dividends get taxed at the same level as regular income (barring changes to tax law)

Quote:

Originally Posted by LOL! What is her marginal income tax bracket? Is conversion to Roth something to do?

Her marginal rate will be 15%. The incremental conversions to a Roth IRA will probably make sense over the coming years to reduce the magnitude of her future RMDs, but the RMDs are probably going to be a fairly close match to her actual spending requirements unless her portfolio grows a lot (a good problem to have!).

Quote:

Originally Posted by LOL! This describes some things to consider: Placing Cash Needs in a Tax-Advantaged Account - Bogleheads

Thanks for that. Their Principles of Tax Efficient Fund Placement-Bogleheads is also well done, though it doesn't address the cash "bucket" during the withdrawal phase.

Thanks again.

[pb4uski]

I'm considering some Bullet shares that Guggenheim offers that are essentially buying a participation in a bond portfolio. They offer numerous portfolios that each have a defined maturity year. You might hold those in amounts designed where the amounts maturing each year are roughly equal to her RMD.

While the value might decline if interest rates increase, the amount of the proceeds upon maturity would not change. These would likely pay more than CDs of similar term. And since they are held in the IRA the income would be tax deferred and might alow the annual Roth conversions to be marginally higher while staying in the 15% tax bracket.

[RetireBy90]

I would suggest that the assets that go inside IRA should be those that grow the most, and thus are able to take advantage of the tax deferral, although at 15% tax rate, not a lot of deferral.

If you agree with this general principal, then CDs would belong outside the IRA to the extent possible. In the future, a CD could yield more than equities, and thus could belong inside the IRA. So I would put the assets that throw off the most taxable income inside the IRA and the least taxable income outside.

[LOL!]

In low tax brackets, long-term capital gains are taxed at a 0% rate.

One should invest tax-efficiently in taxable accounts. That means, one can buy index funds that do not make capital gains distributions.

Unrealized capital gains are not taxed.

Yes dividends are taxed, but qualified dividends are also taxed at a rate as low as 0%.

Have you put MIL's income into TurboTax to see how things play out? I recently helped my mom and did her taxes. She learned some things and moved her bond fund into her IRA.

[Animorph]

I'd probably spend down the cash as income is needed (including Roth conversions to the top of the 15% tax bracket). That leaves the IRA to grow as long as possible. The standard spend-down sequence. Adjust the IRA as needed, or invest some of the outside cash if there is too much, to maintain the target AA. Eventually the IRA and Roth accounts have everything other than RMD and any extra income withdrawals for near-term expenses and the allocation problem goes away.

[nun]

I'd keep a year's worth of cash in a bank account and then apply tax efficient investing principles to the rest of the portfolio. So put the rest of the taxable money into equity index funds an keep your bonds in the IRA. Use IRA RMDs to top up the cash account as needed.

[Aeowyn]

I would keep the cash in the IRA. I would put low turn-over non-dividend paying equity mutual funds in the taxable account. These funds should essentially grow tax-deferred. Even if the Bush Tax Cuts expire at the end of the year - the long term capital gains rates are still less than other federal income taxes. By the way - interest on the CASH accounts would all be taxed as ordinary income if in a taxable account -of course with current interest rates that probably doesn't amount to much.

The other thing I'm thinking is it sounds like her assets are growing faster than she is using them - so she may be leaving a decent inheritance to her heirs. Inherited Traditional IRAs require the beneficiary to take RMDs that are taxed at their tax rate (which could be higher than 15% especially if they are still working at the peak of their career). However if equities are inherited, the cost basis to the heirs is the DOD value of the funds - so all the capital gains incurred prior to that is not taxed at all (at least with current tax laws).

I would recommend Cash in Traditional IRA. Take RMDs from Traditional IRA and supplement extra needed money from taxable accounts if needed. If this adds up to less than the 15% tax bracket, convert Traditional to Roth to max 15% bracket.

If she doesn't want to mess with Roth conversions for some reason, then I would say to take more than the RMD from the traditional each year to max out 15% bracket and move to taxable accounts if she doesn't need to use it all.

[Surewhitey]

Quote:

Originally Posted by LOL! In low tax brackets, long-term capital gains are taxed at a 0% rate. One should invest tax-efficiently in taxable accounts. That means, one can buy index funds that do not make capital gains distributions. Unrealized capital gains are not taxed. Yes dividends are taxed, but qualified dividends are also taxed at a rate as low as 0%. Have you put MIL's income into TurboTax to see how things play out? I recently helped my mom and did her taxes. She learned some things and moved her bond fund into her IRA.

+1 fo sho...

[samclem]

Thanks to all for the input so far.

Quote:

Originally Posted by LOL! In low tax brackets, long-term capital gains are taxed at a 0% rate.

Only this year. If nothing changes, in 2013 the 10% bracket goes away and the first dollar of taxable income is taxed at 15%. The tax on LTCG there is scheduled to be 10%. But, that's still pretty good.

Quote:

Originally Posted by LOL! Unrealized capital gains are not taxed.

Yes, this is a good opportunity to defer taxes.

Quote:

Originally Posted by LOL! Yes dividends are taxed, but qualified dividends are also taxed at a rate as low as 0%.

Yes, but again the "truth may change" next year. Taxes on all dividends for everyone are presently scheduled to be at their ordinary income tax rate.

Quote:

Originally Posted by nun I'd keep a year's worth of cash in a bank account and then apply tax efficient investing principles to the rest of the portfolio. So put the rest of the taxable money into equity index funds an keep your bonds in the IRA. Use IRA RMDs to top up the cash account as needed.

Yes to all, except the bonds. I'll buy them when they get out of their Fed-induced torpor, though she'll have a small slug of short term corporates and ST Treasuries. The CD's will serve as (not entirely satisfactory) stand-ins for bonds right now. Like bonds, all the income they throw off is taxable, so it would make sense to put them in the IRA-- but they're just earning 1.5%. It "feels" like a waste of the IRA sheltering--but now I think it's the least bad option.

Quote:

Originally Posted by Animorph Eventually the IRA and Roth accounts have everything other than RMD and any extra income withdrawals for near-term expenses and the allocation problem goes away.

That would work really well, and it's what I'm going to try to do with my own accounts (now that I appreciate the magnitude of the RMD problems). Unfortunately, in addition to all the (more important) ramifications of my FIL's death, for tax purposes my MIL will now soon be a single filer with low brackets and a low standard deduction. With most of her SS checks being taxed, she'll be at the top of the 15% bracket due to the RMDs (Dang--this money should have been transitioning to a Roth for a long time now!). And the icing on the cake: If there are no changes to tax law the 25% rate goes to 28%. That's gonna sting.

Quote:

Originally Posted by pb4uski I'm considering some Bullet shares that Guggenheim offers that are essentially buying a participation in a bond portfolio.

That's an interesting product. If an investor knows they'll keep the ETF to maturity, it removes all risk of price declines due to rising interest rates. The only risk is the default risk of the underlying bonds. Looks like they yield about 1/2% above the best CD I can find. Hmm.

Quote:

Originally Posted by Aeowyn I would recommend Cash in Traditional IRA. Take RMDs from Traditional IRA and supplement extra needed money from taxable accounts if needed. If this adds up to less than the 15% tax bracket, convert Traditional to Roth to max 15% bracket.

Yep, I can see that's the way to do it. The cash has to go somewhere, and its slower growth rate will reduce the magnitude of the RMDs (I don't know if she'll need/want to spend all of the RMDs each year, but it would be nice to have the option to leave more in the TIRA.) Having equities outside the IRA will also allow deferral of their cap gain (and some prayer of continued favorable tax treatment), allow tax loss harvesting, and she'll be able to gain the tax benefits of donating appreciated equities to her charities.

I do wish we had more headroom to convert to Roths each year, it would help her and possibly her children. Surely there's a creative way to turn some of this into earned income every year . . .

Thanks again for the past and future ideas.

[Aeowyn]

What do you need earned income for?

[samclem]

Quote:

Originally Posted by Aeowyn What do you need earned income for?

If the gains from her after-tax accounts were earned income, she could move 6K each year into a Roth IRA (5K plus 1K "catch up"), which would allow her to avoid paying taxes on it in the future. It's not a huge deal, but with the (on the books) changes in tax rates she'll likely be in the 28% bracket, so moving funds to a Roth is more beneficial than it would have otherwise have been for her.

[Aeowyn]

Of course if it were earned income - she would have to pay SS tax on it. And if the gains are LT Capital Gains - she has more favorable federal tax rates on it than earned income too. Passive income has many advantages over earned income.

I'm also not opposed to taking the "hit" and converting from Traditional to Roth in the 25% bracket. Would have to run some scenarios. I think tax rates are heading higher but I don't have a crystal ball. If you take the hit now, you can reduce/eliminate RMDs in teh future and that might reduce the amount of SS income that gets taxed in future years too.

[walkinwood]

Here's another paper on the subject. More or less along the lines of the advice you've already been given, but with more details.

http://www.irebal.com/docs/AssetLocation.pdf