Asset Location for Early (Semi-)Retirement

[dreamcast]

I'm 32 and hope to semi-retire in 1-3 years. I plan to work at least part of the year to supplement my income and stay active in my industry. I don't know the best way to allocate funds between taxable and tax-deferred accounts. My funds are currently split 85%/15% between taxable/retirement accounts. I have read two conflicting strategies:

1) Use a single asset allocation plan and locate funds according to tax efficiency, e.g. bonds/REITs in tax-deferred accounts. My retirement account would be 100% bonds. This is the traditional advice.

2) Set an aggressive allocation (80/20 stocks/bonds) for the tax-deffered accounts given they won't be tapped for 25+ years. The taxable account needs bonds for withdrawal during years when stocks are down and before the retirement accounts are available. Set a slightly less aggressive/volatile allocation for the taxable account that includes fixed income.

 

[mathjak107]

well i would take all the money as a whole...i would divide it into 3 time frames as to when you will need it...1-3 years, 3-5 , 5 years and more....
the one to 3 id keep very liquid and conservative,,,,,this is all from taxable.....the 3-5 can be from both catagories and conservatively invested ,growth and income funds,dividend paying stocks,bond funds... 5 yrs and longer go for growth.....this would be retirement accounts and whats left over in taxable.invest this like you would any long term money

 

[wildcat]

I am for reducing taxes via - tax account something like Vanguard Tax Managed Index funds (they offer large cap, small cap, international & balanced - I think) and non-tax keep bonds and REITs.

I think you would be better off by putting a couple years worth of expenses in safe investments - ladder CDs. That way you can let the rest of you pile grow and you will still meet your withdrawl needs.

I don't think you should approach it just from an either/or perspective. Nothing wrong with having stocks in your non-tax accounts in addition to bonds/REITs so long as you meet your target allocation.

Just in case you did not know you can tap IRAs early but it looks like you have more than enough in taxable accounts - usually done when people have large amounts in non-tax and little in tax accounts.

 

[Gone4Good]

I don't think there is one right answer to your question.

If you run the numbers you will find that you get the biggest bang out of your tax deferred accounts by stuffing them full of investments that throw off currently taxable income (bonds, REITS, etc) and using your taxable account for investments that don't generate current income (small stocks, etc). All else being equal, using your tax deferred accounts for income producing assets will result in a larger after-tax portfolio down the road.

But all else is never equal. Because you are planning to retire, you will need current income to live on. Although you didn't post enough information for me to know your specific situation, I assume you will need to lean on your portfolio to some extent. This is where dividends and interest payments come in handy. If you have all of your income producing assets tucked away into tax deferred accounts you can't spend that income and will have to sell down other parts of your taxable account to generate spending money. Those sales could produce taxable gains, which might offset the tax deferral benefits of the retirement accounts - in this case you are simply swapping one tax deferral for another.

I think a preference between choices '1' and '2' in your original post depends on your specific situation. Some things to consider:

1) If you allocate 100% of your retirement accounts to fixed income investments will you still have enough room under your desired asset allocation for necessary cash and short-term investments in your taxable account?
2) Will your taxable account generate enough income for your needs?
3) Does your taxable account have large unrealized capital gains?
4) Will a 100% fixed income allocation in the retirement account adversely affect your ability to rebalance your portfolio in a tax efficient manner?
5) Will your taxable account still have enough bonds so that you can avoid selling stocks in declining markets?
6) Does the advantage of deferring taxes on your interest income outweigh the potential challenges posed by having most of your stable, income-producing, assets out of reach?

 

[TromboneAl]

Here's a thought related to this, and maybe some of you can comment.

The problem is that you want to have bonds in the tax deferred account and stock in the taxable, but you will be taking money from the taxable first.  You don't want to take money from the stock fund, though, because it might be a down year.

Here's a solution: You have a mix of stock and bond in the tax deferred, and all stock in your taxable.  Let's say you need to take out 20,000 when the market is down big time.  You take the 20,000 from your taxable stock fund, and also transfer 20,000 from your tax deferred bond to your tax deferred stock fund.

That's essentially what I do.

 

[dreamcast]

TronboneAl,

I like your thought. I wonder why I haven't found this technique described elsewhere. The only disadvantage I can think of is the extra trade required to rebalance. Do you have any links to discussion or articles on this strategy?