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Bonds in taxable account?
Old 11-17-2008, 03:12 PM   #1
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Bonds in taxable account?

I'm quoting LOL! from a different thread to make a point.

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You should not hold your BND, VNQ, RWX and actively managed funds in a taxable account. Put them in an IRA instead.
I see this advice all the time. I don't understand bonds all that well, although I've read about them somewhat. I think I have some sort of mental block regarding them.

I'm retired, and I've been living off cash for the past few years. I'm trying to create a cash flow for moving forward. I'm 52 and have a large amount of my net worth in after tax investments, so it will be a while before I start withdrawing from my IRAs.

That being said, why shouldn't I keep bonds in my taxable accounts, to help with the cash flow situation? I'm in the process of moving my investments into Vanguard funds/ETFs, and the dividends from those and my REIT will create most of my needed cash. But if I'm going to be 55% equities/REIT, 40% bonds, 5% cash, part of my taxable accounts at least will have to be bonds. Given that, I can understand keeping my cap gains in after tax vehicles, but since I'll be in the same (relative) tax bracket in 10 years or so, what does it matter where I keep the bonds?

And if anyone has any suggestions about bond reading material that is easy to understand, I would appreciate it. Thanks.
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Old 11-17-2008, 03:30 PM   #2
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Originally Posted by harley View Post
That being said, why shouldn't I keep bonds in my taxable accounts, to help with the cash flow situation? I'm in the process of moving my investments into Vanguard funds/ETFs, and the dividends from those and my REIT will create most of my needed cash. But if I'm going to be 55% equities/REIT, 40% bonds, 5% cash, part of my taxable accounts at least will have to be bonds. Given that, I can understand keeping my cap gains in after tax vehicles, but since I'll be in the same (relative) tax bracket in 10 years or so, what does it matter where I keep the bonds?
It comes down to the tax rates of the types of income being generated.

If you make $1000 in (non-REIT) stock dividend income in a taxable account and you withdraw it, under current law you have $150 in taxes (at a 15% dividend tax rate).

If you make $1000 in REIT dividends or bond interest, you pay $250 in taxes.

So all else being equal, income from stock dividends (and LTCG) are better taken from a taxable account than an IRA.

And it gets worse: If you earn $1000 in stock dividends in the IRAs, that income will be taxed at your marginal rate (25% in my example) when they could have been taxed at 15%. So you will pay $250 in taxes on that income when you could have paid $150 in taxes in a taxable account.

Same is true for a $1000 long-term capital gain. This is taxed at $150 in a taxable account and $250 (eventually) when withdrawn from an IRA.

So if you are dependent on income from taxable AND tax-deferred accounts -- AND you own both stocks and bonds -- it's better to put the dividend-paying non-REIT stocks in the taxable account and REITs and bonds in the IRA. Since REIT dividends and bond income are taxed at ordinary income tax rates like IRA distributions, you don't save any taxes by putting them in the taxable account.

If part of your taxable has to be in bonds to meet your allocation, so be it -- but in that case, all of your stocks should be in the taxable account (under current tax law) and your IRA should hold nothing but bonds and REITs...
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Old 11-17-2008, 03:44 PM   #3
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What difference does it make if you can remain in the 15% tax bracket in retirement. Taxable income under $63,700 (2007 limit) MFJ which depending on other tax free and deferred income could be gross income in excess of $100,000 and even taking the standard deduction without other tax free and deferred income would be about $80,000. And what happens if the LTCG rate goes to 20 or 28% in 2009 (and there is some talk of it being retroactive to 1/1/2009) would the advice be the same?
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Old 11-17-2008, 03:46 PM   #4
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Just for you: Placing Cash Needs in a Tax-Advantaged Account - Bogleheads

Why be satisfied with the 15% tax bracket when you can be in the 0% tax bracket? And while in the 0% tax bracket you can move your IRA / 401(k) money to a Roth IRA where even your heirs will get to withdraw it tax-free.
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Old 11-17-2008, 03:48 PM   #5
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What difference does it make if you can remain in the 15% tax bracket in retirement.
Because *right now* (under current law), from 2008-2010 if you are in the 15% marginal bracket or lower, at least some of the income from dividends and LTCG have a 0% tax rate*

So it still matters.

* -- until you have enough income from those sources that your total income including those sources is kicked into the 25% bracket, at which time they would be taxed at 15%. Assuming no changes to tax law until 2011, anyway, which may or may not be appropriate.
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Old 11-17-2008, 03:52 PM   #6
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The logic used for accumulation might be opposite what is used in withdraw.

When accumulating sheltering things from taxes creates higher returns.
When withdrawing that same strategy might generate a higher tax at withdraw.

What is most tax efficient going in is not the most tax efficient coming out.

Tax efficient when accumulating:
1) 401k (tax free)
2) Roth (investment earnings/distributions are tax efficient)
3) taxable accounts (deposits were already taxed and any other event is taxable in some regard)

Tax efficient when drawing down
1) Roth (tax free)
2) taxable accounts (lower tax rates right now- 5% and 15%)
3) 401k (taxed at ordinary income levels -10%, 15%, 25%, 28%, 33%, 35%)

In your situation you don't care about accumulating, you only care about two things (from this perspective), IMO:

1) Pre IRA withdraws
2) Post IRA withdraws

Meaning you need one strategy for before IRAs are touched and another for after IRAs are touched.
A third phase might include when SS is collected.

I will state a goal I have for me, only you can decide if it is appropriate for you:

Withdraw as much in 15% tax bracket as humanly possible and avoid the 25% bracket like the plague.

To do this put dividend paying stocks in the taxable account. Can dividends supply all income needed right now?
If not, create some Muni bond positions in taxable accounts. Can dividiends plus muni bond interest supply all income needed right now?

If both of above are true, then you can look deeper into IRA and see:
1) will RMDs be in 25% bracket or 15% bracket?
a) if 15% your strategy needs little tweaking when IRAs are touched
b) if 25% or higher, rethink whole withdraw strategy
for example b) might include
1) converting IRAs to a Roth now and pay 15% taxes NOW to lower RMD into 15% bracket
2) use 72(t) to access IRA now (age 52) and take some of IRA out and spend less of taxable monies to have a lower overall tax paid throughout retirement
3) something else others might chime in
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Old 11-17-2008, 03:59 PM   #7
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I will state a goal I have for me, only you can decide if it is appropriate for you:

Withdraw as much in 15% tax bracket as humanly possible and avoid the 25% bracket like the plague.
I've always planned for this to be my goal. But after the last few months, I hope this is something I have to worry about, because right now, retiring in the 25% bracket seems like a pipe dream...
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Old 11-17-2008, 05:32 PM   #8
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Harley - if you can stomach long munis (not zero coupons), and have about a 55/45 allocation equity/bonds (bonds incl about 5% cash/state mm sweep) then you can have pretty close to zero tax, if your bonds are munis. Note, that is not bond funds, it is the muni bonds themselves. California long munis are yielding around 5.5% plus or minus for AA and A, a bit lower for AAA. This assumes you are in California, but other states also apply. They are federal, state, and AMT tax free. I'm engineering my AA so that I have my basic needs met by the tax free muni interest, and the extras from dividends. With a 55% allocation to dividends and a 1.5-1.7% div rate, you would more than likely be under the radar for taxes, so long as the dividends are less than if you were married filing jointly, and had two exemptions, or had schedule A deductions that were at least as much or higher than the standard deduction. Don't forget your real estate taxes and any charitable contributions, as well as medical costs. The way I have it figured, I can have about $100k income without paying ANY taxes this way (other than real estate, sales, and those kinds of taxes). I don't have time to find the calculators right now, but look around and check it out.
YMMV...as always.

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Old 11-17-2008, 08:34 PM   #9
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Man, you guys are making my head spin! I obviously was much better at accumulating than drawing down. All you have to do to accumulate is LBYM and invest wisely/luckily. Drawing down requires knowledge.

LOL!, I read the it about keeping your cash in a tax advantaged account. Fascinating, but it will require some thought.

jiMOh and Rambler, I like the thought of munis for my taxable accounts. I'm doing some online reading on bonds, and will pay particular attention to that part.

Rambler, why do you say buy the munis themselves, vs. a fund? Do the funds change the tax advantage?

And again, if anybody has any good reading recomendations, feel free. I read well, and there's no reason I can't wrap my mind around this stuff. It's like my reading music. For the longest time I could only read treble clef. I had a mental block about bass clef. But persistance and practice pays off eventually.
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Old 11-17-2008, 08:34 PM   #10
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And if anyone has any suggestions about bond reading material that is easy to understand, I would appreciate it. Thanks.
M* has a series of articles written under the topic The Bond Squad.
use search keyword "bond squad" here
Morningstar Search
i am no financial guru, but i find their articles are easy to read and i get more comfy with the terminology. take it all with a grain of salt, of course.
there is also an Investing Classroom there, designed to give the student a good feel for the definitions and terminology. i believe it is free for anyone.
Stock Investing Education & Courses
there are simple but very informative self paced lessons.

i myself am a big fan of TE munis. VWAHX - i'm DCAing $600 per month, getting a $330 TE dividend per month with recently increased yields, and watching it all grow nicely. this is a long term income generator for me.
some recent losses in TE munis need to be noted, i.e. it can and does happen. VWAHX was actually posting a 9% YTD loss a few weeks ago. it is now down only 7% YTD. be careful if principal preservation is an issue.
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Old 11-18-2008, 01:32 PM   #11
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Man, you guys are making my head spin! I obviously was much better at accumulating than drawing down. All you have to do to accumulate is LBYM and invest wisely/luckily. Drawing down requires knowledge.

Rambler, why do you say buy the munis themselves, vs. a fund? Do the funds change the tax advantage?

And again, if anybody has any good reading recomendations, feel free. I read well, and there's no reason I can't wrap my mind around this stuff. It's like my reading music. For the longest time I could only read treble clef. I had a mental block about bass clef. But persistance and practice pays off eventually.
A bond fund will be subject to a changing NAV which might be more risky (when you depend on the income) based on interest rate changes. If you buy the individual bond itself, and hold to maturity, you do not have any risk of changing interest rates affecting your income stream.
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Old 11-18-2008, 04:58 PM   #12
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Harley, I have a similar block about bonds. I'm working on it, too.

For me, the Bogleheads Guide to Investing had (so far) the clearest discussion of bonds and taxes that I've read so far. I felt that I really needed to start at the beginning and move up from there -- it was a nice primer.
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