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Old 11-17-2009, 01:36 PM   #21
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Quote:
Originally Posted by teejayevans View Post
Its does in 2008-2010, you would not pay taxes on your LTCG and Divs.
You could have 40K of LTCGs and Dividends and pay nothing, nada, zero
in taxes
This brings up the question, if Bush tax cuts expire, does anyone know if the
old 15% tax bracket would be the same as the current?
TJ
something from Turbotax:

Starting in 2011
Higher Tax Rates

Beginning in 2011, tax rates in effect prior to 2001 spring back into effect. The top income tax rate returns to 39.6 percent, and the special low 10 percent bracket is eliminated. Whether this will actually happen will be at the heart of a spirited battle in Congress.

Estate Tax Revived

For individuals dying after 2010, the federal estate tax returns with a $1,000,000 exemption and a 50 percent maximum rate. This assumes that Congress allows the estate tax to disappear in 2010, which is unlikely.

Increase in Capital Gains and Dividend Tax Rates

The tax rate reductions for long-term capital gains and dividends is scheduled to expire this year.

In 2011, the maximum long-term capital gains tax rate goes back up to 20 percent from 15 percent. A lower 10 percent tax rate is used by individuals who are in the 15 percent tax bracket. Their long-term capital gains had been tax-free since 2008.
In 2011, dividend income (other than capital gain distributions from mutual funds) is taxed as ordinary income at your highest marginal tax rate.
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Old 11-17-2009, 03:08 PM   #22
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I had time to only briefly look at responses so far... I have a few comments:

@jdw_fire: thanks for following along and for your answers to some other posts - I think we are on the same page. As for...

Quote:
Originally Posted by jdw_fire View Post
the reason it didnt work out the way it did earlier is that i think you didnt follow 1 of your own assumptions, the 1 about the starting account values. since the tax rate changed to 33% the 401(k)'s value should be 150k to have an equal after tax value to the taxable accounts 100k. i didnt use your spreadsheet but when i ran the numbers on my calculator scenario 2 won (but it was a quick check so maybe i missed something)
... you are absolutely right. I've redone it on my spreadsheet (new one is attached) and under LOL! conditions, I still get equities in taxable account come out ahead by 1% with 33% marginal tax and 15%cap gains tax.

@kaneoh: your simplification example goes back to not taking into account that a dollar in taxable account is different from dollar in tax-deferred one. For instance, in one of your examples you said:
"...
1) Case 1: 133 S (stock) in tax deferred; 40 S + 60 B (bonds) taxable
2) Case 2: 73 S + 60 B in tax deferred; 100 S in taxable
..."

Converting this into after-tax dollars (at 25% tax), this is similar to saying
1) Case 1: my overall asset allocation is 140S + 60B
2) Case 2: my overall asset allocation is 155S + 45B

So, I am sure you can see how comparing above two cases will not produce useful results.

@LOL!: as jdw_fire replied to you, you are missing my point about different values of your $ and effectively making the same mistake as kaneoh above. In your example, comparing A and B is wrong. Putting your 401(k) pre-tax money into 100k worth of BRK is NOT comparable to putting after-tax 100k into the same investment.

Actually, your C and D comparison example is another great illustration of my point!! Look at your results there - seemingly "same" investment with same taxes and everything in your tax-deferred case (D) got you LESS money than if you had it in taxable account all along (C)... Why would that be?? What's your explanation?

I would say it's because it's not the same investment actually - you are starting with different dollars: in (C) they are already taxed but in (D) you still owe taxes on them!
Attached Files
File Type: xls fixed_vs_equity_in_tax_deferred.xls (24.0 KB, 3 views)
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Old 11-17-2009, 05:07 PM   #23
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In your example, comparing A and B is wrong. Putting your 401(k) pre-tax money into 100k worth of BRK is NOT comparable to putting after-tax 100k into the same investment.
True, but remember the after-tax 100K investment cost you $133K if in the
25% tax bracket for example.

So given that you are in 25% tax bracket, and earnings are tax at 15%:
pre-tax: 100 earns 10% (110) and withdrawn paying the 25% tax, you left with 82.5
post-tax: 100 is taxed so you are left with only 75 to earn 10%, paying 15% tax on earnings leaves you 81.38.

401K/IRA is a better option, even if you get preferred tax treatment on the earnings in the post tax account.
TJ
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Old 11-17-2009, 05:52 PM   #24
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I think what happened with taxes BEFORE my scenarios is a moot point and a red herring. Sure you pay taxes before getting your hands on the cash in the taxable account. And you must often pay taxes when you withdraw from a tax-deferred account. But you often end up in a lower tax bracket than you think --- possibly even 0%. We are not discussing whether a tax-deferred account should be used or not; we are discussing what to put in it, when you also have a sizable taxable account.

Anyways, I am sticking with my scenarios because there is no need to elaborate on them.
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Old 11-17-2009, 07:47 PM   #25
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I think what happened with taxes BEFORE my scenarios is a moot point and a red herring.
In 401k case, you still have to pay taxes, but in taxable account you already paid them and thus your money is more valuable there... because AFTER your scenarios (not BEFORE) you will no longer have to pay taxes on that part. So starting with 100k in both does not make sense.

You can stick with your scenarios, but as I mentioned, looking at your (C) and (D), that means you should never be using tax-deferred accounts at all! After all, your tax deferred scenario for exactly "same" investment with same taxes generated less money!

I am sorry if my point is not coming across - I thought your example made it for me but you are still not seeing it! Or maybe it's me... :-(

@teejayevans: what you said is correct and does not contradict anything I said... both of the following are true:

(1) we are starting with some money in 401(k)/IRA and some money in taxable account and deciding whether to allocate 100k to investment X in taxable account or 133k in 401(k). This makes sense and follows what I've been saying.

(2) what you are saying is we could also start a step earlier (before contributing to 401(k)). In this case, our choice is to either contribute just-earned 133k (untaxed) to 401(k)/IRA and proceed with this 133k investment in some X in 401(k)/IRA, or we can pay the tax to get us after-tax amount of 100k and invest this after-tax 100k in X...

Both are describing exactly the same situation and will clearly produce the same results.

What does not make sense is allocating 100k in taxable account to investment X vs allocating 100k in tax-deferred account one.
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Old 11-17-2009, 08:25 PM   #26
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OK, you are in the 25% tax bracket. You have contributed to your 401(k) plan over the years and with some growth, it has $100K in it. Your 401(k) is split 50:50 stocks:bonds.

Then you get a bonus of $133.33K. You pay $33.33K in taxes leaving you with $100K in a checking account.

You now have $100K in a checking account and $100K in your 401(k). You want 50% equities and 50% bonds split up among the $200K because that's your asset allocation and that's what you had before your bonus. You can split them any which way among your remaining $200K. What way would give you the most money years later after withdrawing and spending the money? I answered this above.

You can obscure things all you want. We are not talking about putting $200K in one place or $50K here and $150K. We are not talking about not maxing out one's 401(k) contributions. We are simply talking about starting with $200K split evenly between your checking account and your 401(k). You may not wish to talk about that, but that's your choice.
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Old 11-17-2009, 10:11 PM   #27
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OK, you are in the 25% tax bracket. You have contributed to your 401(k) plan over the years and with some growth, it has $100K in it. Your 401(k) is split 50:50 stocks:bonds.

Then you get a bonus of $133.33K. You pay $33.33K in taxes leaving you with $100K in a checking account.

You now have $100K in a checking account and $100K in your 401(k). You want 50% equities and 50% bonds split up among the $200K because that's your asset allocation and that's what you had before your bonus. You can split them any which way among your remaining $200K. What way would give you the most money years later after withdrawing and spending the money? I answered this above.

You can obscure things all you want. We are not talking about putting $200K in one place or $50K here and $150K. We are not talking about not maxing out one's 401(k) contributions. We are simply talking about starting with $200K split evenly between your checking account and your 401(k). You may not wish to talk about that, but that's your choice.
LOL!, it sounds like you will stay with your opinion no matter what I say at this point. That's fine. Perhaps the same can be said of me (although I hope to keep an open mind still... LOL!)

For the benefit of others who might be reading the thread, I will point out your mistake again...

Truth is you don't have 200K! What you have is 100k after tax money and 100k on which you still have to pay taxes. 100k bonds in 401k and 100k stocks in your after-tax account is NOT a correct 50/50 split! To correctly split your allocation 50/50 you have to actually allocate 87.5k in your taxable account vs 100k in your 401(k) + 22.5k in your after-tax account. That's the real 50-50 split.

It's analogous to saying you have 100k in Canadian dollars and 100k in US dollars, so let's split them 50-50... By LOL reasoning, you would say 100k in canadian dollars should go in one investment and 100k in US$ should go into another because both are "100k" and they both have "dollars" in their name. You give no consideration to the fact that they are actually worth different amounts to begin with, because in US you have to convert Canadian$ to US$ to make use of it and it won't be 1:1 (most likely)... just like with pre-tax dollars - you have to convert them to after-tax dollars first before making use of them...

So, all LOL's comparisons of 100k of one kind of dollars and 100k of another kind of dollars are effectively:
case (1): 100k real after-tax $ in stocks and 87.5k real after-tax $ in bonds (growing tax deferred) vs
case (2): 100k real after-tax $ in bonds and 87.5k real after-tax $ in stocks (growing tax-deferred)
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Old 11-17-2009, 10:44 PM   #28
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One big advantage for holding equities in a taxable account is that you can take advantage of tax loss harvesting. Also, although future dividend and cap gains tax rates are uncertain, both have generally been lower than ordinary income tax rates. Lots to think about on this topic...
Good point about tax-loss harvesting. Remember that it lowers your basis, and thus defers your taxes to your future cap gains tax rate but does not eliminate them, unless your future cap gains tax rate is 0%.. So, as to how huge of an advantage it is, it might be subject for another spreadsheet :-).

Meanwhile, in my examples, I already assume 0% tax rate for all cap gains, although I think more than 0% is still likely since dividends still do exist...

As for dividend / cap gains tax rates being lower than income tax rate, I agree and the example I gave takes those as inputs.

So, you can just take the simple spreadsheet (or of course, create your own), plug in your assumptions and get the results... I think it's really that simple once you are convinced you got the right model.

As I am playing with it, I am finding that in most cases when fixed investments really underperform equities and when you looks at longer periods of time, it makes more sense to push more equities into tax-deferred accounts and fixed ones into taxable accounts. As you get closer to using the funds, the tax-deferred compounding effect is becoming less important compared to the tax-inefficiency of fixed investments; and even then it's often better to keep higher-growth tax-deferred. So far I've seen not too many cases, when you have only a few years left before withdrawing the money when you should start switching the positions the other way...
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Old 11-18-2009, 01:15 AM   #29
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smjsl/jdw.......

Perhaps this is the reason for LOL's beliefs......
Principles of Tax-Efficient Fund Placement - Bogleheads
There are some academic papers footnoted at the bottom. Way over my head. Perhaps they might be of interest to you so you help us reconcile their ideas w/ your spreadsheet. btw.....VG also has a wiki on tax-adjusted asset allocation that agrees w/ your idea.

Still think it would be useful to have a discussion on the bogleheads.org forum discussing your ideas.
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Old 11-18-2009, 05:43 AM   #30
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It is pretty obvious that I will always believe that a 15% tax rate is less than a 25% tax rate.
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Old 11-18-2009, 06:14 PM   #31
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@kaneohe: I will investigate this question further and let you know what I find out.
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Old 11-22-2009, 08:10 PM   #32
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Bogleheads :: View topic - Vanguard CFP and Roth is a thread on bogleheads that addresses after a few posts the issue of the location of equities & bonds in tax-deferred and taxable accounts with a link to a research paper.
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Old 11-24-2009, 11:11 AM   #33
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Of course many of us feel that equities in taxable is a mighty fine way of passing our estate to the kids on a step-up tax basis. This trumps most of everything said above for us, at least.

Cheers,

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Old 12-01-2009, 04:37 AM   #34
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where to keep what all depends on whether your goal is pass on your wealth or live off it as well as whether the equities in your taxable account spin off lots of dividends


if i was planning on not selling my funds in my taxable account and passing them on eventually then low dividend paying index funds would be my first choice for equities .... never paying any taxes on the gains and the kids getting them tax free is the best deal around.

if the funds spin off regular taxable dividends then you have to analyze these numbers as there will be taxes paid all along and the inheritance factor is eroded slightly.

roth and roth conversions would be the next best place.... the biggest gainers namely the equities should be here . my equities buckets have 15 year time frames so they still have lots of growing time.

being i will need withdrawls to live on , and the gains are low, and the time frame much shorter im not so sure converting my bonds to a roth is worth doing at this point (age 57)

i think ill just leave the bond funds in my taxable account and 401k as just that , pay the taxes as i spend it down and leave the equities in both the taxable accounts and the roths to do their growing for many years if not forever.


ill spend the regular ira bond fund money and 401k bond fund money first dwindling down the mandatory withdrawls on the bond funds early on and if tax rates rise off in the future i would already have spent down a big part of that thru the years and payed the taxes all along while tax rates were on sale..
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Old 12-02-2009, 10:35 AM   #35
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finally someone brought up this topic. here is my real life strategy.
All tax defered acct on trading. By the way, I always fully invest on equity. For me, equity means penny stocks,
All cash acct on very conservative invest, basically mm.

Anyone here on my side?
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Old 12-21-2009, 05:53 PM   #36
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I have not forgotten about this question and promised to post a follow up. So, here it is. I did quite a bit of investigations including getting some answers directly from academics. Thanks to kaneohe for the link to Boglehead article which references a few papers at the end (Principles of Tax-Efficient Fund Placement - Bogleheads). I ended up studying them to some degree. This also led me to following paper, which had a lot nicely explained details:
http://spwfe.fpanet.org:10005/public...mining%20R.pdf

I think I have a much deeper appreciation now for what is going on and here it is...

Turned out it's not a simple topic unfortunately, so sorry for the long post, but here is a quick summary

- In most cases it looks like stocks that do not generate much of income are better to be held in taxable account and bonds in tax-deferred. (See below for a summary of how this is derived and therefore the assumptions made.)

- Dollars in tax-deferred accounts are different from dollars in taxable accounts. Correct value of 1 dollar in tax-deferred account is $(1-tn), where tn is the tax you will pay at the end for withdrawing that dollar. This should in part affect how you think about asset allocation.

- Stocks in tax-deferred accounts is a different investment then stocks in taxable accounts because real returns and risk are different for the two. Same applies to bonds.

- Questions I have not resolved (yet?): Accounting for stock dividends in the model will make it more likely that stocks should be in tax-deferred accounts, however to what degree this is true needs to be measured / estimated. On the opposite side, the model had to assume a capital gains tax after each year in taxable account (explained below), and extending this to N years would make stocks in taxable account more preferrable - again degree of this is unknown.

Finally, above conclusion is reached with using standard deviation as the model for risk. There are known problems with modeling risk as standard deviation, and it's unclear to me what the outcome would be if another model were applied (or perhaps there is no better model today, which is why researchers use standard deviation).

Some glory details for those interested...

(1) I was correct in that dollars should be valued differently in tax-deferred and after-tax accounts. William Reichenstein papers referenced on the Boglehead's page address this point in detail and I posted my explanation of this fact earlier in this thread. Another paper (http://wpweb2.tepper.cmu.edu/spatt/location.pdf) mentions this in passing and just works with after-tax dollars in tax-deferred accounts assuming you already made the conversion.

Note that while you do not know your future tax rate (tn), thinking of dollars in your tax-deferred 401(k)/TIRA accounts as dollars in your taxable account effectively assumes your tax rate will be 0% (which is true only if you plan to die before the withdrawals).

So, if your future tax rate for 401(k)/TIRA withdrawal is 20%, then to make your asset allocations the same between investments A and B in taxable and tax-deferred accounts, you have to have for every $1000 in tax-deferred account in investment A, $800 in taxable account for investment B.

Note that conversion from nominal pre-tax dollars to after-tax dollars also affects risk and return as explained in (2b) below.

(2) All my calculations are correct in the OP. So in fact, keeping stocks for N years in tax-deferred account would give you higher ending wealth then the opposite scenario. However, I missed 2 important pieces.

(2a) One was actually mentioned by LOL! but I did not give it enough weight at the time with all the other discussion. This relates to rebalancing. If I tried to maintain the same asset-allocation, I would also have to rebalance every year. Otherwise, with each passing year, I am increasing overall risk of the portfolio. I thought it might be non-trivial to put this into the model, but really it's simple - just consider a single year returns. Assuming you rebalance after a year, next year will follow the same "laws" and arrive as same "conclusions". So, just looking at 1 year is what's needed, but remember that minor differnces in 1 year will compund exponentially later one and therefore should not be dismissed even thought they are minor.

Now, an exception to above logic is that if in taxable account you pay taxes only after N years for stocks, how do you account for this when only looking at 1 year? One approach is to assume you pay capital gain tax rate after the 1 year for the earning of that year. However, a more correct variation would make it a lesser tax (since this tax is deferred over multiple years), but by how much?? Seems like this would depend on number of years, the returns on this rebalanced model, etc. For now, I assumed paying the tax after each year on the earning of that year, but some adjustment is needed.

(2b) A much more important part that was missing is my (lack of) accounting for risk. Interestingly, risk and return of stocks in taxable and tax-deferred accounts is different. This is because of taxes again. (See table 3 in the spwfe.fpanet.org paper I mentioned above and explanation for it.) While I had accounted for return differences, I did not account for risk. In short:

- In taxable account with tax t for your investment, your dollar earns R*(1-t) with the risk of SD*(1-t) for an investment with return R and standard deviation SD (measuring risk).

- In tax-deferred account, your after-tax dollar will earn full return R at the full risk SD. (Short explanation: say your nominal pre-tax $1 dollar produces $(1+X), which after taxes tn will give you $(1+X)*(1-tn). Now, recall that nominal $1 is the same as $(1-tn) real after-tax dollars. Thus, your original $(1-tn) after-tax dollars grew to $(1-tn)*(1+X).. In other words, each after-tax dollar grew by a factor of (1+X) giving it the full return of X. Same logic applies to standard deviation.)

What this means is that stocks (and non-zero-risk bonds) in tax-deferred accounts will produce higher returns but with higher risk. In other words, there are no longer just stock and bond investments when looking at taxable and tax-deferred accounts. Instead, there are 4 kinds of investments:

- Real after-tax dollar in taxable accounts can be invested in StocksPreTax and/or BondsPreTax

- Real after-tax dollar in tax-deferred accounts can be invested in StocksAfterTax and/or BondsAfterTax

Each will have its own returns and risk with the (1-t) factor differentiating PreTax and AfterTax investments.

(3) It no longer makes sense to me to say what an asset allocation is in terms of percentage in stocks vs bonds, since both stocks and bonds have to be qualified as indicated above. For example, (after converting to principal to after-tax dollars), $1000-StocksPreTax and $1000-BondsAfterTax allocation is different from $1000-StocksAfterTax and $1000-BondsPreTax. Claiming that both are 50/50 stock-bonds allocation is misleading. They have different risk and return characteristics.

(4) To decide whether it's best to hold StocksPreTax+BondsAfterTax or StocksAfterTax+BondsPreTax, the following technique can be used (it's an extension of a technique in the http://wpweb2.tepper.cmu.edu/spatt/location.pdf paper where they consider bonds which are risk-free).

(4a) Find out a ratio of tax-deferred and taxable amounts such that standard deviation SD of both combinations is the same. In other words, find ratio between after-tax dollars in taxable and tax-deferred accounts to make risk the same.

For example, say "tc" is tax on capital gains and "to" is ordinary income tax. If bonds are completely risk-free with SDbonds = 0, then for every $1 in tax-deferred account, consider having $1/(1-tc) in taxable account. Then,
- portfolio 1: $1-StocksAfterTax + $1/(1-tc)-BondsPreTax. SDportfolio = SDstocks * [1 / (1+1/(1-tc))] = [(1-tc)/(2-tc)]*SDstocks
- portfolio 2: $1-BondsAfterTax + $1/(1-tc)-StocksPreTax. SDportfolio = [SDstocks * (1-tc)] * [ (1/(1-tc)) / (1+1/(1-tc))] = [(1-tc)/(2-tc)]*SDstocks

(4b) Find out whether portfolio 1 or portfolio 2 has higher expected return (ER). Whichever one has higher return indicates which combination is better since for every portfolio with opposite combination, one could switch stocks and bonds in the proportion found in 4(a) without changing SD and obtaining higher returns. In above example with 0-risk bond, expected returns are:

- portfolio 1: $1-StocksAfterTax + $1/(1-tc)-BondsPreTax. ERportfolio = ERstocks + ERbonds*(1-to)/(1-tc)

- portfolio 2: $1-BondsAfterTax + $1/(1-tc)-StocksPreTax. ERportfolio = ERbonds + ERstocks*(1-tc)/(1-tc) = ERbonds + ERstocks

Since ordinary tax to is expected to be greater than capital gains tax tc, portfolio 2 should be preferred to portfolio 1 for risk-free bonds.

(5) Now, do the same results apply to non-risk-free bonds? I put together a spreadsheet which computes (4a) and (4b) for this more general case. I found that in most cases the answer is the same, but in some combinations it's not. However such combinations are not under "normal" conditions. For example, with 20% cap gains tax, 25% ordinary tax, 8% stock returns with 15% SD, and 4% bond returns with 6% SD (and 0.1 correlation), stocks should be in taxable account. However, moving SD of bonds from 6% to 11% makes them better candidates for taxable account with rest of parameters being the same.
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Old 12-21-2009, 06:13 PM   #37
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smjsl..............I must confess to not understanding much (perhaps most) of what you said which is the same feeling I got when I tried to read the Bogleheads references but it sounds you got something out of that and so I am glad to have been part matchmaker there. Thanks for the followup......often you learn when you are forced to prepare a presentation so I'll take the credit for that too . The concept of AA corrected for tax effects is something I learned from you so thanks for that.
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Old 12-21-2009, 06:53 PM   #38
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No problem kaneohe, and thanks to you too - you deserved those credits indeed ;-)

Perhaps my post was more technical then it should have been. Let me mention a couple of things that might make it easier to understand.

Whenever you try to understand if one portfolio is better than another you have to assume what your portfolio ingredients return. For example, people often assume based on historical record that stocks will have higher returns than bonds. So, you could say invest everything in stocks and nothing in bonds and you will get highest resulting wealth. While this is true (historically speaking), the issue of course if that stocks are riskier, and so somehow you also have to account for risk when evaluating how good a portfolio is. Researchers measure risk in standard deviation today (i.e. how widely actual returns vary around the expected returns).

Now in my OP I had two portfolios which while they invested same amounts of real money into "stocks" and "bonds", the investments actually had different risk profiles because stocks (and bonds) invested in taxable accounts are actually less risky then stocks in tax-deferred ones. So in my original OP, higher-risk portfolio had higher returns, which is not surprising. (Plus it was getting riskier and riskier as years were passing by due to no rebalancing.)

So, once this is taken into account, it turns out that in most cases it might indeed be better to have stocks in taxable accounts... Now, this again assumes a certain model. Presumably this model is better and more correct than my original one, but it still has some limitations that I mentioned above (i.e. it does not account for stock dividends but taxes stock returns each year at capital gains rate, plus it uses the standard deviation to equate risk of two portfolios).
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Old 12-21-2009, 07:39 PM   #39
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smjsl.......thanks for the layman's version. That helped.
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Old 12-22-2009, 03:32 AM   #40
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it still boils down to what you plan to do with the money...if its money your passing on that will be left over nothing beats having those nice growing equities in a roth.

while equities in a taxable account is nice for passing stepped up tax free money to heirs the ability to have 100 years or more of tax free compounding that can go on for generations in a roth trumps all...


inheriting the taxable account has the tax free compounding stop there, thats why i intend to keep only equities in my roth...


once thats filled with as much as i can do ill fill up the taxable account with equities next..

any traditional ira and 401k money in bonds will stay that way and ill be spending that down second to cash in my taxable account but i will also hold the left over bonds in my taxable account too. i wouldnt want to waste any of my higher growth roth money on bonds which might have more limited potential to grow if markets go back to normal........


sooooo bottom line, equities in the roth,,, equities in my taxable--- shorter term bonds in my taxable and traditional ira's ,rest in taxable cash.




if i was going to spend every penny i would do it differently
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