

fixed income vs equities in taxdeferred accounts
11162009, 05:17 PM

#1

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fixed income vs equities in taxdeferred accounts
I've seen people suggest that fixed income should be in taxdeferred accounts like 401k and more tax efficient equities in taxable accounts. The logic is that you get to pay less taxes as you go along.
On the other hand, if you assume your equities rise faster than your fixed income investments, should not this extra growth be in taxdeferred accounts so that higher compound growth is happening inside the taxdeferred accounts? (Actually in example below the reason this approach wins is due to a bit more subtle issue discussed below.)
Since there are these two opposing forces, as you might imagine depending your assumptions you will get different results as to which way is actually better...
I put together a spreadsheet trying to evaluate both scenarios. I'll try to attach it but not sure if it will work as download. In any case here is an example. One thing I noticed in playing with the numbers in my spreadsheet, is that as soon as you start using even 1% or 2% tax (each year) on equities  it quickly becomes more important to hold them in taxdeferred account. Example below however shows that even with perfect 0% tax on equities during the holding period, sometimes it's better to hold them in taxdeferred account...
Initial assumptions (can be changed on spreadsheet):
equity growth rate (pretax) factor 1.08 (i.e. 8%)
fixed income growth rate (pretax) factor 1.04 (i.e. 4%)
number of years 20
marginal income tax 0.25 (i.e. 25%)
cap gains tax at the end 0.20 (i.e. 20%)
cap gains tax during period 0 (i.e. 0%  most tax efficient equity holding)
Thus...
aftertax cap gains growth rate factor 1.08 (same as above, since cap gains during 20year holding period is 0%)
aftertax fixed growth rate 1.03 (4% after 25% tax)
Next, say you have $133,333 in 401(k) and 100,000 in taxable account and you are deciding which should go into which type of investment... Now, you might be wondering why I did not pick 100k in each, and it's very important! So, let me explain...

Explanation:
The truth is I did at first start with 100k in each, but then looking closely at the results I noticed that just looking at fixed income part, it was better off outside of taxdeferred account than inside it. It did not make any sense until I realized my mistake. Since all of 401(k) is taxable at marginal rate in the end (including initial amount), the correct way of comparing is to consider 401(k) balance on aftertax basis (i.e. at 0.75*it's amount)...Thus, on aftertax basis, 401(k) is at 0.75*133,333=100k, same as taxable account.
Let me reiterate this important point  your aftertax dollar in taxable account has MORE real value than pretax dollar in taxdeferred account, since you paid taxes already on your taxable account dollar. So instead of deciding whether to place $1 in taxable account or $1 in taxdeferred, you have to compare investing $1 in taxable account vs $1.33 in taxdeferred one (assuming 25% tax rate)!
And here is another way of explaining... say you want to switch investments A and B in taxable vs taxdeferred account. To preserve your true asset allocation, if you switch $1 from A to B in taxable account, you have to switch $1.33 from B to A in taxdeferred account (under 25% tax assumption). And vice versa of course... switching $1 from A to B in taxdeferred account would need to correspond to a $0.75 switch from B to A in taxable account to preserve same asset allocation in real aftertax dollars.

Now, let's do the comparison....
=================================================
Scenario 1: taxdefer fixed investments
After 20 years, you have...
taxdeferred fixed = 292,149 (which is 133k*1.04^20)
after taxes = above * 0.75 = 219,112
taxable equity = 466,096 (which is 100k * 1.08^20) Note: this is under best for this scenario assumption of 0% tax on equity  this 1.08 rate will be lower if you do pay any taxes for equity, i.e. it pays out any sort of dividends or distributes cap gains!!
after cap gain taxes = (above  initial 100k) * 0.8 + 100k = 392,877
Total after tax sum: $611,988
=================================================
Scenario 2: taxdefer equities
After 20 years, you have...
taxdeferred equity = 621,459 (which is 133k * 1.08^20)
after marginal 25% taxes you get above * 0.75 = 466,095
taxable fixed = 180,611 (which is 100k * 1.03^20) Note: 1.03 is the real aftertax rate you get under above assumptions (4% nominal at 25% tax rate)
after taxes it's the same amount, since it was already taxed along the way: 180,611
Total after tax sum for scenario 2: $646,706
=================================================
Did I get my math wrong anywhere?
If not, under above assumptions, it makes more sense to keep fixed investments in taxable accounts so that highergrowth equities grow taxfree (instead of first paying taxes on them to get them down from 133k to 100k and then have this smaller amount grow).
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11162009, 05:44 PM

#2

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Return of capital is taxfree (in a taxable account), so you paid $20K too much in cap gains taxes in one scenario.
It's easy enough to put annual dividends for equities into a spread sheet. I'd use 2% as the yield.
The tax you pay each year on fixed income has to come from somewhere, so you need to subtract this tax each year and not once at the end.
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11162009, 05:48 PM

#3

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Thanks, I corrected my post for scenario 1 to account for this and reattached the spreadsheet (first 100k should not have been taxed in taxable equities case). Results are the same however  there are many scenarios / reasonable assumptions when you want to keep fixed investments in taxable account and equities in taxdeferred ones.



11162009, 05:51 PM

#4

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Quote:
Originally Posted by LOL!
The tax you pay each year on fixed income has to come from somewhere, so you need to subtract this tax each year and not once at the end.

This is already accounted for by taking 1.03 rate when fixed income is in taxable account (instead of 1.04 when it's in taxdeferred one).



11162009, 06:04 PM

#5

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What if marginal rate is 33% and cap gains rate is 15%?
Also you wrote:
Quote:
On the other hand, if you assume your equities rise faster than your fixed income investments, should not this extra growth be in taxdeferred accounts so that higher compound growth is happening inside the taxdeferred accounts?

Remember that in a taxable account, unrealized cap gains are taxfree, so does that not mean that this extra growth is in a taxdeferred place anyways and taxed less than in a taxsheltered account when it is withdrawn?



11162009, 06:09 PM

#6

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smjsl.........since I just learned about the Boglehead's "unconventional" (to me anyway) strategy recently, this is an interesting topic to me. I admit to not going thru your brainstressing numbers in any great detail. I suspect that the conclusions you come to will depend on the assumptions at the start...........your example of how much starts initially reminds me of the TIRA vs Roth argument:
1) you can assume a limited amount of income that will be taxed and so less is available to go into the Roth(e.g. 4K in TIRA; 3K in Roth). Under these conditions, I believe the TIRA and Roth come out identical after tax assuming the tax situation doesn't change; or
2) you can assume "unlimited" assets so that the maximum amount can be put in both
TIRA and Roth. In this case, the Roth comes out ahead
This is also similar to the Roth conversion problem. If you have limited assets and have to pay the conversion tax from conversion assets (even w/o the 10% penalty), the result is different than if you can pay the conversion tax from outside funds.
I suspect the result may also depend on the time frame, difference between regular and CG tax rates, and difference between the CG yield and the fixed income yield.
I don't have any preconceived notions in this matter so look forward to your discussion w/ LOL . If you escape that hurdle, you might consider posting in Bogleheads.org and see what stones come your way there...........it's actually pretty civilized there.



11162009, 06:31 PM

#7

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Quote:
Originally Posted by LOL!
What if marginal rate is 33% and cap gains rate is 15%?

According to spreadsheet, then scenario 1 comes out ahead by 4%. As I said at the beginning, different assumptions will lead to different results  it seems like it's not a clear cut decision at all and there are many scenarios when scenario 2 wins. Also, I think my assumption of 0% tax rate on cap gains during the 20year period is not realistic. As you start increasing it, you get scenario 2 advantage very quickly. For example, under your assumptions above, if I increase it from 0% to 4%  both scenarios become breakeven. If you pay 5% tax on cap gains in taxable portfolio or more, you are better off with scenario 2 again...
Quote:
Originally Posted by LOL!
Also you wrote:
"On the other hand, if you assume your equities rise faster than your fixed income investments, should not this extra growth be in taxdeferred accounts so that higher compound growth is happening inside the taxdeferred accounts?"
Remember that in a taxable account, unrealized cap gains are taxfree, so does that not mean that this extra growth is in a taxdeferred place anyways and taxed less than in a taxsheltered account when it is withdrawn?

Yes, I do remember this and my spreadsheet and examples in my post account for this already with 0% tax rate (which again, I think is unrealistic because you normally do get some dividends and if you invest in funds, some cap gain distributions)! Please let me know if you see a mistake in my calculations.
@kaneohe: thanks; interesting thoughts  I'll need to think more about them and on whether / how they apply here. Perhaps LOL and other financial types will see some obvious flaws in my reasoning / my example...



11162009, 06:50 PM

#8

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Let's say you have $100K in a checking account and $100K in your 401(k).
I'm not sure what you were trying to do with that extra $33K, but I think that's the problem.
You want a starting asset allocation of 50% equities and 50% fixed income.
You do not rebalance.
You buy BerkshireHathaway with money from your checking account.
A. It goes up 8% per year for the next 20 years and you sell it and pay 20% LT cap gains tax on the gain.
$466096  (0.2 * $366096) = $392877 when cashed out.
B. If you bought BRK in taxdeferred, you would have $466096 * 0.75 = $349572 when cashed out
if you assume the 25% tax bracket goes up to $466K.
So taxable gets you ahead with equities.
Now go to the fixed income.
C. You buy a bond fund that pays 4% annually with your $100K in checking.
You pay 25% tax on the annual gain, so it is like a 3% aftertax gain each year.
1.03^20 = 1.806. You end up with $180,611 if you have this in a taxable account.
D. If you used the 401(k) and withdrew it all at once and paid tax of 25%.
1.04^20 = 2.191. (2.191 * 0.75) = 1.643. * $100K = $164,300.
You wish to compare A+D versus B+C.
$392,877 + $164,300 versus $349,572 + $180,611
$557,177 versus $530,183
A+D wins. Equities in taxable and fixed income in taxsheltered.



11162009, 06:58 PM

#9

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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...



11162009, 09:30 PM

#10

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I'm shooting for the 15% tax bracket, so it won't make much difference where i have my equities or fixed income.



11162009, 10:11 PM

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Quote:
Originally Posted by LOL!
Let's say you have $100K in a checking account and $100K in your 401(k).
I'm not sure what you were trying to do with that extra $33K, but I think that's the problem.
You want a starting asset allocation of 50% equities and 50% fixed income.

lol i think smjsl's position it that dollars inside a 401(k) are not equal to dollars in an account that has already had the taxes paid. (reread his explanation for the different amounts in the 2 accounts)
Quote:
Originally Posted by smjsl
The truth is I did at first start with 100k in each, but then looking closely at the results I noticed that just looking at fixed income part, it was better off outside of taxdeferred account than inside it. It did not make any sense until I realized my mistake. Since all of 401(k) is taxable at marginal rate in the end (including initial amount), the correct way of comparing is to consider 401(k) balance on aftertax basis (i.e. at 0.75*it's amount)...Thus, on aftertax basis, 401(k) is at 0.75*133,333=100k, same as taxable account.
Let me reiterate this important point  your aftertax dollar in taxable account has MORE real value than pretax dollar in taxdeferred account, since you paid taxes already on your taxable account dollar. So instead of deciding whether to place $1 in taxable account or $1 in taxdeferred, you have to compare investing $1 in taxable account vs $1.33 in taxdeferred one (assuming 25% tax rate)!
And here is another way of explaining... say you want to switch investments A and B in taxable vs taxdeferred account. To preserve your true asset allocation, if you switch $1 from A to B in taxable account, you have to switch $1.33 from B to A in taxdeferred account (under 25% tax assumption). And vice versa of course... switching $1 from A to B in taxdeferred account would need to correspond to a $0.75 switch from B to A in taxable account to preserve same asset allocation in real aftertax dollars.

and if you think in terms of what the after tax values are at the beginning of the 20yr period he is right (provided the 100k in the taxable account doesnt have any unrealized CGs). soo if you truely want an asset allocation of 50/50 when you start that 20 yr period you do need to convert all sums to their after tax values, then do the asset allocation and then convert back for the actual purchasing of investments. however, he didnt maintain the AA over the 20 yr period.



11162009, 10:19 PM

#12

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Quote:
Originally Posted by smjsl
According to spreadsheet, then scenario 1 comes out ahead by 4%. As I said at the beginning, different assumptions will lead to different results  it seems like it's not a clear cut decision at all and there are many scenarios when scenario 2 wins. Also, I think my assumption of 0% tax rate on cap gains during the 20year period is not realistic. As you start increasing it, you get scenario 2 advantage very quickly. For example, under your assumptions above, if I increase it from 0% to 4%  both scenarios become breakeven. If you pay 5% tax on cap gains in taxable portfolio or more, you are better off with scenario 2 again...

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)



11172009, 01:24 AM

#13

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smjsl........I went through your initial example w/ calculator and paper and got similar results. The thing that stands out to me is that the conclusion seems to depend on the starting assumptions/definitions......why does the AA have to be 5050? And certainly your definition of "after tax" AA is not exactly conventional.....but certainly creative. Here's another way of thinking about it..........
Suppose you have 266 units of income......half is dedicated to taxdeferred and the other half to aftertax. As in your example 133 goes into taxdeferred and of the other half,100 goes into the aftertax account. Same as your example so far. In more conventional AA which ignores where the asset is, for a younger person perhaps 25%
might go to fixed income ........25% of (133 + 100) = about 60 for simplicity.
Now the question is where should the 60 units of fixed income be....
in the 133 tax deferred or in the 100 of after tax?
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
If you reduce this to simplest terms, I think it is the same as
1) Case 1: 60 S in deferred: 60 B in taxable
2) Case 2: 60 B in deferred; 60 S in taxable
Now this looks more like LOL's example.
As you said, the conclusion depends on the conditions so maybe it just depends on what conditions you pick to match your own . It's late so maybe this is all wet.



11172009, 07:52 AM

#14

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strange......can't find the edit button even tho logged in.
strange thing......tried to use the methodology above to calculate for various other AA....higher fixed income content as might be used for older folks; tried 40% and 50% fixed income and was surprised to see that the results look identical so it almost looks like an identity that regardless of AA (if defined as ignoring whether asset is in deferred or taxable acct), the end result (in terms of difference in account values) is acting as if the same amounts started in the 2 accounts which would be compatible w/ LOL's position.
Ex: 50% fixed income AA
In more conventional AA which ignores where the asset is, for a older person perhaps 50%
might go to fixed income ........25% of (133 + 100) = about 113 for simplicity.
Now the question is where should the 113 units of fixed income be....
in the 133 tax deferred or in the 100 of after tax?
1) Case 1: 120 S (stock)+ 13B in tax deferred; 100 B (bonds) taxable
2) Case 2: 20 S + 113 B in tax deferred; 100 S in taxable
If you reduce this to simplest terms, I think it is the same as
1) Case 1: 100 S in deferred: 100 B in taxable
2) Case 2: 100 B in deferred; 100 S in taxable
"it" in the sentence above means the difference between the 2 cases can be determined by analyzing this simplified case. That wasn't clear in my post a few positions higher and I don't see an edit button there for some reason.



11172009, 08:08 AM

#15

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Quote:
Originally Posted by kaneohe
strange......can't find the edit button even tho logged in.

The ability to edit a post expires after 6 hours.
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11172009, 08:48 AM

#16

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Quote:
Originally Posted by kaneohe
smjsl........I went through your initial example w/ calculator and paper and got similar results. The thing that stands out to me is that the conclusion seems to depend on the starting assumptions/definitions......why does the AA have to be 5050? And certainly your definition of "after tax" AA is not exactly conventional.....but certainly creative. Here's another way of thinking about it..........
Suppose you have 266 units of income......half is dedicated to taxdeferred and the other half to aftertax. As in your example 133 goes into taxdeferred and of the other half,100 goes into the aftertax account. Same as your example so far. In more conventional AA which ignores where the asset is, for a younger person perhaps 25%
might go to fixed income ........25% of (133 + 100) = about 60 for simplicity.

i believe the point to smjsl's post is that to be accurate you must treat pretax money as having less value than after tax money in your AA because ultimately when you get around to using that pretax money you will have to pay taxes on it (there is an exception to this but it involves inheiritance but then in that case you arent really using it). soo why do you abandon his line of thinking in the middle of your example? 25% of the aftertax value of the portfolio in your example would be ~$50k.
Quote:
Originally Posted by kaneohe
Now the question is where should the 60 units of fixed income be....
in the 133 tax deferred or in the 100 of after tax?
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

actually then
1) Case 1: 133 S (stock) in tax deferred; 50 S + 50 B (bonds) taxable
2) Case 2: 66.5 S + 66.5 B in tax deferred; 100 S in taxable
Quote:
Originally Posted by kaneohe
If you reduce this to simplest terms, I think it is the same as
1) Case 1: 60 S in deferred: 60 B in taxable
2) Case 2: 60 B in deferred; 60 S in taxable
Now this looks more like LOL's example.

i dont see this step, as it doesnt look the same at all



11172009, 10:18 AM

#17

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jdw.................I didn't explain that very clearly so I understand why I lost you:
Now the question is where should the 60 units of fixed income be....
in the 133 tax deferred or in the 100 of after tax?
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
Assuming you accept this (I know you don't but just try to follow the logic for the moment):
Case 1) has 133 S (stock) in tax deferred
Case 2) has 73 S + 60 B in tax deferred
The difference between case 1 and case 2 in tax deferred is the same as having
Case 1A) 60 S in tax deferred and
Case 2A) 60 B in tax deferred
(just subtracted the common 73 S from both cases)
Similarly,
Case 1) has 40 S + 60 B in taxable
Case 2) has 100 S in taxable
The difference between case 1 and case 2 in taxable is the same as having
case 1A) 60 B in taxable
case 2A) 60 S in taxable
(just subtracted out the common 40 S from both cases)
If you reduce this to simplest terms, the difference between case 1 and 2 is the same as between Case 1A and 2A
1) Case 1A: 60 S in deferred: 60 B in taxable
2) Case 2A: 60 B in deferred; 60 S in taxable
Now this looks more like LOL's example.
hopefully that was a little clearer?
In any case, I'm not necessarily trying to defend this argument which , as you pointed out, hinges on the initial definition of the problem. Just trying to point out that the conclusion depends on the initial definition. and as I initially suggested, if you manage to get by LOL here, I'd take it to the "World Court" at bogleheads.org to see what kind of reaction you get there.



11172009, 10:28 AM

#18

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Quote:
Originally Posted by LOL!
What if marginal rate is 33% and cap gains rate is 15%?

Very true for now, but I suspect the 15% rate on LTCG and dividends is soon to be extinct. I do suspect they will continue to be lower than ordinary income rates for highincome individuals, but my guess would be in the 2025% range. So going longer term, I don't think the tax break on LTCG in a taxable account will be as significant  but I could be wrong.
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11172009, 10:46 AM

#19

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Quote:
Originally Posted by kaneohe
jdw.................I didn't explain that very clearly so I understand why I lost you:
Now the question is where should the 60 units of fixed income be....
in the 133 tax deferred or in the 100 of after tax?
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
Assuming you accept this (I know you don't but just try to follow the logic for the moment):
Case 1) has 133 S (stock) in tax deferred
Case 2) has 73 S + 60 B in tax deferred
The difference between case 1 and case 2 in tax deferred is the same as having
Case 1A) 60 S in tax deferred and
Case 2A) 60 B in tax deferred
(just subtracted the common 73 S from both cases)
Similarly,
Case 1) has 40 S + 60 B in taxable
Case 2) has 100 S in taxable
The difference between case 1 and case 2 in taxable is the same as having
case 1A) 60 B in taxable
case 2A) 60 S in taxable
(just subtracted out the common 40 S from both cases)
If you reduce this to simplest terms, the difference between case 1 and 2 is the same as between Case 1A and 2A
1) Case 1A: 60 S in deferred: 60 B in taxable
2) Case 2A: 60 B in deferred; 60 S in taxable
Now this looks more like LOL's example.
hopefully that was a little clearer?
In any case, I'm not necessarily trying to defend this argument which , as you pointed out, hinges on the initial definition of the problem. Just trying to point out that the conclusion depends on the initial definition. and as I initially suggested, if you manage to get by LOL here, I'd take it to the "World Court" at bogleheads.org to see what kind of reaction you get there.

i guess i dont understand why you put together your example i.e. what point you are trying to make. since your thoughts on AA are the same as LOL's (all dollars are equal whether already taxed or not) of course your example comes out looking like LOL's.
and math is math, in your example your total portfolio is 233k in both cases and you are allocating 60k to bonds in both cases so of course 173k will be allocated to stocks in both cases.
what makes this thought of smjsl's interesting is the differing values of particular pieces of a portfolio and the effects that perspective has on future values of that porfolio.



11172009, 12:17 PM

#20

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Quote:
Originally Posted by nun
I'm shooting for the 15% tax bracket, so it won't make much difference where i have my equities or fixed income.

Its does in 20082010, 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
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