Holding bonds in pre tax accounts

[tdv2]

25 years ago or there about, I read in one of my investment books that it made sense to hold bonds in pre tax accounts and stocks in after tax accounts during working years. This made sense to me since bond income is taxed as ordinary income—advantage being greatest while still employed in high tax bracket.

I’m about six months from ER—will be 54 and have about 2/3 of my assets in after tax accounts. BTW, I always rebalance in pre tax to avoid cap gains—Still have about 25% stocks in pretax. With the market way up, the bond portion if my pre tax has increased substantially.

Leads me to my question—when I do Roth conversions should I stick with higher percentage of bonds in the IRA? My AA is 62/30/8 stock/bond/fixed.

I’m thinking I can come up with a reasonable solution but wanted to hear what others have done in this respect.

 

[pb4uski]

I put all my bonds/fixed income in tax-deferred (pre-tax as you call it). I hold all equities in my taxable accounts (after-tax as you call it) because equities are tax preferenced with qualified dividends and LTCG getting preferential tax rates. I don't like the idea of equities in tax-deferred accounts because what it effectively does is convert tax preferenced income to ordinary income. My tax-free (Roth) accounts are all equities as well. YMMV.

 

[tdv2]

Thanks for the confirmation PB4. I can’t get to 100% fixed income in tax deferred accounts just yet because it would push my asset allocation below my 60% equity target. Makes sense to have equities in Roth as you suggest.

I will start Roth conversions next year—DW’s accounts first since she is a few years older than me.

 

[tdv2]

Need to get my terminology cleaned up. pre tax=tax deferred, after tax=taxable.

 

[pb4uski]

Well done. And Roth and HSAs are tax-free.

 

[LOL!]

Putting all of one's desired fixed income in tax-deferred does not mean 100% of tax-deferred is supposed to be fixed income.

And putting only tax-efficient equity funds in taxable does not mean that 100% of one's equity funds are supposed to be in taxable.

And there are exceptions. For instance, a highly taxed, high income taxpayer may wish to use tax-exempt muni bonds in taxable as well as have tax-efficient equity funds in taxable.

 

[pb4uski]

True. For example if you AA is 60/40 and your tax deferred >40% then all your fixed would be in tax-deferred and tax-deferred would have equities as well.

 

[RockyMtn]

100% of my tax deferred is in bonds but that still doesn't get me to my desired bond allocation so I use muni's in taxable accounts to get to the right AA.

Once my deferred comp is done being paid I will probably go to another type of bond in taxable accounts as my marginal tax rate won't make the muni's as attractive.

 

[mathjak107]

for years now rates are so low it makes little sense holding bonds in retirement plans and taking up valuable space where stocks should be .

unless you are in the zero capital gains bracket according to kitces , as little as a 1% dividend or distribution over the long term will easily wipe away any tax advantage from long term capital gains rates .

EXECUTIVE SUMMARY

while the traditional asset location strategy “rule of thumb” is that tax-inefficient bonds go into an IRA, while equities eligible for preferential tax rates go into a brokerage account, the reality is that for investors with long time horizons the optimal solution may be the opposite. Once stock dividends and portfolio turnover are considered, the ongoing “tax drag” of the portfolio can be so damaging to long-term returns that placing equities into an IRA may be more efficient, even though they are ultimately taxed at higher rates!

In fact, it turns out that almost any level of portfolio turnover will eventually tilt equities towards being held in IRAs given a long enough time horizon (and especially while today’s low interest rates result in almost no benefit for bonds to gain tax-deferred growth inside of retirement accounts). Which means in the end, good asset location decisions depend not only on returns and tax efficiency, but an investor’s time horizon as well!

https://www.kitces.com/blog/asset-l...e-account-versus-ira-depends-on-time-horizon/

 

[audreyh1]

Thanks for the link.

It's been a moot issue for us. Only 13% of our retirement assets are in IRAs, so we haven't bothered to try to juggle tax efficiency.

 

[GalaxyBoy]

Here’s a link to the “conventional wisdom”:

https://www.bogleheads.org/wiki/Tax-efficient_fund_placement

 

[mathjak107]

i can see logically the conventional way not making sense anymore since the rates are so low to make tying up deferred space worth it .
not only that but even a 2% dividend that gets taxed will out weigh any tax advantage very quickly in a brokerage account

 

[LOL!]

I don't really want my tax-deferred accounts to grow larger than they are. I prefer that my Roth account (no more taxes) grows larger. Also, I prefer that my taxable account grows larger since I don't pay any taxes on it either and my wife and my other heirs will get a tax-free stepped up basis.

No RMDs in Roth nor taxable accounts, but those RMDs in my tax-deferred accounts will probably turn out to be problematic.

As for the Kitces article, I agree that turnover that is taxed in a taxable account creates taxes and hurts long-term performance. The answer to that is: No taxable turnover in a taxable account which is fairly easy to accomplish, but that's the subject of another discussion. Suffice it to say, we haven't paid any capital gains taxes since around 1999 and I cannot remember earlier than that.

 

[mathjak107]

even index funds have a 2% dividend. many have other things that spin off taxable distributions as well so just the fact you use index funds will not get around the distributions . you need non dividend paying individual stocks to avoid any distributions or just be in the zero capital gains tax bracket . .

 

[pb4uski]

for years now rates are so low it makes little sense holding bonds in retirement plans and taking up valuable space where stocks should be....

Makes no sense in my situation... I do NOT want to convert tax preferenced income at 0% (or 15%) into ordinary income at 15% (or 25% or more) and I do not want to make the tax torpedo bigger.

While our income is in the 15% tax bracket our marginal tax rate on equities is negative... why would I screw that up by putting more equities in tax-deferred? In fact right now my taxable accounts are better than a Roth... negative tax with no strings!

For those wondering how the negative tax works, the rate on qualified dividends and LTCG is 0% and we have some non-qualified dividends from international stocks that attract some tax but the foreign tax credit that we receive exceeds the smidgeon of tax on non-qualified dividends... so our net tax on taxable account investments is negative.

 

[mathjak107]

at zero i can see holding stocks in non ira accounts . but if not , if you are getting taxable distributions of 1% or more and just the s&p 500 is at 2% than you will pay more in taxes over time than you save .

all my stocks have big gains , i would hate to pay taxes in a brokerage account every time i make a change in a fund .

but whatever , it is a personal choice . i just want to make sure everyone here knows that it is not a slam dunk that putting bonds in your ira is the best way to go . despite old conventional wisdom , which is now being proven wrong as a general way of doing things . ..

 

[UnrealizedPotential]

I have always had equities in my 401k[now traditional ira] and I have always had equities in my Roth Ira. I figured that any growth and capital gains would be tax free for either one until I am 59.5 or until I take distributions[I am 48 now]. I have all my bonds in taxable because I need the income now and if I put it in my tax deferred I couldn't get to it because I am not old enough.

But I am not arguing for or against where bonds should go. It probably just depends on a lot of factors. That and the fact I will gladly let others debate the math.

 

[pb4uski]

I have always had equities in my 401k[now traditional ira] and I have always had equities in my Roth Ira. I figured that any growth and capital gains would be tax free for either one. I have all my bonds in taxable because I need the income now and if I put it in my tax deferred I couldn't get to it because I am not old enough.

But I am not arguing for or against where bonds should go. It probably just depends on a lot of factors. That and the fact I will gladly let others debate the math.

Growth and capital gains are not tax free in a tIRA... they get taxed at higher ordinary tax rates.

 

[scrabbler1]

25 years ago or there about, I read in one of my investment books that it made sense to hold bonds in pre tax accounts and stocks in after tax accounts during working years. This made sense to me since bond income is taxed as ordinary income—advantage being greatest while still employed in high tax bracket.

I’m about six months from ER—will be 54 and have about 2/3 of my assets in after tax accounts. BTW, I always rebalance in pre tax to avoid cap gains—Still have about 25% stocks in pretax. With the market way up, the bond portion if my pre tax has increased substantially.

Leads me to my question—when I do Roth conversions should I stick with higher percentage of bonds in the IRA? My AA is 62/30/8 stock/bond/fixed.

I’m thinking I can come up with a reasonable solution but wanted to hear what others have done in this respect.

A lot of (but not everything) what you wrote I have done over the years.

In my working years, I had in my taxable account mainly tax-free bond funds and a stock fund (for growth; it was the 1990s). I was in the 28% bracket in the 1990s (became 25% in the 2000s) so the munis were how I reduced my tax bill. In my 401k I held a variety of things over the years, from company stock to a stable-value fund to an S&P 500 index fund to a balanced fund. When I ERed 9 years ago, I consolidated the non-company-stock in the 401k into a single stock and single corporate bond fund. It is now around 55/45 bond/stock and I do most of my rebalancing there. Now in a lower tax bracket, I have reduced my muni bond fund holdings a lot, leaving it aside as an emergency fund.

My taxable account is designed to be income oriented, and it is about 63/37 bond/stock. Overall, I have just under 2/3 of my portfolio in the taxable account. I rarely rebalance here, only if I need to tweak the income it generates.

I don't have any Roth IRA holdings, so I can't offer any advice about Roth conversions.

 

[UnrealizedPotential]

Growth and capital gains are not tax free in a tIRA... they get taxed at higher ordinary tax rates.

I didn't think that capital gains or growth would be taxed in my traditional Ira until I received distributions. Is that incorrect? I won't be 59.5 for 11.5 years.

 

[bingybear]

I didn't think that capital gains or growth would be taxed in my traditional Ira until I received distributions. Is that incorrect? I won't be 59.5 for 11.5 years.

You are correct. The post was noting that eventually these will be taxed at normal income rates. In taxable accounts these may be taxed at lower rates, including possibly 0% rates.

 

[UnrealizedPotential]

You are correct. The post was noting that eventually these will be taxed at normal income rates. In taxable accounts these may be taxed at lower rates, including possibly 0% rates.

Ok. Thanks for the clarification.

 

[audreyh1]

We're just going to be taking the tax torpedo in the gut. I'm doing what I can to reduce taxable income before SS and RMDs hit. But with our IRAs such a small part of our retirement assets, and having (mostly cap gains) income well above the 0% cap gains tax bracket, it doesn't make sense to do Roth conversions in the near term. RMDs will be a small part of our annual income once we start taking them. And maybe we'll gift a chunk.

 

[LOL!]

even index funds have a 2% dividend. many have other things that spin off taxable distributions as well so just the fact you use index funds will not get around the distributions . you need non dividend paying individual stocks to avoid any distributions or just be in the zero capital gains tax bracket . .

That is true, but lucky for me at the present time, my qualified dividend income is taxed at 0% just as my LTCG are taxed at 0%.

OTOH, I offset capital gains with harvested losses from the past, so one could say that with another $3,000 used to offset income, I can write that the $3,000 offsets non-qualified dividend income. Furthermore, if I get a foreign tax credit of say $1,000 a year, that would be like offsetting the tax on $1,000/0.15 or another $6,667 of non-qualified dividend income. Since my ratio of QDI: nonQDI is about 80:20, that means I can have more than $40,000 in dividend income before I pay taxes on it. And at 2% yield that's a $2,000,000 taxable portfolio.

And the above doesn't even include exemptions and deductions which I can say offset Roth conversions. Nor does it include return-of-capital which is tax-free and doesn't really show up on one's tax return.

 

[pb4uski]

You are correct. The post was noting that eventually these will be taxed at normal income rates. In taxable accounts these may be taxed at lower rates, including possibly 0% rates.

Yes, my point was that tIRAs are tax-deferred, not tax-free, which is what the post that I was responding to said.