Rebalancing taxable vs. tax-exempt/deferred accounts

[AV8]

I've searched the forum, but can't find that this has been discussed before.

The simple way for me to rebalance our AA without incurring a taxable event would be to reallocate within my and DWs Roth IRAs and my TSP (401k). The end result would be that a high percentage of the more volatile portion of our AA (Intl, Small-cap, Mid-Cap) would be in the IRAs and TSP (401k). Is there a problem with doing this? Perhaps it depends on our age/time to retire due to the increased risk/volatility?

Something bothers me about the IRAs/TSP being comprised mainly of our higher risk/volatility funds, but I'm unable to conceptualize why it might matter. Perhaps the taxable and tax-exempt/deffered accounts should each hold an approximation of the AA. Any thoughts that could help us develop a good rebalancing plan?

AV8

 

[Gone4Good]

There is no problem having your "more volatile" assets allocated to the tax deferred accounts, per se. However, doing so is not the most efficient use of these accounts. Ideally, you want to stuff your IRAs (and the like) full of income producing assets (i.g. Bonds, REITs, etc). That way you maximize the benefit of the tax deferral (by converting currently taxable income into future income and allowing those before-tax earnings to compound). Most of the returns from small-cap & mid-cap stocks are going to come from capital gains, which are already tax deferred, so you won't get much benefit from putting them in the tax advantaged accounts. In a worst case you may actually be doing harm because your IRA withdrawals are treated as ordinary income, which is currently taxed at a higher rate then capital gains.

The easy (and not terribly helpful) answer is that you should try to put as much of your bond portfolio in the IRA as possible. But you may not want to do that if it means you have to take capital gains to reallocate (the whole point, after all, is to minimize the tax leakage of your portfolio). Take a look at your current tax situation, the tax basis of each of your holdings, familiarize yourself with the current capital gains rates (they are going down again to as low as zero), and figure out how you can stick as many bonds in the IRA as tax efficiently as possible.

 

[Bailing-Bob]

The common advice is to put as much of your fixed income asset allocation into your tax deferred accounts as possible and put your equities in your taxable account. But on the other hand the common advice during early retirement is to withdraw from your fixed income to provide for living expenses when equities are down. Not sure how that works when your FI allocation is locked up in your tax deferred accounts.

 

[donheff]

Since most of us will be withdrawing from our taxable accounts in the early years the issues get a bit confusing. If we are going to keep several years in cash equivalents, they need to be in taxable accounts to avoid higher tax rates. Also, if we don't attempt some sort of sensible allocation within the taxable accounts, we could easily see it disproportionately adversely affected in a market downturn. It isn't clear to me if that is worse (forces you to turn to turn to the IRAs sooner) than re-balancing within a taxable account.

 

[LOL!]

... to reallocate within my and DWs Roth IRAs and my TSP (401k).

I cannot specifically address your comment because we do not have Roth IRAs. Since your Roths are tax-free and your TSP is tax-deferred, I wonder if you have any taxable accounts where I think it is more critical to do some tax management.

In the 1990's we noticed that our taxable mutual funds were putting out about 10% of their value in distributions each year. With federal and state income taxes, those distributions were taxed at between 20% and 30%, so the taxes were like a 2% drag on our annual return. When we realized this, we began to choose our taxable investments with an eye to minimizing those annual distributions.

For example, no more bond funds in our taxable side of mutual funds. No REIT funds in our taxable accounts. Individual stocks and funds with low turnover numbers such as ETFs and index funds were in our taxable accounts. Even the small cap etf IWM is found in our taxable account. Funds with high turnovers are found in our 401(k)s.

But it's no sin to have low turnover funds in your Roth or 401(k) either. I also do not think it's a problem to have a CD in your IRA if that's what you need for asset allocation.

If we are going to keep several years in cash equivalents, they need to be in taxable accounts to avoid higher tax rates.

Sorry, I do not understand that statement. The highest tax rates will be in incurred by your taxable accounts. If you are in a very high marginal income tax bracket, then tax-free municipal bonds can make sense.

 

[AV8]

There is no problem having your "more volatile" assets allocated to the tax deferred accounts, per se. However, doing so is not the most efficient use of these accounts. Ideally, you want to stuff your IRAs (and the like) full of income producing assets (i.g. Bonds, REITs, etc).

There is no problem having your "more volatile" assets allocated to the tax deferred accounts, per se. However, doing so is not the most efficient use of these accounts. Ideally, you want to stuff your IRAs (and the like) full of income producing assets (i.g. Bonds, REITs, etc).

I'm starting to get it I think. However, as a future military pensioner we've been considering the pension our "fixed income" portion of our portolio (while we're still relatively young at least--late 30s). With the exception of a rental property, we're primarily in equities. If I understand correctly, the thing to consider would be future tax liability of fund positions in the withdrawal phase of RE, not necessarily during the growth phase. Correct?

AV8

 

[Bailing-Bob]

I am retiring at age 52 in a couple years. I intend to hold seven years of expenses in cash (CDs, Treasuries and/or Bond Funds) in my taxable account. This will minimize the chance I will have to tap equities in a down market or to incur the early withdrawal penalties if I was forced to tap my IRAs before 59. My plan is not to have to touch my tax deferred accounts any earlier then age 60 or later. Storing all your cash/FI allocation in a tax deferred accounts is really not a realistic plan for those of us who are going to RE without a pension.

My 2 cents

Open to alternative suggestions for those in my boat.

 

[ats5g]

For argument's sake, let's say you're an early retiree with both taxable and tax deferred accounts, and let's say that you've chosen to invest the taxable account is tax efficient equities.

When you start taking withdrawals from the taxable account, from the equities, couldn't you just sell the equities in the taxable account (paying the LT cap gains or losses) and "rebuy" the equities you just sold in the tax deferred account by transferring money from bonds to equities?

Would this solve the problem for an early retiree?

- Alec

 

[rockyj]

This is a timely thread about which I am still am somewhat confused myself. Perhaps some of our more experienced members can comment with illustrative specifics or point to a good resource on the subject (i.e. tax efficient allocation/rebalancing).

The simple way for me to rebalance our AA without incurring a taxable event would be to reallocate within my and DWs Roth IRAs and my TSP (401k).
The end result would be that a high percentage of the more volatile portion of our AA (Intl, Small-cap, Mid-Cap) would be in the IRAs and TSP (401k).

Seems that the Roth is a good place to hold the accounts within which you expect to realize
the greatest net gains (compared with taxable account) for the anticipated holding period,
not just the highest rate gains. So, while the traditional advice on holding income funds in Roth may indeed produce the greatest percentage savings based on tax rates for income versus cap gains, for example, over a long holding period one could very easily realize sufficiently greater capital gains in one of those volatile classes you refer to to more than offest the better tax rate savings gained from income funds (i.e. while a lower potential cap gains tax rate may be involved, there may also be sufficiently greater gains to make the Roth the long term winner). So, I don't see any problem with holding asset classes with high potential for long term cap gains growth in the Roth, assuming you're not holding significant and less tax efficient assets in taxable accounts.

One simple tip from other threads that can help with tax efficient rebalancing in taxable accounts is to have all dividends and realized gains redirected into a money market fund, from which one can then make deposits to underweighted asset clasees without selling shares of the originating funds (as might need to be the case if the dividends/gains were auto-reinvested into the originating funds).

If I understand correctly, the thing to consider would be future tax liability of fund positions in the withdrawal phase of RE, not necessarily during the growth phase. Correct?

Seems that tax consequences at deposit, withdrawal *and* within the account during accumulation/growth all are factors. For example, an active MF account that realizes significant dividends and capital gains would hands down do much better in a Roth than in either the 401K or taxable account, due to tax free accumulation and withdrawal. This is once the money is committed, but there may also be considerations going in as to whether the tax deferral of 401K is better than the after tax deposit (but tax free growth/withdrawal) of Roth.

The same fund in a 401K, on the other hand, would benefit from tax free compounding during accumulation/growth, but at withdrawal, gains that would have been taxed along the way at dividend or cap gains rates are instead taxed at income rates (which may very likely be higher). Also, however, a larger amount of money would have been compounding along the way due to the tax deferral (compared with taxable account).

Personally, I'm still a bit confused on the fine points, but fortunately we have been in a postion to fund Roth, 403B and taxable accounts - tax diversification as Updegrave calls it. Most holdings in all three are equity mutual funds. So for tax efficiency considerations what we we do is
1) try to hold index funds or other tax efficient funds in taxable accounts,
2) redirect dividends and cap gains in taxable accounts to money market for subsequent purchases into underweighted classes at the time,
3) hold funds that produce higher income/turnover/gains in tax deferred accounts (Roth and 403B), as well as some of the higher volatility funds regardless of income characteristics,
4) distribute new 403B money (DCA) and annual Roth deposits into underweighted classes at the time (this is facilitated by holding some of the same funds in both Roth and 403B)

Not sure if this helpful for anyone. Sorry for the ramble, but I'm also be interested in hearing the thoughts of others on any finer points we might be missing.

 

[Bailing-Bob]

All good points, but I do not see how an early retiree can avoid selling equities in a down market without having adequate cash/FI allocations in their taxable account. If the cash/FI allocation is locked up in the tax deferred account, then you are going to be forced to sell equities in a down market to fund expenses, unless you want to pay early withdrawal penalties or commit to a 72t early withdrawal scheme.

I know I am repeating my self, but I have not seen any alternative to holding large amounts of cash in a taxable account during ER, if you are depending on your portfolio to fund expenses and not tap equities during a bear market.

 

[LOL!]

Presumably you only going to use 4% of your assets in any given year. Also you are probably generating at least half that in the form of dividends. That leaves only a 2% shortfall to make up by selling equities. Big whoop. Your current portfolio went up 2% in January 2007 already. In a bear market, you can find 2% of your portfolio in equities that you want to sell, couldn't you? And you get to take the tax loss as well.

In other words, I don't see it as a sin to sell equities ... even in a dropping market.

 

[JohnEyles]

hold funds that produce higher income/turnover/gains in tax deferred accounts (Roth and 403B) ...

I don't think it makes any sense to consider tax-deferred account (like 403b, 401k, IRA)
as being the same animal as a Roth. That's because you'll never ever pay any tax
on the Roth (except for the money going in). Thus it makes sense to put assets with the
highest likely long-term gain into the Roth - probably foreign and smallcap stuff. On the
other hand, you will eventually pay taxes on the gains in the tax-deferred accounts, and
as ordinary income - so it makes no sense to put anything there that you could potentially
get lower taxation on by holding it in a taxable account (e.g. long-term capital gains and
qualified dividends).

As far as the issue of wanting to spend from the taxable accounts early in retirement, and
having mostly equities there, yes, it's a puzzler. But I think the scheme mentioned above,
of NOT reinvesting dividends (and cap gain distributions) for the stuff in the taxable account,
and using that money to spend, makes sense. Thus maybe you'll need only about half your
living expenses (for however many years) in cash and short-term bonds in the taxable
account. That should (hopefully) leave enough funds in the taxable accounts, plus the
Roth, to cover your equity allocation.

 

[rockyj]

I don't think it makes any sense to consider tax-deferred account (like 403b, 401k, IRA)
as being the same animal as a Roth. That's because you'll never ever pay any tax
on the Roth (except for the money going in). Thus it makes sense to put assets with the
highest likely long-term gain into the Roth - probably foreign and smallcap stuff.

Thanks for pointing that out - not the same animal - so for Roth go for highest anticipated gains (considering potential tax savings where you have to choose between substantially equivalent prospects on return, albeit from differing types of income/gain), which may address OP's concern about high volatility stuff in Roth.

On the other hand, you will eventually pay taxes on the gains in the tax-deferred accounts, and as ordinary income - so it makes no sense to put anything there that you could potentially get lower taxation on by holding it in a taxable account (e.g. long-term capital gains and qualified dividends).

Clearly better, on the withdrawal side, to have accrued income in 401K/403B rather than cap gains and qualified dividends. But the overall calculations on 401K/403B are what confuse me. Tax savings on deduction going in (amount is situation dependent), tax deferred compounding along the way, potential conversions to Roth starting in a couple of years (with conversion taxes due at that time, again rate dependent on situation(?)), and abilty to manipulate withdrawals
among various accounts to help control tax rates coming out (once again situation dependent) - all compounded by uncertainty about future tax rates (except that they're perhaps not likely to go down). In light of which, a "rule of thumb" that says
avoid holding equities in 401K/403B due to conversion of cap gains/dividend rates
to ordinary income rates on the way out seems like it may be overlooking some things.

It is confusing. So I'm looking for a good reference source or calculator with illustrative examples, to help think through specifics, and flesh out the rules of thumb - as helpful as they may be.

 

[Nords]

All good points, but I do not see how an early retiree can avoid selling equities in a down market without having adequate cash/FI allocations in their taxable account. If the cash/FI allocation is locked up in the tax deferred account, then you are going to be forced to sell equities in a down market to fund expenses, unless you want to pay early withdrawal penalties or commit to a 72t early withdrawal scheme.

Roth IRA contributions can be withdrawn at any time for any reason with no penalties. It just gets messy if you want to chew into the gains on those contributions.

I put this whole taxable/tax-deferred debate into the categories of "over-tweaking" and "too hard". Some deadline journalist realized that cap gains in a taxable account would be taxed more favorably than as earned income from a tax-deferred account, while bond income (especially TIPS) would not be penalized by taxes while it's compounding in a tax-deferred account. So the "rule" became to split up your assets that way and to start tapping the IRA when you retired after the age of 59.5. Besides, darn few deadline journalists know anything about retirement, let alone ER.

Five years into ER we're still rebalancing the profts into our cash stash (which is in a taxable money-market account). We only had to chew through our cash stash in 2002-2003 and it's grown quite handily since then. We're rebalancing from our taxable accounts because the cap gains are taxed quite favorably and because our last higher-cost bloated mutual fund is in a taxable accounts. I've already talked about selling strategies in a bear market, but I'd hope to be able to go through the entire taxable portion of the portfolio before I'd have to start in on the IRAs (however we do that-- Roth contributions or 72(t)s).

Of course we don't hold any bonds, either, so we've sidestepped that entire bond/tax-deferred account issue. But maybe TIPS or other bonds would be a good way to get through the RMD phase of drawing down the IRAs.

 

[rockyj]

I put this whole taxable/tax-deferred debate into the categories of "over-tweaking" and "too hard".

I suspect you've nailed it with that one.

 

[Telly]

.........I know I am repeating my self, but I have not seen any alternative to holding large amounts of cash in a taxable account during ER, if you are depending on your portfolio to fund expenses and not tap equities during a bear market.

Yup. You've got it, Bob.

For someone retiring early, without a pension (or only having a tiny one), the income is going to come from taxable accounts if you're not going to do a 72T scheme (which I'm not). Furthermore, if you were/are making pretty good money at the job, you were probably maxing your 401k, and not eligible for a Roth.
So your tax-deferred equities may be doing fantastic, going up whatever percent recently. Which is irrelevant to your pre-59&1/2 expenses. Any dividends on the tax-deferred side, as great as they may be, are on the other side of the tax boundary.
So as your tax-deferred side grows, your taxable side declines with expenses. How quickly it declines, or if it indeed grows after expenses is of course dependant on how big your taxable accounts are relative to your annual expenses.
One can make the taxable side decline more slowly or maybe actually grow with a healthy share of equities there... and then be subject to a down-turn in the market that could devastate the $ that you were going to be using for living expenses. Like the 2000 through 2002 bear market. So it would seem that the taxable side is going to be tilted strongly to fixed income side to insure survival.

I don't think too many people here, who are:

Actually ER'd
Well below age 59
Have been ER'd for a while
Do not have a pension

Have 25 times their yearly expenses in their taxable accounts!

So your question and comments are good ones.

 

[modlair]

For argument's sake, let's say you're an early retiree with both taxable and tax deferred accounts, and let's say that you've chosen to invest the taxable account is tax efficient equities.

When you start taking withdrawals from the taxable account, from the equities, couldn't you just sell the equities in the taxable account (paying the LT cap gains or losses) and "rebuy" the equities you just sold in the tax deferred account by transferring money from bonds to equities?

Would this solve the problem for an early retiree?

I have wondered about this a great deal of late. There is a valid point above that deadline journalists don't have a clue as to the intricacies of all this and so their having pointed out that FI in tax advantaged accounts are the norm du jour should probably be ignored.

Here's my read on this. If one chooses to use AA rebalance events to also re-allocate from taxable vs non taxable -- it would seem to me that the solution is in hand.

You keep FI in non taxed/tax advantaged accts. If the market crashes, you sell equities from your taxable account to raise cash to live on, and you buy the correct amount of equities in your 401K/IRA/Roth segment to maintain your target FI/Equity AA -- so that Guyton's downside imperatives are satisfied.

If the market then booms, you still have all equities in taxable accounts, and you sell them -- again to raise cash to live on, but you also sell equities (accumulated during the crash) in your 401K/IRA/Roth segment to get the FI/Equity AA back to the target.

That should address the problem if the crash comes first.

If the boom happens first, there would appear to be no way to avoid having some FI in your taxable accounts to maintain the target AA. But if the boom happens first, Guyton's rules are less stressed.

 

[AV8]

Lots of great info to ponder. I think for the Roth IRAs we can accept a higher amount of high volitility/risk equities (mid/small-cap and int'l) and leave a heavier lg-cap exposure on the taxable side (still no bonds). Later as we consider a FI portion we can ponder where to put it, but from what I gleaned at least some would need to be in taxable accounts (like the dividends into a MM idea). I'm still working though what to do with the TSP (401k) and whether it might matter for the tax deferred accounts.

Thanks all.

AV8

 

[donheff]

Presumably you only going to use 4% of your assets in any given year. Also you are probably generating at least half that in the form of dividends. That leaves only a 2% shortfall to make up by selling equities. Big whoop. Your current portfolio went up 2% in January 2007 already. In a bear market, you can find 2% of your portfolio in equities that you want to sell, couldn't you? And you get to take the tax loss as well.

In other words, I don't see it as a sin to sell equities ... even in a dropping market.

Yeah, but if that 4% involves all of your assets then that includes tax advantaged funds. If your portfolio throws off 2% but only 1/3 of your portfolio is taxable, then the taxable component throws off around .66% of your needs. You would have to liquidate the rest. The poster's bottom line is correct. If you are keeping cash for a down market it needs to be in taxable accounts in the early years. I have been building up some CDs/bonds for that purpose over the last year. It is all in taxable accounts. The IRAs are more aggressive since I don't anticipate tapping them for a while.

 

[Gone4Good]

You keep FI in non taxed/tax advantaged accts. If the market crashes, you sell equities from your taxable account to raise cash to live on, and you buy the correct amount of equities in your 401K/IRA/Roth segment to maintain your target FI/Equity AA -- so that Guyton's downside imperatives are satisfied.

If the market then booms, you still have all equities in taxable accounts, and you sell them -- again to raise cash to live on, but you also sell equities (accumulated during the crash) in your 401K/IRA/Roth segment to get the FI/Equity AA back to the target.

Yes. This is absolutely correct. Your asset allocation is indifferent as to whether your equities are sold in a taxable account and replaced in a tax deferred account or vice versa . . . the only one who cares is the tax man.

 

[Gone4Good]

I'm starting to get it I think. However, as a future military pensioner we've been considering the pension our "fixed income" portion of our portolio (while we're still relatively young at least--late 30s). With the exception of a rental property, we're primarily in equities. If I understand correctly, the thing to consider would be future tax liability of fund positions in the withdrawal phase of RE, not necessarily during the growth phase. Correct?

AV8

Your consideration of the pension as the fixed income allocation is an important point, which I may have missed in your original post. The fact that you are mostly/entirely invested in equities renders my previous comment moot with respect to your specific situation (but still valid for anyone who has a more "normal" asset mix).

In your case, I wouldn't worry too much about which assets go into the tax deferred account. For the same reasons stated earlier, I'd still try to put income producing equities (like REITs or large cap financials) in the tax deferred accounts and leave the growers for the taxable.

More important for you, though, is to maximize your contributions to the tax deferred accounts to take advantage of compounding on your before-tax contributions. Otherwise, I wouldn't worry about it.

 

[AV8]

More important for you, though, is to maximize your contributions to the tax deferred accounts to take advantage of compounding on your before-tax contributions. Otherwise, I wouldn't worry about it.

We're doing that, thanks. Maxing the TSP and both Roths every year and also send a good chunk to taxable accounts and a couple of 529s too.

In your case, I wouldn't worry too much about which assets go into the tax deferred account. For the same reasons stated earlier, I'd still try to put income producing equities (like REITs or large cap financials) in the tax deferred accounts and leave the growers for the taxable.

The light bulb finally went on last night on income producing assets vs cap gains in tax-deferred and taxable accounts respectively. It still woud be painful to sell the large cap equities in the taxable account, take the tax hit, and reallocate when I could sell them within the Roth without any taxable event. Maybe the Roth's are the answer...put the potential high growers in there.

AV8

 

[Moemg]

I know this is slightly off the subject .I have some bonds in my taxable account .Would it make sense for me to sell them first for expenses and then buy more bonds in my IRA ? Also does it make more sense tax wise to spend the dividends first before selling the bonds ?Thanks!