Bonds in After-Tax Account

[mbnj77]

Hey all, thought this was a quick question but as I am typing I'm realizing not so much. Sorry.

So, I get why you should keep bonds and bond funds in your tax advantaged account due to their tax inefficiency. I also get that when looking at AA, you need to take a look at the total of ALL your buckets.

So if we're looking at a 60/40 AA for our combined brokerage and 401(k)s, all 40% of the bonds should go in the 401(k)s. So theoretically, just looking at round numbers, we may have a 90/10 AA in the brokerage and a 10/90 AA in the 401(k)s,

Fine so far. But when we retire at 55,(in two years), because DW's 401(k) does not allow for partial withdrawals, we will need a lot more of the after-tax bucket to fund the gap until 59 1/2 when she can roll the whole thing over and start to draw from it. (I haven't been in my job long enough so there's not enough in my 401(k) ).

So since the time horizon is shorter for the after-tax bucket and the need so great for it to fund the gap, I am concerned about having too much in equities in our brokerage account to reach the overall 60/40 portfolio AA. So even though it's not tax efficient, in our case, should we try to have the 60/40 AA in EACH bucket?

Thanks for the usual insightful contributions I'm sure to get.

 

[sarasota]

You might want to check on your wife's 401k plan because one of the advantages of keeping money in a 401k vs. IRA is that you can withdraw the money without penalty starting at age 55 if you retired with the company at 55+. I never heard of a 401k that doesn't let you make any withdrawels other than a total withdrawel.

The window between 55 and when you take social security is a chance to reclass some of your pre-tax money as Roth via a Roth conversion. You pay no tax on your first 20,250 due to standard deduction and exemptions. Then you only pay 10% on the next 18,650 so it might be worth looking at reclassing pre-tax money to Roth if you are living off mostly post-tax assets and your TI is less than 40k.

 

[mbnj77]

Yea, we checked the documentation and it's lump some or rollover only.

 

[MuirWannabe]

My 401K has the same stipulations. I use a tax free muni fund in my taxable account to achieve desired AA. VWIUX

 

[Aiming_4_55]

I was looking at tax free muni fund in my taxable account also as I'm sitting on a bit of cash from a real estate transaction. I feel my equity is high and might re-invest in other real estate, but that could be 1 - 3 years or never. It seems to provide a better return than the 1% online savings and tax free.

I understand tax free while working, why so much when one is RE with little to no income?

 

[pb4uski]

Your OP is a common source of confusion, and is easily addressed.

Let's say that your target AA is 60/40 that r total retirement investments, 20% is after tax and 80% is pre-tax and your WR is 4%. Since if you retire at 55 you only have 4 1/2 years of withdrawals at 4% before you are 59 1/2 and have penalty free access to your tax-deferred funds, the 20% that you have in taxable accounts is sufficient to bridge the gap.

Let's say that you have $1 million for easy figuring. At retirement your tax deferred account is $800k, composed of $400k of bonds and $400k of equities and your taxable account of $200k is all equities. Overall your AA is 60/40.

I'll ignore growth to make the example simpler. After a year of withdrawals, your taxable account is down to $160k and your AA is 58/42.... 58 being ($160k equities in taxable + $400k equities in tax-deferred)/($1 million - $40k withdrawals).

To rebalance, in your tax deferred account you sell $16k of bonds and buy $16k of equities... this brings your overall balances to $160k of equities in your taxable account and $416k of equities in your tax deferred account... a total of $576k of equities... 60% of your total $960k of retirement investments.

Repeat the process annually. Your taxable account remains all equities for tax efficiency and your tax-deferred accounts make up the difference to balance out ot your target AA.

 

[kaneohe]

My understanding is that you swap equity for fixed income in taxable as you need it (and do the corresponding swap in retirement funds to keep AA the same). Ex: 100K in taxable; 100K in retirement. 60-40 AA means 120K in equity and 80K in fixed income so taxable is 100K equity (100%) and retirement is 20K equity/80K fixed income (20%/80%).

When you retire , suppose equity drops 50%. You now have 50K in equity in taxable; 10K in equity/80K fixed income in retirement. If you need to spend 50K, you sell the 50K equity in taxable and buy 50K equity in retirement.
That leaves you will 50K fixed income in taxable; 60K equity/30K fixed income in retirement .

True, you did sell 50K equity at low prices, but you added 50K equity in retirement that has the ability to recover. One thing that is different however
is that any gains in equity in retirement account are taxed at ordinary rates whereas similar gains in taxable are at the more favorable CG rates. So maybe the tax advantage you get by putting fixed income in retirement
are cancelled by this.

Perhaps a more detailed analysis is needed.

 

[mbnj77]

Thanks much Kaneohe and pb4uski, and I think I get the rebalancing part. The issue is that I cannot sell from my pre-tax accounts to back fill, (and rebalance at the same time), my after-tax account until we're 59 1/2. My time horizon on the after-tax is only 2 years and because we will rely on it for 4 1/2 years, we are concerned about a big down-turn in the market when we have nowhere else to go to fund our ER. DW has a pension but it's non-cola and we will be relying on this after-tax bucket.

After 59 1/2, then easy-peazy, but I am questioning whether I should sacrifice tax efficiency so we will ensure we don't lose a big chunk in a down market if we are too heavy in equities.

thanks again.

 

[pb4uski]

You don't need to withdraw from your tax deferred accounts at all... just shift money from bonds to stocks within your tax-deferred account. Note that in the example I conjured up that the tax-deferred accounts are unchanged at $800k... it is just at retirement it is $400k/$400k and after a year of withdrawals from the taxable account and rebalancing it is $416k/$384k... but still $800k in total since you can't withdraw from those accounts without penalty.

You just need to be able to change the AA within the 401k account between 55 and 59 1/2, which you typically can do.

 

[kaneohe]

....................... The issue is that I cannot sell from my pre-tax accounts to back fill, (and rebalance at the same time), my after-tax account until we're 59 1/2. .........................

Not sure I understand this.........you are not moving funds from retirement to taxable ; you are just swapping allocations in the 2 accounts. I find it hard to believe that your retirement fund doesn't allow you to change allocations.

edit to add: based on repeated tests, no doubt pb4uski is faster

 

[pb4uski]

Perhaps it takes longer for electrons to travel to the e-r servers from the middle of the Pacific Ocean than from New England.

 

[mbnj77]

Ok, I understand that and yes, we can certainly re-balance at will in the 401(k). I misunderstood pb4uski.

But I am still not sure I understand how that answers my question for my after-tax account. As an example, let's say I have 500K in my after-tax brokerage and I need every bit of 111K per year for the 4.5 years gap until we're 59.5. If my overall allocation in this account is 90/10 because my OVERALL AA is 60/40 and I am not supposed to put bonds in after-tax accounts, then what happens if the market is down 20% after the first year of withdrawals. 500,000-111000 x .80 = $311,000. That means, assuming no further losses or gains, we only have about 89K left per year for the remaining 3.5 years of the gap and no way to replace it from pre-tax accounts.

So rebalancing the 401(k) doesn't help us in that situation. So my question was whether I should sacrifice tax efficiency by adding more bond funds to our after-tax bucket so we will ensure we don't lose as big a chunk in a down market. Perhaps I am either unclear in how I am asking this or I am just dense. (very likely both)

 

[pb4uski]

Actually, now that I think of it... does your 401k allow penalty free withdrawals if you leave their service in the year that you turn 55 or later? Most do but you need to check into it. If so, and they allow at least an annual withdrawal your liquidity problem could be solved tax efficiently but just doing a penalty-free withdrawal annually if needed.

OTOH, if your 401k does not allow penalty-free withdrawals and your taxable account is that close to what you need (no redundancy), then you might be better off having some in cash or CDs or tax-free munis... in the situations I am thinking of there is a little more leeway for the taxable accounts to absorb some market volatility. If you do this you will essentially be trading some tax efficiency for lower iquidity risk. Or you could stay with equities in the taxable account with the understanding that if things go bad that you may have to make some withdrawals and pay the 10% penalty or start a 72t from the 401k if you think your taxable account will run out before 59 1/2.

 

[kaneohe]

I might also worry about something else. If your taxable is depleted in5 yrs due to market decline and taxable is 50% of total worth, what does FIRECALC say about situation? Seems like mismatch between spending level and assets?

 

[mbnj77]

Thanks pb4uski, yea, I had posted in another thread about the variances in how different plans allow for the rule of 55. In DW's case, after a lot of run-around, we discovered that YES, no problem taking money in the year she turns 55 after she resigns. BUT, and it is an unfathomably BIG BUT, she can't take partial distributions, only one lump some. So unless we want a ridiculous tax bill that year, for all intents and purposes, we really can't touch it.

We do have some cash and I think I need to add to it but I guess, as someone else mentioned as well, tax-free muni's may be the best option available. I actually had some but got the willies when interest rates went up and bailed.

Thanks Kaneohe, it's not 50% of the total. I didn't think I intimated that but may have.
After 59.5, we'll have plenty of Do Re Mi.

 

[pb4uski]

Is it that she would have to take it out all at once in one lum sum or that she can only do one partial withdrawal annually? The latter seems plausible but the former doesn't pass the smell test as it effectively negates the ability to take penalty free withdrawals to begin with.

What you might consider is rolling over the 401k to a tIRA and then doing a 72t from the tIRA to provide some liquidity and less risk of your taxable account being depleted if it is invested in equities... that would also reduce the tax-deferred accounts somewhat and lower your RMDs later compared to relying solely on the taxable account for the gap period. You might be able to get the best of both worlds... liquidity and tax-efficiency.

 

[mbnj77]

THANKS! I forgot about the 72t and that may be the way to go. As for her plan, yes, that is the only option available. Nuts, I know. From her SPD:

Distribution Option(s) The following distribution options are currently available under the Plan:

Lump Sum Distribution This is the primary form of distribution under the Plan. If you elect this option, your entire vested account balance will be paid to you in a single distribution. No other benefits will be available to you, your designated beneficiary(ies), or any other person after this distribution.
In

 

[kaneohe]

...................., it's not 50% of the total. I didn't think I intimated that but may have.
After 59.5, we'll have plenty of Do Re Mi.

I think I deduced that based on your AA in taxable and retirement plans.
Didn't seem like you were too one-sided in amounts in one or the other.
Glad I was wrong and Do Re Mi is not a problem later.

 

[LOL!]

This is essentially the same question answered, but at Bogleheads:
https://www.bogleheads.org/forum/viewtopic.php?f=1&t=219792

Many folks are worried about a drop in equities while early-retired before they can withdraw from tax-deferred accounts without penalties because their taxable or age-55 accounts will be decimated by a 40% to 50% stock market drop if that bucket was 100% equities.

I think if equities drop 50% (and stay down), then they are going to probably tighten up their spending anyways, plus there are ways to access those other accounts without penalty anyways before age 59.5. I don't think bonds in these pre-age-59.5 buckets are going to save them.

 

[LOL!]

Do we have any testimonials from early retirees who had a bucket run out in the 2008-2009 market dump? What did you do?

 

[ocean view]

I have a related question, so thanks mbnj77 for starting this topic today.

I understand the theoretical tax efficiency of holding bonds in the tax deferred accounts vs taxable, however in my set of facts I think it is a wash. We are already retired, early fifties and have no other stream of income until 59.5 except from the taxable bucket. 2016 was the first full year of retirement, where we we paid no tax. It is our intention to begin Roth conversions in 2017 (missed the boat in 2016) and continue each year until it is done (probably 10 years). We are currently holding all of our bonds in the taxable account, so that the monthly interest can be used to partially fund monthly expenses. Yes, I know it is taxed as ordinary at 15%. But if the bonds were held in the t-IRA, we would have a larger balance to convert to Roth, that will be taxed as ordinary at 15% in this year or some later year. Each year when we do the Roth conversion we will buy bonds in the Roth and re-balance all buckets and then see the full tax efficiency of the Roth.

Am I missing something? It seems as though the tax efficiency of bonds in a t-IRA/401k is diminished or lost if the taxpayer is in the lowest bracket. If we were still working and in a higher bracket, I can see the benefit.

 

[LOL!]

I am doing Roth conversions now. Any extra income just takes up space that could be used for conversions. Return of capital is not income and does not show up on your Form 1040.

So consider this:

You need $75,000 a year for expenses (top of 15% marginal income tax bracket).

You have an index fund of equities in taxable that pays out about 2% in qualified dividends a year (say an S&P500 index fund).

You sell $70,000 of the S&P500 index fund, but the cost basis was $35,000 and you get $5,000 of qualified dividends. (Or pick other combos: get $30,000 of qualified dividends and sell $45,000 of stock).

You tax-loss harvested in the past so you have $3,000 of carry over losses to apply to your current tax return AND the $35,000 of realized capital gains is offset, too.

With the above scenario your adjusted gross income is -$3,000 before deductions, exemptions, and credits.

Now you can do Roth conversions ... a big chunk of the Roth conversion is at 0%.

Sure, you may not have those carryover losses and sure you may have a higher percentage of gains, but if you are using Specific Identification for choosing the shares to sell, maybe you can control that during your Roth conversion years.

Contrast all that with using bond fund dividends which CANNOT be offset that much by carryover losses AND are not qualified. Of course, you can sell the shares to realize gains and losses and it is likely that return of capital is a higher percentage of sale proceeds.

Anyways, I am 100% equities in taxable while doing Roth conversions. I don't want to use up my $75,000 with taxed bond dividends.

 

[pb4uski]

....Am I missing something? ....

What you are missing is that by holding bonds instead of equities in your taxable account you are essentially converting what could be tax-free income (qualified dividends and LTCG are 0% tax for those in the 15% tax bracket or below) into ordinary income. You are also increasing the effective tax rate on your conversions because your bond income, which is ordinary, uses up some of your deductions and exemptions.

Let's take and example of a married couple in their mid-50s who are retired and principally living off of taxable accounts. The first couple has $25,000 of investment income from bonds and uses the standard deduction and 2 exemptions. If convert to the top of the 15% tax bracket they can convert $71,000... their tax bill will be $433 before the conversion and $10,371 after the conversion so the effective tax rate on the $71,000 converison is 14%. In addition, qualified dividends from the equities in their tIRA will ultimately be taxed at ordinary income rates and the tax preference of qualified dividends and LTCG will be lost forever.

The second couple invests in equities instead and has $25,000 of qualified dividends and LTCG. Like the first couple, they can convert $71,000... but their tax before the Roth conversion is $0 and after is $6,621... and effective rate on the conversion of 9.3%. For this couple, the bond interest in their tax-deferred account will be taxed as ordinary income when it is withdrawn rather than when it is earned, but nonetheless in both cases at ordinary income rates.

Paying 9.3% is better than paying 14%.

 

[ocean view]

I am doing Roth conversions now. Any extra income just takes up space that could be used for conversions. Return of capital is not income and does not show up on your Form 1040.

So consider this:

You need $75,000 a year for expenses (top of 15% marginal income tax bracket).

You have an index fund of equities in taxable that pays out about 2% in qualified dividends a year (say an S&P500 index fund).

You sell $70,000 of the S&P500 index fund, but the cost basis was $35,000 and you get $5,000 of qualified dividends. (Or pick other combos: get $30,000 of qualified dividends and sell $45,000 of stock).

You tax-loss harvested in the past so you have $3,000 of carry over losses to apply to your current tax return AND the $35,000 of realized capital gains is offset, too.

With the above scenario your adjusted gross income is -$3,000 before deductions, exemptions, and credits.

Now you can do Roth conversions ... a big chunk of the Roth conversion is at 0%.

Sure, you may not have those carryover losses and sure you may have a higher percentage of gains, but if you are using Specific Identification for choosing the shares to sell, maybe you can control that during your Roth conversion years.

Contrast all that with using bond fund dividends which CANNOT be offset that much by carryover losses AND are not qualified. Of course, you can sell the shares to realize gains and losses and it is likely that return of capital is a higher percentage of sale proceeds.

Anyways, I am 100% equities in taxable while doing Roth conversions. I don't want to use up my $75,000 with taxed bond dividends.

So really what I'm hearing you say is to get your t-IRA converted as quickly as possible (while staying within the 15%) so that it has more time to grow tax free. Even if that means using carryover losses to shelter income that would have been taxed at zero anyway because of my low bracket. Intuitively a loss carry forward used against otherwise tax free gains is NOT an efficient use of that loss. But perhaps it is cost of getting the Roth converted my quickly.

 

[pb4uski]

Where did the tax losses come from?... no mention in post #21.

I think that might allow you to do more Roth conversions because you can do LTCG without using any headway since the LTCG will be offset by carryover losses... still equities, but probably low or no dividend equities and harvest gains.