Rebalancing

[tdv2]

I hit my 5% threshold for re-balancing my portfolio. Yesterday I made some changes to my IRA's and 401k's to bring things back in check. For a couple of years now my target has been 60/40 equity/Bond-cash. I'm 53 now and on a timeline to pull the plug before the end of the year. DW has a date for FIRE set at early next year.

I have been doing all my re-balancing in my tax advantaged accounts to avoid cap gains and paying state income tax on the sales.....live in NJ at the moment. I know it the right thing to do but since 2/3 of my savings are in after tax accounts, most of my equity index funds reside there. I am the opposite on the pre-tax accounts....heavy on the bonds.

As with most folks near FIRE in their 50's, I worry about sequence risk. I know I have enough cushion and that I can make it work even with a significant bear market....but non the less, I still worry.

 

[pb4uski]

To carry bonds in your after-tax accounts is horribly tax inefficient since qualified dividends on equities and long-term capital gains are tax preferenced... 15% for people in the 25% tax bracket and higher and 0% for people in the 15% tax bracket and lower. The impact of the tax preference dwarfs my roughly 3.5% state income tax rate.

By holding equities in your tax-deferred accounts, it seems to me that you are converting tax-preferenced income into ordinary income.

Both bond interest and equity dividends/LTGC are taxed in my state as well (above an annual exclusion amount) but I chose not to let the state income tax tail wag the federal income tax dog. The LTCG on my annual cash raise would generally be less than the annual exclusion amount so those are tax free as well.

My taxable accounts are my 5% cash/liquidity allocation and all domestic and international equities. Due to the foreign tax credit, my effective tax rate on my taxabe accounts is actually a slight negative (the foreign tax credit exceeds the tax on interest from my tax allocation and non-qualified dividends from my international equities).

All bonds are in my tax deferred accounts. My cash allocation is sufficient, along with taxable account dividends, to cover 2-3 years of living expenses. In the last quarter of each year when I usully rebalance, I sell equities in my taxable account to replenish my 5% cash allocation and then do the rest of my rebalancing in my tax-deferred accounts.

The cash allocation provides liquidity and peace of mind at a minor cost... about 5bps or 0.05%.

With the approach that I take, rebalancing into a bull or bear market doesn't matter to me... my taxable positions have significant unrealized capita gains so there will be a gain no matter what the market is.

 

[tdv2]

To carry bonds in your after-tax accounts is horribly tax inefficient since qualified dividends on equities and long-term capital gains are tax preferenced... 15% for people in the 25% tax bracket and higher and 0% for people in the 15% tax bracket and lower. The impact of the tax preference dwarfs my roughly 3.5% state income tax rate.

By holding equities in your tax-deferred accounts, it seems to me that you are converting tax-preferenced income into ordinary income.

Both bond interest and equity dividends/LTGC are taxed in my state as well (above an annual exclusion amount) but I chose not to let the state income tax tail wag the federal income tax dog. The LTCG on my annual cash raise would generally be less than the annual exclusion amount so those are tax free as well.

My taxable accounts are my 5% cash/liquidity allocation and all domestic and international equities. Due to the foreign tax credit, my effective tax rate on my taxabe accounts is actually a slight negative (the foreign tax credit exceeds the tax on interest from my tax allocation and non-qualified dividends from my international equities).

All bonds are in my tax deferred accounts. My cash allocation is sufficient, along with taxable account dividends, to cover 2-3 years of living expenses. In the last quarter of each year when I usully rebalance, I sell equities in my taxable account to replenish my 5% cash allocation and then do the rest of my rebalancing in my tax-deferred accounts.

The cash allocation provides liquidity and peace of mind at a minor cost... about 5bps or 0.05%.

With the approach that I take, rebalancing into a bull or bear market doesn't matter to me... my taxable positions have significant unrealized capita gains so there will be a gain no matter what the market is.

I hear what you are saying about holding all the bonds in tax deferred accounts.....I'm almost there. In my taxable account, I have a municipal bond fund to avoid the extra ordinary income while we are still employed. When I FIRE, I will likely convert this fund to a bond index or something similar with low fees.

 

[pb4uski]

Ah, a muni makes sense in your situation now being employed.

Once you retire, you could take a look at replacing the muni bond with equities and then making commensurate changes in your tax-deferred account to get to your target AA.