3-5 years cash in taxable or IRA?

[donheff]

I know the general rule is to keep bonds and other fixed income funds in IRAs to avoid paying taxes as the gains are realized. But what about the 3-5 years of expenses that we talk about holding for down markets. Since the general wisdom is to pull from taxable funds first and IRAs last I have assumed I should keep my 3 years cash in a taxable account so it can be readily liquidated without paying at the full income tax rate. But I will be paying the full income rate on the 5.x% it generates year after year in an up market. Maybe it is better to move it to taxable and accept the income hit on the cash in a down market.

Has anyone run the numbers to figure out when/if it makes more sense to keep the cash in an IRA?

 

[LOL!]

You can "run the numbers" in your head. Let's say a year is 4% of assets and your return per year is 5%. That means .04 * .05 = 0.0020 or 0.2% of your assets will be taxable interest each year.

Or say you have $2MM total, that's $4,000 in interest. Since you will probably have $20000 of taxable dividends anyways, I don't think it's something to worry about.

 

[donheff]

You can "run the numbers" in your head. Let's say a year is 4% of assets and your return per year is 5%. That means .04 * .05 = 0.0020 or 0.2% of your assets will be taxable interest each year.

Or say you have $2MM total, that's $4,000 in interest. Since you will probably have $20000 of taxable dividends anyways, I don't think it's something to worry about.

I don't really follow that. Lets use the $2M portfolio you posited with an $80k draw per year. Lets also say my taxable funds are $750K of the $2M. If most of my dividend producing holdings are in IRAs/401Ks then I don't have $20,000 of "taxable" dividends. Most of that $20K will remain in the IRAs and will not be taxed until some far future date when I withdraw it.

The question relates to the years before I get to the IRAs when I would be withdrawing from from taxable funds if the market does well. If my taxable funds do not include cash, I would pull the proportionaltely small amount of distributions generated in the taxable accounts (probably far less than $20K) plus principle to make up the yearly $80k. The principal would include a portion of long term capital gains taxed at low CG rates. So, while the market does well this appears to be a great approach.

On the other hand, if keep my cash in taxable accounts, I will have to liquidate some taxable equities to produce them (and pay CGs on those) and I will have to pay tax immediately on the dividends those cash assets generate even though I don't want to use cash since the market is doing well. Also, I will now have less equities in taxable accounts to pull from - if the market continues to do well and I continue to pull equities rather than cash, I will run out of taxable assets sooner than if I left all taxable assets in equities. Again, in a good market that is a bad strategy - at least in hindsight.

Conversely, things flip flop to some degree in a down market. if I keep the 3-5 cash bucket in IRAs, I now have to pull pull the entire $80K from the IRAs at regular income tax rates. For me that will be pretty high. In the down market scenario if the cash were in taxable I would pull the dividends the taxable account generated plus a lot of cash to make up the $80K. All that extra cash would already have been taxed so it would be untaxed when used. So, if I knew I was facing a down market, I would prefer my cash to be over there.

But not knowing what the market will do I don't see a simple way to run those comparisons in my head to decide ahead of time what is the most optimal mix at the outset - all cash in taxable, all cash in IRAs, or some mix. If it is a wash, I would simply liquidate some of the equity portion of the IRAs and turn them into cash.

How about some answers about what people are planning to do with their cash (during retirement, not while accumulating). Are you keeping it in taxable, IRAs, a mix?

 

[Animorph]

I'm holding bonds in the 401k. I'll sell stock funds from the taxable acount and replace them by selling the 401k/IRA bonds and buying stock funds in the 401k/IRA.

As long as the transaction costs and taxes aren't unreasonable, that seems like it will be easy enough. Taxes might be the hidden cost in all of that, if you don't have a stock fund with only modest gains to sell, you might have more taxes due than if you just sold the bonds.

Dan

 

[LOL!]

I based my $20,000 in taxable dividends based on what I get now with no fixed income in my taxable account.

If you have $750K of assets in taxable accounts, how much in dividends will that produce? Suppose you had $750K of VTSMX (reasonably tax-efficient) in 2006. You would have received about $13,000 in dividends without trying. That may be "far less than $20K" to you, but it is still significant. I think it is very difficult to not have dividends in your taxable account, so you may have more dividends in your IRAs, but you will still receive a significant amount from your taxable investments.

If you were weighted into value funds, I would not be surprised to see a 2% yield on your $750K which would be $15K a year.

Of course, if you have $750K in the taxable portion and you want 12% of assets (or $240K) in a taxable money market fund, then you will only have $510K at most in equities in your taxable account.

 

[donheff]

I based my $20,000 in taxable dividends based on what I get now with no fixed income in my taxable account.

If you have $750K of assets in taxable accounts, how much in dividends will that produce? Suppose you had $750K of VTSMX (reasonably tax-efficient) in 2006. You would have received about $13,000 in dividends without trying. That may be "far less than $20K" to you, but it is still significant. I think it is very difficult to not have dividends in your taxable account, so you may have more dividends in your IRAs, but you will still receive a significant amount from your taxable investments.

If you were weighted into value funds, I would not be surprised to see a 2% yield on your $750K which would be $15K a year.

Of course, if you have $750K in the taxable portion and you want 12% of assets (or $240K) in a taxable money market fund, then you will only have $510K at most in equities in your taxable account.

OK, maybe it is $20K dividends in the taxable account. But you still need to pull another $60K out every year to cover the $80K expenses. And you want three years of expenses in cash. The question I am trying to answer for myself at the outset is should I turn $250K of the equities in the taxable account into cash. Or turn $250K of equities in the $1.25M IRA into cash?

 

[LOL!]

The question I am trying to answer for myself at the outset is should I turn $250K of the equities in the taxable account into cash. Or turn $250K of equities in the $1.25M IRA into cash?

Or have some cash in both places. We have cash in both taxable and tax-deferred accounts. We consider it part of our non-equity assets (i.e. fixed income). We use cash for rebalancing and to take advantage of short-term opportunities such as buying on the dip (i.e. market timing).

And I would not be turning equities into cash. You select your equity:fixed_income ratio and stick with that. You convert some fixed income to cash and leave equities alone.

If you need to convert equities to fixed income as part of rebalancing, then so be it.

 

[donheff]

And I would not be turning equities into cash. You select your equity:fixed_income ratio and stick with that. You convert some fixed income to cash and leave equities alone.

I have been a long time 95%+ equities type. I have a nice COLAd pension so that isn't as extreme as it sounds. But I am changing as a result of reading this board. DW is about to retire and I am getting more attuned to lower volatility and in particular to having several years cash to spend during a bear market. Gotta get to the proper allocation somehow. I will probably do most of the remaining change I need in tax deffered accounts. But the optimal mix between taxed and deffered escapes me.

 

[baldeagle]

It isn't an either/or situation for us -- we do both. 3 years of cash is kept on hand across both locations.

We spend IRA cash for basic living expenses, and spend taxable cash to pay the taxes on the IRA withdrawals and to pay for extraordinary expenses (house repairs, trips, new car someday, etc.). Helps us stay within the 15% FIT bracket now, and keeps us spending enough of our IRA that RMDs in 8 years won't push us into the next bracket (we hope).

 

[samclem]

I've kept our small cash "buffer" in taxable accounts mainly under the same rationale as donheff mentioned--to avoid paying tax penalties if we have to use it before we turn 59 1/2. I gotta say I never thought about keeping it in the tax-deferred accounts. I guess we do pay a small tax premium every year for this, but it's not very much.

Also, if/when the capital gains rate goes up closer to the "regular" income rate over the next few years, the difference between keeping the cash in taxable/tax-deferred accounts will become even smaller.

 

[clifp]

Most of my cash is in a taxable account for a fairly simple reason it is more accessable in a taxable account than in a IRA. Now I am in a somewhat unusual position that my taxable assets are 50% bigger than my tax deferred assets. So for me I have a fairly large fixed income portion in my taxable account along with a lot of high-yielding dividend stocks and MLP, therefore my annual income is roughly equal to my expenses, so my cash is 3-5 year of income-less expenses.

In the example you gave. I'd be inclined to have something in the neighborhood of 100-150K in CDs/short term bond @5-6% 50K in money market @5% and the remaining 550-600K in the market at a yield <2%, this would generate ~20K worth of income. For the remaining money I would think you'd want to set up a 72(t) to take advantage of the low tax bracket you would be in. In this situation I would be primarily selling equitities in the tax defered account to fund my expenses.