Hi-yield investments in taxable account -- crazy?

[Urchina]

Is it crazy to put high-yield investments in a taxable account if you're still 10 years out from FIRE?

DH and I are finally opening a taxable brokerage account (probably with Vanguard). In theory, I understand the logic of putting only tax-managed funds in a taxable account, but since this is the account that's going to act as our "bridge" from when we RE until we're at standard retirement age, wouldn't it make sense to have some income instruments in there? And since we're starting small on this account (just $250/month until we get our HELOC paid off), we'd like to make wise choices we can stick with for a while.

We're currently in a 28% marginal bracket (federal -- I can't remember our state bracket but we're in CA) and are maxing out our tax-deferred accounts prior to putting anything in this bucket. We've got our emergency fund up and running and will be adding it as we go, so this taxable brokerage account is for long-term money only. This past week has proved to us that we have the nerves of steel required of those whose equity/bond allocation is in the 90/10 range (though we're considering a 80/20 split due to the discussions on similar returns with less volatility).

Why can I just not wrap my brain around the reasons against income producers in a taxable account, especially when you're going to be using that account to generate 12-15 years of income? I'm trying to battle any mental irrationality I come across, but right now I feel like I'm trying to hammer a lag bolt into my brain with a toothpick. I've been doing my reading, too -- help!

 

[socca]

It's impossible to provide a general answer to your question - far too many variables and assumptions involved. The best thing to do is sit down with a spreadsheet, and run some predictive analyses based on various portfolios and assumptions. In the end, you'll have to choose one portfolio and one set of assumptions, and go from there. Down the road, if it appears that your assumptions were seriously out of whack, you can alter your portfolio accordingly.

Sorry to be so vague.

 

[Urchina]

It's impossible to provide a general answer to your question - far too many variables and assumptions involved. The best thing to do is sit down with a spreadsheet, and run some predictive analyses based on various portfolios and assumptions. In the end, you'll have to choose one portfolio and one set of assumptions, and go from there. Down the road, if it appears that your assumptions were seriously out of whack, you can alter your portfolio accordingly.

Sorry to be so vague.

Socca,

The vagueness is OK, I'm feeling frustrated with my own vagueness as well. This question is an attempt to help me pin down what my next educational steps need to be. I'm trying to clear the fog of not-getting-it from my head. So... I ask:

Run predictive analyses of what? Tax bite? Total return? Feasibility? Failure rate? All of the above?

I'd welcome suggestions on what "assumptions" and "variables" might be involved. I hate to sound this clueless about the process, especially after two years of trying to educate myself and six months on this board. And if this is all in FIREcalc and I'm finally publicly busted for not using it yet, my bad. Believe it or not, I have a plan for running FireCalc numbers next year -- maybe I should move that plan up above "finalize asset allocation"?

Thanks!

 

[dex]

I don't think in your tax bracket it is a big problem. And having some income in your "bridge" account could be helpful. Vang High Yield Corp is yielding 8%+ now. I don't need the income. But I think it has good upside potential when things turn around - I reinvest the dividends.

Also, you should look at your effective tax rate - look at your last years tax forms.
Your Fed. effective tax rate is probably less than 28%.

 

[Urchina]

Dex,

Thanks. We currently receive K-1 dividends and the taxes aren't eating us alive, so I kind of like the idea of adding to current income. We're looking at the Vanguard Hi-yield as well as Wellesley. Unlike some on these boards, we're not tax-averse, just want to be tax-aware.

I finally ran through a series of Firecalc. Will play with it more to see if we can get the numbers to be a bit more promising....

 

[grumpy]

Why wouldn't you want to pay only 15% tax on dividends and cap gains in a taxable account rather than your marginal rate later on in an IRA? I have all of my high dividend paying stocks in my taxable account. I use the dividends to augment my pension income. My tax rate in retirement is pretty much the same as when I was working.

Grumpy

 

[LOL!]

Yes, it's crazy.

Here are the arguments: Bogleheads :: View topic - Backwards asset location

 

[socca]

Run predictive analyses of what? Tax bite? Total return? Feasibility? Failure rate? All of the above?

+ start with a list of potential investments
+ learn enough about each investment so you can make a performance prediction based on various assumptions about future economic conditions
+ assemble various portfolios, and see if your prediction regarding how they perform will match your goals

There are so many possible variables and assumptions when considering the entire scope of possible investments, that I really can't list them all. What you decide to predict depends upon what you care about. Net asset value? Before-tax income? After-tax income?

There are a huge number of books that can help you plan your investing strategy. I don't have any particular recommendation, but your local library or amazon.com may be able to give you a hand.

Good luck!

 

[Darryl]

What's the interest rate on the HELOC? Dumping that is probably the best investment you can make.
After that if you have equities in tax deferred the argument would be buy low yield equities in taxable and place the high yield in deferred to minimize your tax bill.

 

[LOL!]

Let me ask you to look at your 2007 tax return. How much income was reported on Schedule B and Schedule D? If you could change it so that Schedule B showed $0 and Schedule D showed a loss of $3000, how much less would your taxes be?

It's pretty easy to engineer your portfolio so that Schedule B shows almost $0 and Schedule D shows a loss. That is, if you keep high-yield investments out of taxable.

 

[cute fuzzy bunny]

I cant say that theres a hard and fast answer unless all you want to do is minimize taxes.

You have to model it for your own needs, expectations and risk tolerances. Theres no such thing as a certain answer.

I'd need to know more about your specifics, but if you want the fixed income to generate income you can spend, then putting it in a tax deferred account is irrelevant. You're going to pay taxes on it as ordinary income either way, you wont even be able to have access to the money if you're under 59.5 without a 72t, and you'd be wasting the tax efficient account.

Nice thread on the bogleheads, but do note that almost none of those guys are early retirees and a lot dont plan to be early retirees. The principal core there is investing for maximum growth and minimal taxes.

So asking this question there amounted to asking people here what they think about working for 20 more years. You arent going to get a lot of supportive agreement.

 

[LOL!]

Taxes are important for early retirees. If you can minimize your taxable ordinary income, then you can be filling up your low tax bracket with conversions from traditional IRA to a Roth IRA.

Furthermore, money in your left pocket is the same as money in your right pocket. As a retiree, if I need to withdraw income to pay for my expenses, I would rather pay little to no taxes on that income. One way to do this has been discussed here a couple of time before. It has been written up here: Placing Cash Needs in a Tax-Advantaged Account - Bogleheads

The basics are put your high-yield investments in your tax-advantaged accounts. Put your tax-efficient index funds in your taxable accounts. If you need cash to spend (say you are early retired), then sell some of your tax-efficient index funds in your taxable account. The taxes you will pay are minimal because return of capital is tax-free, LT capital gains taxes are lower than ordinary income tax, and capital losses give you a tax deduction.

Furthermore if you built up a large capital loss carryover by judicious tax-loss harvesting over the years, then those will get used up by any capital gains that you realize when selling your tax-efficient index funds. You should have many, many years of reduced taxes.

Then to keep your asset allocation the same, exchange some of your high yield investments in your tax-advantaged account into the same index fund shares that you just sold in your taxable account. This keeps your asset allocation the same. Also if you are selling low in your taxable account, you are also buying low in your tax-advantaged account.

Once you understand the basic principle behind this tax-saving move, you will never want to keep high-yield investments in a taxable account ever again.

 

[Urchina]

Thank you all for the thoughtful responses.

LOL, thank you for the link to the Bogleheads thread. I'd searched their forums for something like that but just hadn't found it. I also appreciate the more detailed explanation of just *how* one might structure the "bridge" taxable account for early retirement, if minimizing taxes are a main consideration.

Socca, thanks for the clarification. Since we're still in the early stages of this journey I don't have a lot of processes nailed down yet (and the books I've been reading are long on theory and not so much on "how-to.") I need the theory, but as a person I also really tend to require "how-to," so I appreciate the ideas.

Darryl, yes, paying off the HELOC is a priority for us. The HELOC is large, however, and will take about 30 months to pay off; we're unwilling to wait on the taxable account for that long. So we split the difference in DH's raise: 1/2 to HELOC, 1/2 to taxable account.

CFB -- Thanks for providing another view on the tax situation. Also, for help understanding the underlying philosophy of the Bogleheads forum. That will be useful to me when interpreting further posts, and making them.

 

[cute fuzzy bunny]

The method LOL describes does have a few minor concerns. Some people rely on fixed income for...well..fixed income and volatility reduction during tough times and the ability to defer sales of equities when you're in a bear market.

For example, people having to sell equities into this current situation to meet income needs arent going to be made entirely well again come tax time.

So theres a bit more to it than snappy asset allocation and avoiding the tax man. If you're counting on the income from the fixed income, you might want to keep it where you can have access to it, regardless of the market conditions.

 

[LOL!]

Hey craazzy_fuzzy_bunny,

Suppose I need $9500 to pay my expenses.

so if I sell 100 shares of a total index fund ($10 a share) in my taxable account at a market low to meet income needs (pay $500 tax) and the same day, buy 100 shares of a total index fund in my tax-advantaged account (I get the money to buy those shares by using the $10000 of "income" from my bond funds in my tax-advantaged accounts). Did I lose money?

Contrast that with the asset location switched around. Suppose I have the fixed income in my taxable accounts and it gives off $10000 dividends. I pay $1500 or more in taxes each year on it. Now I have only $8500 to meet my expenses, so I have to either cut my expenses or get more dividends or sell some shares of my bond fund. I have 100 shares of a total index fund in my tax-advantaged account, but I don't want to sell it at a market low.

With my preferred location of assets, I will still have volatility reduction by owning fixed income assets. They will just be in my tax-advantaged accounts where I can defer taxes on the income from them.

I am not adverse to you paying more taxes than you need to, but I myself want to minimize my taxes and reap the benefits associated with that

 

[cute fuzzy bunny]

Did I lose money?

Yes, you did.

 

[unclemick]

Hmmmm - being a retired engineer I said screw the numbers. Filed head of household in the 90's.

I honked expenses way down - lived off selling duplex/proceeds, a small cash stash, 1 yr temp work, and badda bing Norwegian widow stock dividends/cap gains from involuntary mergers(two file cabinets of DRIP plans/peaked at 52 stocks or so). This allowed my trad IRA to compound.

BTW - do not listen to me - lived in a fish camp over Lake Ponchartrain, 12k all time low yearly budget and went 12 yrs without health insurance.

This is not the nineties - I was happy with the compounding of IRA untill 2000. Is the Market dropping down low enough for another good run? Don't know - I'm not a dirty market timer like CFB, but I do have personal hormone issues.

heh heh heh - depending on your personal situation - more than one way to skin a cat. .

 

[plex]

The boglehead method works very well as long as you are doing this with a tax-deferred account, in both an up and a down market, but especially a down market. Why? Because in a tax-deferred account you are going to be paying at your taxable rate eventually anyways. The only way it wouldn't be beneficial using this method is if LT gains were higher than your normal taxable rate.

Do not do this though with a tax-free account (ROTH/HSA), the money in that account is already going to come out tax-free, as long as you meet their withdrawl requirements.

 

[cute fuzzy bunny]

Seems to me that in a down market, you'd lose your ability to collect the loss on your equities due to the wash sale rule when you rebought them in your IRA.

Then you'd pay ordinary income tax rates on the money when you withdraw it from your IRA, with no loss benefits from the deferral due to the wash sale.

Of course, you could buy something similar in your IRA to avoid the wash sale, but if you're into things like indexes, thats not accepted by the IRS.

If the rates on ordinary income go up in the future...and considering we're doling out trillions of dollars on wars and bailouts, thats practically a certainty...that might get a little expensive on you a little later in life.

 

[Nords]

Why wouldn't you want to pay only 15% tax on dividends and cap gains in a taxable account rather than your marginal rate later on in an IRA? I have all of my high dividend paying stocks in my taxable account. I use the dividends to augment my pension income. My tax rate in retirement is pretty much the same as when I was working.

Same here.

The bugaboo of having income-producing equities in a taxable account (and not bonds) is "But... but... but what if I have to sell stocks in a down market?!?"

The answer is asset allocation. A couple years' spending cash and a diversified portfolio mean that you'll rarely, if ever, have to take a loss on a stock to pay the bills. Aside from the portfolio's dividends, you'll have enough growth from something that you'll be able to sell the winners first and, if necessary, balance your taxable gains with a loser or two.

Remember that the taxable ER portfolio only has to get you to age 59.5, not RMD. If you're willing to do a 72(t) SEPP then you don't even have to wait that long.

And if Taleb shows up with a herd of black swans then you'll cut spending.

 

[jIMOh]

Yes it makes sense to put income producing securities in taxable accounts. I am formulating a plan to do the same thing.

Considerations:

Muni bonds (especially if in high tax bracket and/or in state with high taxes).
Dividend paying stocks (taxes paid will be lower than interest on bonds)

Others here have pointed out that if you sell 100 shares of stock in an IRA then buy same 100 shares of stock in a taxable account, that is an OK move to maintain allocation (to create room for bonds in an IRA).

I would try to hold dividend paying stocks in a taxable account before I would hold bonds in a taxable account. I would hold muni bonds in a taxable account before I would hold regular bonds in same taxable account, especially if in high tax bracket (and I consider 28% bracket high).

 

[Urchina]

So here's my take-away from this thread (so far):

1. There is a difference of opinion as to whether or not one should hold income-producing assets in a taxable account.

2. If you decide to hold income-producing assets in a taxable account, those that pay dividends are preferable to those that pay interest income (all other things being equal) because dividends are taxed at a lower level than interest income.

3. Munis are also preferable for a taxable account because the interest income is often tax-free.

4. When selling and then buying in two accounts, be aware of IRS wash sale rules.

5. Different people rely on income assets for different purposes. Awareness of your needs will help you allocate your assets most effectively.

So, a new question (brought to the forefront by Nords' post) is: asset allocation is the answer to the problem of being forced to sell equities at a market low. But our taxable account and tax-deferred accounts are going to be drawn upon at different times in our lives. This would mean that both our taxable and tax-deferred accounts should have bonds as well as equities. If we had just equities in our taxable account (as LOL proposes), we'd be selling at a loss if we were drawing from that account during a market low (say, during the first 10 years of ER). And since we look at our portfolio as a single entity, the portfolio as a whole would be taking a loss. Correct?

This is still murky water for me, but is getting clearer (or maybe I'm just getting used to bumping around in the darkness).

Thanks!

 

[DblDoc]

Urchina;

You need to re-read and understand LOL's post:

So, a new question (brought to the forefront by Nords' post) is: asset allocation is the answer to the problem of being forced to sell equities at a market low. But our taxable account and tax-deferred accounts are going to be drawn upon at different times in our lives. This would mean that both our taxable and tax-deferred accounts should have bonds as well as equities. If we had just equities in our taxable account (as LOL proposes), we'd be selling at a loss if we were drawing from that account during a market low (say, during the first 10 years of ER). And since we look at our portfolio as a single entity, the portfolio as a whole would be taking a loss. Correct?

I know it took me a couple of go rounds to understand this concept.

For example you sell TSM from your taxable account to cover expenses. You then sell a bond fund in your tax deferred account and buy TSM in your deferred account thus maintaining your AA and NOT locking in a loss if TSM had fallen. You have effectively "sold bonds" to cover expenses. If you want to TLH you have to wait 31 days to avoid the wash sale rule.

DD

 

[cute fuzzy bunny]

But she'd then need to read what I said about buying TSM in the tax deferred account after selling it in the taxable account incurring the wash sale rule, eliminating the ability to claim the loss, and then paying ordinary income rates on the withdrawals from the sales of the equities in the deferred account without being able to adjust the cost basis due to the loss.

If you guys have been doing this and claiming the loss because you think that selling in a taxable and rebuying in a tax deferred somehow doesnt make it a wash sale, you'd better start amending your returns before you get audited.

Of course you could sell TSM in one account and buy a chunk of the S&P500 and the extended market in the right ratios in the other and slip by it.

The next shoe dropping is if the special rate for qualified dividends goes away, and the old capital gains rates come back. Given the bailouts and spending thats almost a given, or at least quite likely.

At that point the only way to fix your portfolio will be to take a bunch of huge capital gains from all those equities in your taxable account.

 

[LOL!]

I don't see why CFB keep interjecting comments that confuse the issue. There are trivial ways to avoid any wash sales. Also a wash sale possibility only occurs if you have a loss. If you are a long term holder of equities in taxable and you have been prudently doing tax-loss harvesting every year, this will not be a real issue. CFB also states this will not be a real issue, so we can stop bringing it up. It's a red herring.

Let me try another analogy.

Suppose I start off with only $10 bills in my right pocket and $20 bills in my left pocket. Each year, I count my $10 bills and my broker gives me 2% in dividends (20 cents for each bill) and the government takes 15% or 3 cents of the 20 cents each year. Each year I count my $20 bills. The government gives me $1 for each $20 bill I have and I don't have to pay any taxes on those $1 bills. If I get enough $1 bills, I can exchange them for $20 bill or even a $10 bill, but all that stays in my left pocket.

Now I need to spend some money. I can only spend money from my right pocket because if I take money from my left pocket there will be a 10% penalty. I can spend all the change in my right pocket (those 2% in dividends) and I can spend the $10 bills.

In my left pocket, I have those $20 bills which just sit there earning some $1 bills. I can also trade a $20 bill in my left pocket into two $10 bills but those $10 bills have to go back in my left pocket.

If I want to keep at least the same number of $10 bills in total that I have in both pockets even when I spend a $10 bill from my right pocket, what do I do? If I spend a $10 bill from my right pocket, I simply take a $20 bill in my left pocket and exchange it for two $10 bills which I have to keep in my left pocket. It simply looks like I spent a $20 bill.

OK, please don't make me think of an analogy with apples and oranges.

I have been following this method and reduced my taxes by thousands of dollars. Those are dollars that I get to keep in my pockets. Because my tax rate becomes low, I will be able now to convert more of my traditional IRA funds to Roth IRA funds at low tax rates well before required minimum distributions happen.