Should I use 401k Fixed Income Fund for my Bond Asset Allocation?

[nico08]

I have about 21% of investment savings in a 401k. Fixed Income fund in the 401k is set for 3.18% for 2015. My asset allocation goal is 60% stock, 30% bond, 10% cash. Does it make sense for me to put all of the 401k money into the fixed income fund, and allocate it to the 30% bond fund goal that I have? Most of my bond fund money is in the 401k's bond index fund and in a vanguard bond fund.

Thank you for your insight.

 

[robertf57]

a 3% return is a generous interest rate and suggests a long duration. What is this fund? is it a GIC or a diversified bond fund. If it is a diversified bond fund with a long duration, I would not be a fan. I personally believe there will be interest rate increases in the near to moderate term which would lead to a decline in the value of your holding. Holding your fixed income assets in a tax advantaged account generally makes good sense.

Really need a little more information to give you any further advice.

 

[nico08]

a 3% return is a generous interest rate and suggests a long duration. What is this fund? is it a GIC or a diversified bond fund. If it is a diversified bond fund with a long duration, I would not be a fan. I personally believe there will be interest rate increases in the near to moderate term which would lead to a decline in the value of your holding. Holding your fixed income assets in a tax advantaged account generally makes good sense.

Really need a little more information to give you any further advice.

The Fund seeks to generate a predictable return through a specified interest rate, with preservation of original principal invested. The Plan Administrator has the opportunity to adjust the fixed income rate on a quarterly basis. However, it is the intent of the Plan Administrator to offer the stated rate for the entire calendar year unless unforeseen investment circumstances make maintaining the rate impractical. Starting January 1, 2014 and until further notice the Fund's effective annual interest rate is 2.81%. The Fund's effective annual interest rate for 2013 was 3.16%.

Strategy
The Fund invests in several MetLife issued GIC (Guaranteed Investment Contracts) Alternatives, which consist of bonds, international securities, public utilities and similar corporate issues. The Fund's GIC Alternatives are managed by MetLife's Investments Department, BlackRock, Western Asset Management Company and Pacific Investment Management Company (PIMCO). Participants receive a blended rate of return based on a weighted average of all the separate interest rates payable under the various underlying assets.

Risk
Invested principal is preserved in the Fixed Income Fund, which pays a specified interest rate to participants. Market risk, therefore, is reduced but inflation risk may be a factor (the value of investment returns may diminish after taxes and inflation are taken into account).

 

[robertf57]

OK,

So this description looks like at least the bulk of the investment is insurance company contracts which they describe as "GIC Alternatives". The risk statement implies the principal is guaranteed. The only other concern: is there some limit to moving out of the fund if alternative investments look better?

For the short term, this investment is doing better than short term CDs and is probably just holding its own against inflation.

 

[pb4uski]

It sounds to me like a stable value fund that pays interest at the stated rate (which is reset periodically) and is not interest rate sensitive. I wish I had access to one... and 3.18% is a great rate for something that is liquid and has no interest rate risk. I would probably put my whole 30% fixed income allocation in it.

 

[Animorph]

That's a tempting idea, if it really is the safe stable value fund it sounds like. On the other hand, while you are being tax efficient, you are also guaranteeing low growth in an account where that growth is tax free. I'd be a little concerned about using the 401k entirely for the bond allocation. There will be a point where growth and taxes balance out. You might try some spreadsheet experiments.

 

[nico08]

That's a tempting idea, if it really is the safe stable value fund it sounds like. On the other hand, while you are being tax efficient, you are also guaranteeing low growth in an account where that growth is tax free. I'd be a little concerned about using the 401k entirely for the bond allocation. There will be a point where growth and taxes balance out. You might try some spreadsheet experiments.

Hi. Im not too experienced with spreadsheets. Do you know if there are any online calculators that would help me to determine a point where growth and taxes balance out?

 

[Texas Proud]

That's a tempting idea, if it really is the safe stable value fund it sounds like. On the other hand, while you are being tax efficient, you are also guaranteeing low growth in an account where that growth is tax free. I'd be a little concerned about using the 401k entirely for the bond allocation. There will be a point where growth and taxes balance out. You might try some spreadsheet experiments.

As always, you should do the calculation to see what is best for you...

But...

Even though the income grows tax free, you will have to pay regular tax on the gain when you take it out.. so, if you have stock in your 401... you are in a sense converting cap gain into regular taxable income...

Also, if you own bonds in a taxable account.... it will be regular taxable income.. and you have to pay it right away... if you owned stocks that appreciated.... you do not have to pay tax until you sell.... and then at cap gain rates...

That is why it is recommended to have your bond investments in your 401...

A ROTH is different.... you want to maximize your income that will not be taxed at all... that is why most of my ROTH is in stocks...


Hmmmm.. just remembered that I converted a 401 to an IRA... will need to adjust where my bond allocation is located...

 

[pb4uski]

That's a tempting idea, if it really is the safe stable value fund it sounds like. On the other hand, while you are being tax efficient, you are also guaranteeing low growth in an account where that growth is tax free. I'd be a little concerned about using the 401k entirely for the bond allocation. There will be a point where growth and taxes balance out. You might try some spreadsheet experiments.

No! No! No!

The growth in a 401k is tax-deferred, not tax-free! Your higher growth assets (equities) will be in taxable accounts (which can be tax free if you're in the 15% bracket or lower or otherwise 15%) and tax-free accounts like a Roth.

 

[sengsational]

It sounds to me like a stable value fund that pays interest at the stated rate (which is reset periodically) and is not interest rate sensitive. I wish I had access to one... and 3.18% is a great rate for something that is liquid and has no interest rate risk. I would probably put my whole 39% fixed income allocation in it.

+1
I'd stick the whole thing in there. In fact, I've got almost all of my "bond" allocation in a stable value fund inside a 401k. And glad to have confirmation that my placement is not unwise when considering tax consequences.

 

[clifp]

+1
I'd stick the whole thing in there. In fact, I've got almost all of my "bond" allocation in a stable value fund inside a 401k. And glad to have confirmation that my placement is not unwise when considering tax consequences.

I certainly would do the same. A stable value fund is basically a CD with a floating rate, and no FDIC insurance. I'd rather have a 3% CD than 3% Stable Value fund, but since I've heard no rumor that our friend at PenFed are going to offer 3% CD this year your fixed income choices are very limited.

Anything that offer a similar interest rate is going to expose you to both credit risk and interest rate risk. Anything that offers similar principal protection is going to provide you with much lower interest rate.

60/30/10 is perfectly reasonable AA, unless you are decades away from retirement I won't advocate a much higher AA. (Unless you are glutton for risk like myself.)

 

[Animorph]

No! No! No!

The growth in a 401k is tax-deferred, not tax-free! Your higher growth assets (equities) will be in taxable accounts (which can be tax free if you're in the 15% bracket or lower or otherwise 15%) and tax-free accounts like a Roth.

Not at all! Heck, normally I don't bother replying to threads where you already gave my preferred answer. How come we disagree here?

If your tax is 25% into a 401k and 25% out (any rate that is the same in and out) then your growth is tax free. Here's the math:

You make $10,000 that is normally taxable. You have three choices, defer taxes using a 401k, pay taxes and stick it in a Roth, or pay taxes and stick it in a taxable account.

Start: 401K=$10,000; Roth=$7,500 ; Taxable=7,500

Then you let it sit for 10 years and manage to double your money in equities that never generate any taxable income in the mean time.

Growth: 401k=$20,000; Roth=$15,000; Taxable=$15,000

Then you take your money out to spend it, paying your 25% as necessary, and 15% capital gains.

After Taxes: 401k=$15,000; Roth=$15,000; Taxable=$13,875

So in the end the 401k was the same as the Roth, and both did better than the taxable account. Growth is tax-free in a 401k.

Two things will impact this result, changing tax rates (tax rate out is different than tax rate in), and the fact that Roth 401k contribution limits are the same as traditional 401k limits. Obviously if tax rates are changing it will be advantageous to pay at the lower tax rate, in or out of the account. The contribution limits favor the Roth since you can contribute more after-tax value to a Roth if you are contribution limited.


And yes, if you can stay in a 0% CG tax bracket, the taxable account equals the 401k and Roth if you can avoid non-qualified dividends.


Let me see if I can find the thread about 401k growth and asset placement.

 

[Animorph]

Here's the thread I started, with a spreadsheet in the first post:

http://www.early-retirement.org/for...account-or-tira-spreadsheet-answer-71548.html

So, considering everything, where is the best place for bonds? What I found was that of course the tIRA was better for both stocks and bonds (with equal in and out tax rates). However, the advantage was larger with stocks rather than bonds. So if you contribute $1000 for stocks in the tIRA and $1000 - $250 taxes for bonds in the taxable account your withdrawal amounts are higher than if you bought bonds in the tIRA and stocks in the taxable account. The withdrawals were about 8% higher with bonds in a taxable account and stocks in the tIRA. The result was fairly robust with a few different tax rates and investment gains. Bond yields had to approach stock total returns before they were better placed in the tIRA.

I can't get the spreadsheet links to work for me, as usual. I'll work on it if anyone wants it.

 

[Animorph]

Played with a new spreadsheet covering 20 years of accumulation. Taxed all bond growth at 25%, paid yearly. Taxed capital gains at 15% at the end only. Assumed taxes in and out of the 401k were 25%. No additional contributions during the 20 years.


It was better to keep all bonds in a taxable account if stock yearly gains were 1.7x the bonds yearly gains before taxes. For example, if yearly bond returns were 3% then stock returns had to be greater than or equal to 5.1% to justify keeping bonds in a taxable account.


I think this scenario favors placing bonds in the 401k about as much as possible. You could make capital gains taxes 0%, but then dividends could also be assumed to have 0% taxes. Hey, if there's no taxes who cares where you put the bonds?

 

[pb4uski]

Not at all! Heck, normally I don't bother replying to threads where you already gave my preferred answer. How come we disagree here?....

In understand your math and your point, but the growth in the 401k is not tax free as the $10,000 in growth is subject to 25% tax so to characterize it as tax-free is not correct. It would be correct to state that if the tax rates at deferral and withdrawal are the same that one would be indifferent to deferring or not deferring but that is intuitively obvious without any fancy math.

The more important point is that it is more likely than not that the tax rate in retirement will be lower than while working which is the whole point of deferring and can easily be seen if the exit tax rate is changed to 15% and the 401k comes out ahead.

Also, bond interest will attract ordinary tax rates whether in a taxable account or in a tax-deferred account since withdrawals are ordinary income. Putting stocks in a 401k changes tax preferential qualified dividends and capital gains into ordinary income effectively increasing the tax rate on that growth from 15% to 25%. Why would anyone do that?

 

[sengsational]

Putting stocks in a 401k changes tax preferential qualified dividends and capital gains into ordinary income effectively increasing the tax rate on that growth from 15% to 25%.

This is factor that caught my eye when deciding on the equity to bond allocation within taxable vs 401k accounts.

Not the case being discussed here, but in my case, there is a factor pushing me the other way: I need stability of taxable funds for spending. Since only 10% of my savings are in taxable accounts, that means if those accounts had equities, and the market tanked, I'd be in a position of either cashing in equities at depressed prices, or pulling from tax deferred accounts and showing "too much" income. Keeping the taxable accounts in a stable asset class means I'll be able to continually pull from those funds, no matter what the market does.

This discussion was really great to help me solidify my thinking around what I should be doing with my asset class / account type strategy.

 

[Animorph]

In understand your math and your point, but the growth in the 401k is not tax free as the $10,000 in growth is subject to 25% tax so to characterize it as tax-free is not correct. It would be correct to state that if the tax rates at deferral and withdrawal are the same that one would be indifferent to deferring or not deferring but that is intuitively obvious without any fancy math.

The more important point is that it is more likely than not that the tax rate in retirement will be lower than while working which is the whole point of deferring and can easily be seen if the exit tax rate is changed to 15% and the 401k comes out ahead.

Also, bond interest will attract ordinary tax rates whether in a taxable account or in a tax-deferred account since withdrawals are ordinary income. Putting stocks in a 401k changes tax preferential qualified dividends and capital gains into ordinary income effectively increasing the tax rate on that growth from 15% to 25%. Why would anyone do that?

No, again with equal tax rates in and out. Certainly lower tax rates out helps the 401k, though I'd have to think a bit about how that affects bond placement. At first glance I think it might be better to have stocks in the 401k to take advantage of the lower output tax rate.

When you place $10,000 in your 401k account, $7500 of that is yours, effectively tax free (or better if tax rates go down), given that we assume a constant 25% tax rate in and out. That's the same $7,500 you would place in a Roth or taxable account after taxes. $2,500 of the $10,000 belongs to the government. They just let you invest it for them in the 401k before they finally get it. When you double your money, you have $15,000. The government has $5,000. You both doubled your money. You still don't owe taxes on your $15,000. You just need to give the government their $5,000. Doesn't matter that you invested in stocks or bonds. Your $7,500 doubled and you didn't pay taxes on that growth. It's not like paying income tax rates for qualified dividends.

If you paid 15% output tax instead of 25%, that lets you take some of that $5,000 government money in the 401k for yourself. That's why I was thinking a bigger pot of money from stocks might be better than having bonds in there, more government money available to you.

I think looking at taxes saved inside the 401k is one key for bond placement. You can have high taxes on smaller bond growth in the taxable account, or lower taxes on higher stock growth in the taxable account. You have effectively no taxes through the 401k, setting aside the government's cut. So do the bonds or the stocks create more lifetime taxes in the taxable account? 15% of 100% growth, paid at the end, or 25% of 4% yearly growth? All dependent on a specific tax situation of course.

 

[sengsational]

Reading this hurt my brain a bit, but I think the term "the growth" might be the problem. There are two parts to it...the growth of the government's part of the pie (GG) and the growth of my part of the pie (MG). MG is tax free. GG is gone, along with the base that creates the GG.

 

[pb4uski]

This is factor that caught my eye when deciding on the equity to bond allocation within taxable vs 401k accounts.

Not the case being discussed here, but in my case, there is a factor pushing me the other way: I need stability of taxable funds for spending. Since only 10% of my savings are in taxable accounts, that means if those accounts had equities, and the market tanked, I'd be in a position of either cashing in equities at depressed prices, or pulling from tax deferred accounts and showing "too much" income. Keeping the taxable accounts in a stable asset class means I'll be able to continually pull from those funds, no matter what the market does.

This discussion was really great to help me solidify my thinking around what I should be doing with my asset class / account type strategy.

Here's the way I think of your dilemma (and I could have the same situation if equities declined).

Let's say you start of the year with $1,000k and have $100k in taxable accounts and $900k in tax-deferred accounts and your target AA is 60/40. So you have $100k of equities in taxable accounts and $500k of equities in your tax-deferred accounts and $400k of fixed income in your tax deferred accounts which is 60/40 overall.

For the year, stocks decline 15% and bonds increase 5% so before any rebalancing on Dec 31, you have $85k of equities in your taxable account, $425k of equities in your tax deferred account and $420k of fixed income in your tax-deferred account for a total of $930k across all accounts.

You want to withdraw $40k for living expenses for the upcoming year, so you sell $40k of equities and that $40k goes out of the portfolio, reducing the total value to $890k, $45k of equities in your taxable account ($85k less the $40k withdrawal), $425k of equities in your tax deferred account and $420k of fixed income in your tax-deferred account.

So after rebalalancing, you want to have $534k of equities across all accounts ($890k * 60%) and you have $45k of equities in your taxable accounts so you want to increase equities in your tax-deferred account to $489k ($534k - $45k). So now, you sell $64k of fixed income and buy $64k of equities in your taxable account.

If you put the transactions together, the $40k withdrawal came from a sale of $64k of fixed income offset by $24k purchase of equities and the remaining $40k transferred to your bank account for spending.

After that transaction, you have $45k of equities in your taxable account, $489k of equities in your tax-deferred account and $356k of fixed income in your tax deferred account, which is 60/40 when looking across accounts.

 

[pb4uski]

No, again with equal tax rates in and out. Certainly lower tax rates out helps the 401k, though I'd have to think a bit about how that affects bond placement. At first glance I think it might be better to have stocks in the 401k to take advantage of the lower output tax rate. .....

I see your point and you may be right but don't really care enough as to continue to debate it so let's agree to disagree and and I hope it works out for you. You should let Bogleheads know so they can revise their tax efficient placement webpage.

In my situation, retired and in the 15% tax bracket, putting bonds in my tax-deferred accounts definitely works for me as the equities in my taxable accounts are subject to little tax (0% on qualified dividends and LTCG so I only pay ordinary rates on unqualified dividends and I also get the foreign tax credit on my international equities). For me, placing those equities in a tax-deferred account would increase my ultimate tax rate on qualified dividends and LTCG from 0% to 10-15%.

 

[nico08]

I took a look at the annual rate of return of a total bond fund (Vanguard) and compared it to the rate of return on the 401k fixed income fund. Based on these numbers, so you think it would be a good idea to keep whatever bond allocation I have in the 401k in the fixed income fund? It looks like for 5 out of the 10 years selected, the fixed income fund had a greater rate of return than did the total bond fund.

C1 C2 C3
2004 4.51 4.24
2005 4.77 2.40
2006 4.99 4.27
2007 5.18 6.92
2008 5.31 5.05
2009 5.3 5.93
2010 4.3 6.42
2011 4.17 7.56
2012 3.64 4.05
2013 3.16 -2.26

C1- year
C2- fixed income 401k fund
C3- vanguard total bond fund

 

[pb4uski]

I would prefer the fixed fund at this point because it has no interest rate risk. At some point interest rates will increase and the value of the bond fund will decline as a result but the fixed fund will not decline. Since interest rates are at historical lows, the likelihood of interest rates increasing seems much higher than interest rates declining, although when the change will happen is not real clear.