Best AA and RE tax strategy?

[DawgMan]

So I have spent some time reading about different AAs of those both close too and those in RE and realize that this is not a one size fits all decision. Yes, it "depends" on risk tolerance, assets, RE timeline, spending goals, etc. My question revolves more around best AA strategies for those who have more aggressive RE spending goals with only their own assets to rely on (i.e. no pension other than SS if you really include that). To get more specific in my case, here is where I am and what I would like to do...

- 52, self employed, no income from DW, will have last 2 kids (out of 4) out of college in 3 yrs... heavy lifting should be done then.
- On paper, using the 4% rule, I should be able to potentially launce RE at 55, however, I think a combination of OMY and not knowing what I will be RE too yet, may keep me in the saddle potentially to age 60... who knows.
- RE spending goals +/- $200K after tax growing with inflation.
- Assets are weighted in order include 401K, brokerage accts, income producing real estate. Only debt is my home and the only reason I don't pay it off is because the interest rate is so low.
- Current AA (in approximate terms excluding real estate) is +/- 70/30, ratcheted down about 2 yrs ago from about 80/20.

Questions/Comments...
- I am a Schwab guy and use their AA models as a guideline to set my AA portfolio strategy. What I find interesting is the historical returns between a moderate portfolio (40/60) and aggressive (95/5) are 9.0% vs 10.3%, but with significant differences in volatility. This begs the question as why take the extra risk??
- A combination of higher post RE higher income/spending objectives and pulling significantly from 401K $ creates a more tricky tax situation. My income is too high right now to consider Roth conversions. One reason to keep my business going in some capacity past 55 is for potential additional tax deductions to help minimize taxes. What strategies are you higher RE income folks using to minimize taxes??
- Knowing the above, what would you suggest I consider changing (i.e. AA, other) to maximize my after tax income goals?

 

[pb4uski]

As you know, there is no "right' answer.

I transitioned from a high equities AA to 60/40 over the last 5-10 years before retiring principally by putting new money (principally 401k contributions) into fixed income and that worked well for us.

On tax efficiency, we follow the guidance in https://www.bogleheads.org/wiki/Tax-efficient_fund_placement and keep fixed income in tax-deferred accounts. Our taxable accounts are only domestic and international equities and cash. Most of our dividends are qualified and are tax-free (0% QDI tax) and we get a good size foreign tax credit. In fact, the foreign tax credit usually exceeds the 15% tax we pay on non-QDI income for our international funds.

Early in retirement, I concluded that the benefit of lower taxes on Roth conversions were more beneficial to us than ACA subsidies (but our circumstances are somewhat unique) so we have been doing Roth conversions to the top of the 15% tax bracket... and typically pay about 10% or less federal tax on those conversions vs 25% of we do them after SS and pensions start.

 

[ERD50]

What I find interesting is the historical returns between a moderate portfolio (40/60) and aggressive (95/5) are 9.0% vs 10.3%, but with significant differences in volatility. This begs the question as why take the extra risk??

Well, you could state that another way -- since the 95/5 provided significantly more money, this begs the question as why accept the lower returns?

Over 30 years...

1.103^30 = 1.103^30
≈ 18.935003

1.09^30 = 1.09^30
≈ 13.267678

So at 10.3%, $1M grows to $1.89M, 9% grows to $1.33M - that leaves $560,000 on the table!

Now, it's not as simple as that, the returns aren't the same each year as averages show, but you get the point.

I think people get too hung up on volatility. In a down market, you still have divs. And if you are conservative and worried about this, your divs are probably providing most of your income (SPY provides ~ 2% divs). And if stocks are down, you don't sell them for the remainder of the income, you would be selling your fixed income as part of your rebalancing strategy.

But I don't get hung up on this, FIRECalc shows historical success rates are pretty flat between 40/60 and 95/5. Set it and forget it.

-ERD50

 

[COcheesehead]

The 40/60 probably shows the value of the bull market in bonds that may have just come to an end.

 

[2017ish]

We are in a similar situation re: retirement spending sources and not too far off on desired [highly-discretionary] spend amount (via fixed percentage each year). A bit more than 80% in tax favored accounts, nearly all of which is traditional. Retiring at 57/56 (and the 56 y.o. has the bulk of assets).

Like us, you can't reasonably convert to Roths now, but as soon as your earned income stops, you'll have many years open to do so. Our present plan is to annually convert to top of 25% bracket while living off the after-tax amounts in the first three years. After that, we'll reevaluate and see what looks best.

As for allocation, we still are too heavy in equities, but I'm trying.... Remember Bernstein's observation: "When you’ve won the game, why keep playing it?"

 

[DawgMan]

Well, you could state that another way -- since the 95/5 provided significantly more money, this begs the question as why accept the lower returns?

Over 30 years...

1.103^30 = 1.103^30
≈ 18.935003

1.09^30 = 1.09^30
≈ 13.267678

So at 10.3%, $1M grows to $1.89M, 9% grows to $1.33M - that leaves $560,000 on the table!

Now, it's not as simple as that, the returns aren't the same each year as averages show, but you get the point.

I think people get too hung up on volatility. In a down market, you still have divs. And if you are conservative and worried about this, your divs are probably providing most of your income (SPY provides ~ 2% divs). And if stocks are down, you don't sell them for the remainder of the income, you would be selling your fixed income as part of your rebalancing strategy.

But I don't get hung up on this, FIRECalc shows historical success rates are pretty flat between 40/60 and 95/5. Set it and forget it.

-ERD50

I suppose my thought here is the more volatility in AA while in RE and drawing down $$, the more exposed you might be and it is better to minimize your volatility/risk here. Yes - 1% compounded = real $$ over 30 yrs, but trying to evaluate the risk/reward, both $$ wise and psychologically when in a draw down phase is where I struggle. I am, as I would guess most are, more comfortable taking these volatility risks for greater returns when I am generating $$ that 1) cover all my expenses, and 2) allow me to sock away a bunch of dough, but suspect my boldness will be tempered once I am drawing down on my assets without any pension as a partial backstop. As it relates to collecting dividends, I see how creating a portfolio like this may create a "faux" pension, but I tend to be a total return guy which means I will be selling (capital gains) & collecting what dividends come with my AA at least once a year to fund RE. I can be convinced otherwise, which is why I asked the question.

 

[DawgMan]

We are in a similar situation re: retirement spending sources and not too far off on desired [highly-discretionary] spend amount (via fixed percentage each year). A bit more than 80% in tax favored accounts, nearly all of which is traditional. Retiring at 57/56 (and the 56 y.o. has the bulk of assets).

Like us, you can't reasonably convert to Roths now, but as soon as your earned income stops, you'll have many years open to do so. Our present plan is to annually convert to top of 25% bracket while living off the after-tax amounts in the first three years. After that, we'll reevaluate and see what looks best.

As for allocation, we still are too heavy in equities, but I'm trying.... Remember Bernstein's observation: "When you’ve won the game, why keep playing it?"

Like you, my projected RE income is a pure want/preference and purely discretionary as a down size (pay all cash) or stay in my house (pay off mortgage) will eliminate my only debt come RE. Good point on Bernstein and definitely speaks to logic. I suppose the entrepreneur in me says I need to grow that puppy and be more proactive with my portfolio!

Since you are a couple/few years ahead of me, I look forward to you sharing the secret sauce!

 

[ERD50]

.... but suspect my boldness will be tempered once I am drawing down on my assets without any pension as a partial backstop. As it relates to collecting dividends, I see how creating a portfolio like this may create a "faux" pension, but I tend to be a total return guy which means I will be selling (capital gains) & collecting what dividends come with my AA at least once a year to fund RE. I can be convinced otherwise, which is why I asked the question.

I am totally a 'total return' guy.

But a portfolio of SPY and BND (or equiv) is going to provide ~2~3% in divs. I would just take those as income. So if you have a conservative WR, you only need to make up ~ 1% or less in sales (and some might come from cap gains distributions). In a down market, those sales will likely be from the fixed income side. You won't need to sell equities when they are down.

-ERD50

 

[DrRoy]

The 40/60 probably shows the value of the bull market in bonds that may have just come to an end.

This is just a fact. Bonds cannot return going forward what they have over the last 30+ years. It is straight math due to years of falling interest rates that cannot repeat. I also think that equity returns will be lower because growth drivers are reduced too.