Bonds & taxes (separate topics)

[Finance Dave]

I have a variety of questions, would like your thoughts.

Background:
We both work today at MegaCo and are in the 33% marginal bracket. That will change when I rehire in the next 1-2 years, as we'll then be in the 25% bracket for a couple years, and after that will be in the 15% bracket. We are high earners, but LBYMers...so we live more like someone in the 25-28% bracket today. I'm not sure I NEED munis given this, but would like your thoughts. I anticipate we'll spend around $75-$80k our first year of rehirement, indexed for inflation after that.

We have few tax deductions, as our mortgage is paid off (recently) and we have few medical expenses currently.

Our rehirement savings are around $1.6M now, 70/30 AA. Goal is to get to about $1.9M before she leaves the workforce. I do plan to work a part-time low-wage job for a few years. We have no pensions, but do have excellent cash balance plans with lump-sum balances, 401k plans, Roth IRAs, and after-tax accounts...all of which are included in the $1.6M above. Between what we put into our rehirement accounts and what the MegaCo put in, we're adding about $60k/year to the balance...add a bit of growth and hopefully we'll hit the $1.9M soon.

We also own 2 rental properties, currently negative cash flow as we only started 2 years ago and are still plowing profits back into major repairs such as siding, kitchen floors, and so on...but anticipate buying one more, and having net income of about $12k/year for eternity starting in about 3 years (by then we hope to have all the major upgrades done and the ongoing repairs will be more modest). One of the rentals is fully paid for, the other partly borrowed on a HELOC but we plan to pay it off in 2-3 years, and a new one would be borrowed on the HELOC if rates stay low, or could pay out of savings if needed but it would put our emergency fund on the thin side. I'm very handy and do 80% of the work myself on the rentals and manage the tenants...therein might lie my part time job in rehirement.

First off, bonds:
Considering some bond purchases in the next few years. I know there are trade-offs between bonds and bond funds. Want to explore a few things and hoping you folks can help.

1) As long as I buy an individual bond and I hold to maturity, I'm guaranteed (except in the case of bankruptcy) face value plus the coupon, right? (yes, I know if there's a call option, that's another risk)

2) What risks are there then to laddering individual bonds?

3) Compare and contrast a bond such as above to a dividend-paying stock (sounds like an exam question) . I know the "place in line" with a stock is lower, but could buy preferred stock to improve this...although obviously creditworthiness of the company is a key factor).

4) I've always heard "GO" (General Obligation) bonds are a safer choice in terms of munis...what are your thoughts on this?

5) If buying munis, I'd want to do so in an after-tax account, right? Other than this, any tax considerations?

I've bought a few individual ones for my dad, as I manage his finances, but it's a relatively small position in his portfolio and basically it was to ladder some liquidity...did this 5 years ago and it's working well compared to the piddly rates being offered today.

Second, medical insurance/costs:
We will likely have to purchase private medical insurance before DW leaves the full-time workforce in about 3 years.

1) I don't want to be "uninsurable", so I'd like to purchase this coverage BEFORE she FIREs...what do you think of this approach? We're both relatively healthy now, but things like blood pressure and cholesterol are marginal and I'm not sure how insurance companies view that.

2) If we buy LTC and medical insurance privately, are the premiums for each of these deductible as far as medical expenses exceeding the 7.5% limit? If so, our taxes will REALLY be low.


Third - income in rehirement generated by various sources:
Another area that confuses me is how the gov't views various income sources in retirement. For us, we'd roll over the 401k to an IRA and then remove money over time...I know that's taxed at "normal" rates...which is fine since our marginal bracket will go down...so I'd likely use a combination of withdrawal from IRA and rental profits up to the 15% bracket max each year, and then if we need any extra I'd take it from the Roth or my after-tax accounts. This would effectively cap our average rate at fairly low number. Does this seem like a good strategy?

Thoughts?

 

[MichaelB]

First off, bonds:
Considering some bond purchases in the next few years. I know there are trade-offs between bonds and bond funds. Want to explore a few things and hoping you folks can help.

1) As long as I buy an individual bond and I hold to maturity, I'm guaranteed (except in the case of bankruptcy) face value plus the coupon, right? (yes, I know if there's a call option, that's another risk

Right. But, European sovereign bionds are showing us there is a category in-between pay and default. Can that happen here? Probably not, but with bonds, like all other investments, diversification helps.

2) What risks are there then to laddering individual bonds?

See above. One additional risk is "reinvestment risk". When interest rates have fallen and one has to reinvest at a lower rate.

3) Compare and contrast a bond such as above to a dividend-paying stock (sounds like an exam question) . I know the "place in line" with a stock is lower, but could buy preferred stock to improve this...although obviously creditworthiness of the company is a key factor).

It is still a stock, not a bond.

4) I've always heard "GO" (General Obligation) bonds are a safer choice in terms of munis...what are your thoughts on this?

Some people recommend revenue bonds that are tied to secure revenue sources, such as water. Others say GO, but at a state level. Probably best to stay between those two to lower risk.

5) If buying munis, I'd want to do so in an after-tax account, right? Other than this, any tax considerations?

With GO bonds, no. With others, including some revenue bonds, you have some private activity bonds that are subject to AMT. You would want to avoid these.

I've bought a few individual ones for my dad, as I manage his finances, but it's a relatively small position in his portfolio and basically it was to ladder some liquidity...did this 5 years ago and it's working well compared to the piddly rates being offered today.

1) I don't want to be "uninsurable", so I'd like to purchase this coverage BEFORE she FIREs...what do you think of this approach? We're both relatively healthy now, but things like blood pressure and cholesterol are marginal and I'm not sure how insurance companies view that.

COBRA gives you the right to enroll in her policy for 18 months, applying the unsubsidized rate. After that you get a conversion policy to move it into another plan, if your state has those rules.

2) If we buy LTC and medical insurance privately, are the premiums for each of these deductible as far as medical expenses exceeding the 7.5% limit? If so, our taxes will REALLY be low.

Health insurance - yes, all. LTC, part.

Third - income in rehirement generated by various sources:
Another area that confuses me is how the gov't views various income sources in retirement. For us, we'd roll over the 401k to an IRA and then remove money over time...I know that's taxed at "normal" rates...which is fine since our marginal bracket will go down...so I'd likely use a combination of withdrawal from IRA and rental profits up to the 15% bracket max each year, and then if we need any extra I'd take it from the Roth or my after-tax accounts. This would effectively cap our average rate at fairly low number. Does this seem like a good strategy?

Thoughts?

Yes, it seems like a reasonable strategy, until you are age 70 1/2, then you have to take a required minimum. You might look to see if you have any room to convert part of your IRA to Roth in years when your rental income is low.

 

[LOL!]

It appears that you have plenty of tax-advantaged space to hold all the bond funds that you want. Why would you want to own any bonds whatsoever in your taxable account?

If you do have plenty of taxable investments, then they should probably be 100% equities (since you should have all your bond funds in tax-advantaged). As you draw down taxable to pay for expenses, your taxes will probably be zero since return of capital is tax-free and any realized gains will be long-term cap gains and taxed favorably or not at all. In this scenario you would be doing conversions of your 401(k)/IRA to a Roth IRA as many folks on this forum already do.

So once again, why bonds in taxable? And why is your tax rate in retirement not practically zero?

 

[haha]

Right. But, European sovereign bionds are showing us there is a category in-between pay and default. Can that happen here? Probably not<...>

Wouldn't the "adjustments" that were forced on Chrysler and GM bondholders be an example of this? (In substance, albeit not in form.) The normal bankruptcy rules of precedence were ignored in favor of governmental arm-twisting.

I have a variety of questions, would like your thoughts.

4) I've always heard "GO" (General Obligation) bonds are a safer choice in terms of munis...what are your thoughts on this?

Thoughts?

I can comment only on this one. Given the state of many taxing bodies finances, and the much better state of certain industrial projects, I believe in selected cases dedicated industrial project bonds are probably better. But this is biting off a lot of work, unless you intend to enter in size.

Also, bond analyst are pretty down to earth people, it will not be easy to earn your keep in this field.

A general observation- if a bond allocation or muni allocation is strategic and more or less unvarying, don't emphasize too heavily the differences between a bond ladder and several mutual funds or ETFs with laddered durations. If rates are going up, your bond capital will go down in proportion to duration. It is just easier for some people to ignore if they hold straight bonds. Much personal finance is basically ignoring reality in favor of feel-good distortions.

Ha

 

[MichaelB]

Wouldn't the "adjustments" that were forced on Chrysler bondholders be an example of this? (In substance, albeit not in form.) The normal bankruptcy rules of precedence were ignored in favor of governmental arm-twisting.

I can comment only on this one. Given the state of many taxing bodies finances, and the much better state of certain industrial projects, I believe in selected cases dedicated industrial project bonds are probably better. But this is biting off a lot of work, unless you intend to enter in size.

Also, bond analyst are pretty down to earth people, it will not be easy to earn your keep in this field.

A general observation- if a bond allocation or muni allocation is strategic and more or less unvarying, don't emphasize too heavily the differences between a bond ladder and several mutual funds or ETFs with laddered durations. If rates are going up, your bond capital will go down in proportion to duration. It is just easier for some people to ignore if they hold straight bonds. Much personal finance is basically ignoring reality in favor of feel-good distortions.

Ha

I'm not familiar with the Chrysler details but that may be a case. When one looks at the total amount of debt outstanding in the US its hard to believe there will be no defaults.

Your point on the appearance of control and the benefit of muni funds of different durations is well made. I would only add that if there is a concrete plan to draw down the funds on specific dates individual bonds might work. It is also very difficult to diversify a personal holding of bonds.

 

[haha]

Your point on the appearance of control and the benefit of muni funds of different durations is well made. I would only add that if there is a concrete plan to draw down the funds on specific dates individual bonds might work. It is also very difficult to diversify a personal holding of bonds.

Totally agree. That is why I tried to limit my observation to a permanent, relatively unchanging allocation, which I suppose could only happen with a non-liquidating strategy.

Ha

 

[Finance Dave]

Michael B, thanks for all your responses...I had not thought of transferring the IRA money to a Roth. It's not in an IRA yet, but upon the 401k rollover it will be...I'll consider this.

It appears that you have plenty of tax-advantaged space to hold all the bond funds that you want. Why would you want to own any bonds whatsoever in your taxable account?

If you do have plenty of taxable investments, then they should probably be 100% equities (since you should have all your bond funds in tax-advantaged). As you draw down taxable to pay for expenses, your taxes will probably be zero since return of capital is tax-free and any realized gains will be long-term cap gains and taxed favorably or not at all. In this scenario you would be doing conversions of your 401(k)/IRA to a Roth IRA as many folks on this forum already do.

So once again, why bonds in taxable? And why is your tax rate in retirement not practically zero?

I want bonds for a revenue stream, that's all. I'm one of these guys who would rather work an extra 6-12 months and then have a safer AA than have a heavy amount in stocks after rehirement. So I'd probably go with about 30% equities at rehirement, 30% bonds, and 40% guaranteed funds. That would be at age 54 or so...and then I'd reduce equities and bonds by about 5% each every decade. I suppose there are many ways to create the income stream, I'm looking at TIPS too for part of it...but again the question comes of whether to buy individual TIPS or funds. I am thinking individual to avoid the price changes...and then hold to maturity if I can get short enough durations.

I suppose my tax rate would be quite small, but not zero since most of my savings is in a pre-tax 401k plan, so it will get taxed as we pull it out. Perhaps with the standard deduction and so on we could get it down some....I've been in a high tax bracket so long I don't know what it's like to pay low tax rates. I recieved my bonus check this week for 2011 and they took out $11,500 in federal taxes!!!

Am I missing something in regards to my taxes after FIRE? Why would you think they'd be near zero?

 

[Finance Dave]

If rates are going up, your bond capital will go down in proportion to duration. It is just easier for some people to ignore if they hold straight bonds. Much personal finance is basically ignoring reality in favor of feel-good distortions.

Ha

THanks Ha. That's why I discussed holding individual bonds to maturity...it would be very comforting to me to almost completely eliminate the price risk as rates move. I may have to spend a full day picking out the individual bonds the first day to get the call options I want, the right maturities, and so on...but that's ok with me.

 

[Finance Dave]

I would only add that if there is a concrete plan to draw down the funds on specific dates individual bonds might work. It is also very difficult to diversify a personal holding of bonds.

Agreed...and I would have such a plan. You made a good point earlier about reinvestment risk, and I'll need to think through that.

 

[Finance Dave]

Totally agree. That is why I tried to limit my observation to a permanent, relatively unchanging allocation, which I suppose could only happen with a non-liquidating strategy.

Ha

Could you explain what you mean by a non-liquidating strategy? My plan would be that when a given bond comes due, I buy one of the same duration and same face amount...thus keeping the ladder in place. Sure, at some point I'd need to shorten or liquidate these, but this could be done over a very long time.

 

[LOL!]

Am I missing something in regards to my taxes after FIRE? Why would you think they'd be near zero?

Because your taxable income would be so low ... only about $80K or less a year. Note I wrote "taxable income" and not "gross income" and not "adjusted gross income".

As for a revenue stream, to me there is no difference between money coming from bond dividends and money coming from selling stocks. Money is money. However, the taxes are quite a bit different.