Corporate Bonds / Treasuries in Taxable Question

[Austin704]

I understand tax efficient fund placement and I’m doing what I can with those strategies to minimize taxes now and in the future. But what I am still not understanding is why so few people are in favor of holding investment-grade corporate bonds and/or treasuries in taxable accounts. Even though they are relatively tax inefficient, they do produce income—albeit taxed as ordinary income. But so do CDs, money market accounts, and high-yield savings accounts, and no one seems to recommend against those in taxable accounts.

For retirees looking for steady income and relatively lower risk, investment grade bonds seem to be a reasonable choice. A stock index fund might be more tax efficient (capital gains vs. ordinary income) but there’s so much volatility, and one can’t be sure that principal will be there when it’s needed.

And what about those of us just looking for a place to park $100k or $200k in cash? If someone were to offer a CD paying 3% interest right now, most people would jump on that as a great place to stash cash—and yet, it would be taxed as ordinary income, same as a bond fund. What’s the difference?

Have I misunderstood the reasoning?

Thanks!

 

[pb4uski]

..... A stock index fund might be more tax efficient (capital gains vs. ordinary income) but there’s so much volatility, and one can’t be sure that principal will be there when it’s needed.....

Have I misunderstood the reasoning?

Thanks!

Perhaps.

A lot of people have trouble getting their head around how equities in a taxable account work in withdrawal phase and the impact of volatility. I'll try to clarify with an example.

Joe Retiree has $1 million of savings... $500k taxable and $500k tax-deferred and he plans on a 4% WR. His target AA is 60/40. So he begins the year with $40k in cash, $460k of in stocks in a taxable account and $140k of stocks and $460k of bonds in his IRA.

During the year, he spends the $40k in cash and stocks tumble 20% and bonds increase 5%.... so before rebalancing at year end he has $0 in cash, $368k in taxable account stocks, $112k in stocks in his IRA and $483k in bonds in his IRA....for a total of $963k. His new target AA is $40k of cash, $578k of stock and $345k of bonds.

Joe sells $40k of stock from his taxable stock portfolio to raise the cash needed for next year's spending.... leaving $328k of stocks in his taxable account. He then sells $138k of bonds in his IRA and buys $138k of stocks in his IRA.

After rebalancing, he has $40k of cash, $328k of stocks in his taxable account, $250k of stock in his IRA and $345k of bonds in his IRA... and an overall AA of 60/40.

Having stock in taxable doesn't impede his liquidity at all... he just make commensurate changes to the asset composition in his IRA.

His portfolio is very tax efficient with a little bit of taxable interest on the cash.

Also, to the extent that you hold equities in tax-deferred accounts you are effectively converting tax-efficient qualified dividends and long-term capital gains into tax inefficient ordinary income.... why would one do that? And if you hold international equities in tax-deferred or tax-free accounts it is even worse in that any foreign taxes paid that could be used to get a foreign tax credit go to waste.

 

[Austin704]

Having stock in taxable doesn't impede his liquidity at all... he just make commensurate changes to the asset composition in his IRA.

His portfolio is very tax efficient with a little bit of taxable interest on the cash.

Also, to the extent that you hold equities in tax-deferred accounts you are effectively converting tax-efficient qualified dividends and long-term capital gains into tax inefficient ordinary income.... why would one do that? And if you hold international equities in tax-deferred or tax-free accounts it is even worse in that any foreign taxes paid that could be used to get a foreign tax credit go to waste.[/QUOTE]


This is a very helpful illustration of how fund placement and the interplay between taxable and tax-deferred can be used to minimize taxes and keep the cash rolling in. Very helpful indeed. Thank you.

Now, let me ask this question, if I may. Let’s say that Joe decides over the next 5 years that, in addition to the $40k he’s pulling from taxable stocks to live on, he wants to build up $100k in cash reserves to pay for his grandkid’s college. Is there any reason why Joe shouldn’t park the cash in a taxable bond fund while it grows?

 

[pb4uski]

Yes, because it is tax inefficient.

Joe can build the $100k in his IRA (effectively changing is AA or having a notional side fund in a bond fund for the grandkid's college expenses within his portfolio). Then when the time comes to pay the tuition checks, sell stock in the taxable account to make those tuition payments and then sell the same amount of bond funds in the IRA and buys stock with the proceeds... the net effect is to reduce the cash reserves/bond funds in his portfolio for the amount of the tuition paid.... but in a tax efficient manner.

 

[RunningBum]

There are exceptions. I have a CD ladder and money market cash in my taxable account. This allows me to keep my income below 400% FPL, to get an ACA subsidy. It's possible I could still do that with stocks with the cash in an IRA, but its unpredictable and the capital gains could put me over. So I've got enough cash in taxable to get me to 65, then I'll go back to only keeping enough cash for a few months in taxable.

 

[TechLead]

There are exceptions. I have a CD ladder and money market cash in my taxable account.

Same with me. You can't rely on Corporate Bonds like you can on CDs.

Where would they be today without Fed Backstop?

 

[VanWinkle]

Perhaps.

A lot of people have trouble getting their head around how equities in a taxable account work in withdrawal phase and the impact of volatility. I'll try to clarify with an example.

Joe Retiree has $1 million of savings... $500k taxable and $500k tax-deferred and he plans on a 4% WR. His target AA is 60/40. So he begins the year with $40k in cash, $460k of in stocks in a taxable account and $140k of stocks and $460k of bonds in his IRA.

During the year, he spends the $40k in cash and stocks tumble 20% and bonds increase 5%.... so before rebalancing at year end he has $0 in cash, $368k in taxable account stocks, $112k in stocks in his IRA and $483k in bonds in his IRA....for a total of $963k. His new target AA is $40k of cash, $578k of stock and $345k of bonds.

Joe sells $40k of stock from his taxable stock portfolio to raise the cash needed for next year's spending.... leaving $328k of stocks in his taxable account. He then sells $138k of bonds in his IRA and buys $138k of stocks in his IRA.

After rebalancing, he has $40k of cash, $328k of stocks in his taxable account, $250k of stock in his IRA and $345k of bonds in his IRA... and an overall AA of 60/40.

Having stock in taxable doesn't impede his liquidity at all... he just make commensurate changes to the asset composition in his IRA.

His portfolio is very tax efficient with a little bit of taxable interest on the cash.

Also, to the extent that you hold equities in tax-deferred accounts you are effectively converting tax-efficient qualified dividends and long-term capital gains into tax inefficient ordinary income.... why would one do that? And if you hold international equities in tax-deferred or tax-free accounts it is even worse in that any foreign taxes paid that could be used to get a foreign tax credit go to waste.

Very good description of tax efficiency and how to re-balance in each account to maintain the tax efficiency through the withdrawal phase. I started using this same method in the last 2 years and have seen an advantageous change in my taxable income.

Thanks for the clear description pb!!!!

 

[Austin704]

I always learn so much here. Thanks for your time and expertise folks!

 

[Austin704]

Then when the time comes to pay the tuition checks, sell stock in the taxable account to make those tuition payments and then sell the same amount of bond funds in the IRA and buys stock with the proceeds... the net effect is to reduce the cash reserves/bond funds in his portfolio for the amount of the tuition paid.... but in a tax efficient manner.

Just to clarify, in the example above when Joe sells bonds/cash in the IRA he uses the proceeds to buy stock in the taxable account to replenish it correct? In doing so, Joe has to pay income tax on the proceeds right? So eventually, if one wants/needs to use the funds in the IRA to replenish the taxable account the income tax must be paid.

It seems that as long as one has a sizeable taxable stock fund to draw from, the approach is workable, but if the demands on the taxable account become too great, or the market reduces its value, then the only choice is to draw from the IRA and pay the income tax (assuming it's not a Roth IRA).

 

[Austin704]

Just to clarify, in the example above when Joe sells bonds/cash in the IRA he uses the proceeds to buy stock in the taxable account to replenish it correct? In doing so, Joe has to pay income tax on the proceeds right? So eventually, if one wants/needs to use the funds in the IRA to replenish the taxable account the income tax must be paid.

...And, if Joe uses taxable stock funds to pay the tuition he gets hit with capital gains taxes AND then pays income tax on the proceeds from the IRA to replenish the taxable account... Wouldn't it be better just to take the tuition from the IRA, pay the income tax, and leave the taxable stock gains unrealized?

I am confused!

 

[Montecfo]

It seems that as long as one has a sizeable taxable stock fund to draw from, the approach is workable, but if the demands on the taxable account become too great, or the market reduces its value, then the only choice is to draw from the IRA and pay the income tax (assuming it's not a Roth IRA).

I think this is a good point. Holding bonds in a taxable account may be tax inefficient, but it also may very well be efficient cash flow planning because the modest but predictable returns generate modest predictable income taxes.

I really do not want to have to pull taxable funds from IRAs until later. While most of my bonds are in tax deferred accounts, I have CDs and bond funds in my conservatively invested taxable account along with conservative dividend paying equities.

A couple of benefits: 1. flexibility to manage taxable income about as low as I want to and 2. No worries about future changes to historically favorable cap gain/dividend taxation.

 

[RunningBum]

...And, if Joe uses taxable stock funds to pay the tuition he gets hit with capital gains taxes AND then pays income tax on the proceeds from the IRA to replenish the taxable account... Wouldn't it be better just to take the tuition from the IRA, pay the income tax, and leave the taxable stock gains unrealized?

I am confused!

Those are not equal amount tax events. Not even close.

Using taxable stock funds, Joe owes a tax on the gains only. Hopefully at the lower LTCG rate, and he can sell the shares that have the least gain, or maybe even harvest a loss. The tax will be a small fraction of the tuition. He could either sell a bit more of the stock from taxable to cover the tax, or withdraw a small amount from the IRA.

Taking tuition from the IRA, he owes tax on the entire amount of the tuition, at regular income tax rates. And he's still going to have to take extra out of the IRA to pay for those taxes. More extra than with the other case because the tax liability is higher.

When I get confused on things like this I put numbers in a spreadsheet or a tax program to see how the numbers work out.

 

[MandM]

...And, if Joe uses taxable stock funds to pay the tuition he gets hit with capital gains taxes AND then pays income tax on the proceeds from the IRA to replenish the taxable account... Wouldn't it be better just to take the tuition from the IRA, pay the income tax, and leave the taxable stock gains unrealized?

I am confused!

Austin, if you are sure that you want to help with tuition, can you not just set up in a 529 college plan and withdraw at that time for allowed education expenses without some federal tax consequences in that year. Now there may be other financial aid issues to consider but that might be an option. There are those more knowledgeable on this matter that could weigh-in.

 

[pb4uski]

Just to clarify, in the example above when Joe sells bonds/cash in the IRA he uses the proceeds to buy stock in the taxable account to replenish it correct? In doing so, Joe has to pay income tax on the proceeds right? So eventually, if one wants/needs to use the funds in the IRA to replenish the taxable account the income tax must be paid.

It seems that as long as one has a sizeable taxable stock fund to draw from, the approach is workable, but if the demands on the taxable account become too great, or the market reduces its value, then the only choice is to draw from the IRA and pay the income tax (assuming it's not a Roth IRA).

No, he sells bonds/cash in his IRA and uses the proceeds to buy stocks in his IRA to maintain his AA across all of his accounts.

It is true that eventually the taxable account will expire as a result of spending, but that will happen irrespective of whether your asset placement is tax efficient or inefficient so it isn't really relevant to the decision. In fact, since historically stocks generate higher returns... the higher returns along with better tax efficiency would make the taxable account last longer than if it were in bonds.

 

[Out-to-Lunch]

Just to clarify, in the example above when Joe sells bonds/cash in the IRA he uses the proceeds to buy stock in the taxable account to replenish it correct?

No, I don't think you understood the example correctly. Look at PB's original example, where he very clearly states that the IRA money stays in the IRA (just changes form):

Joe sells $40k of stock from his taxable stock portfolio to raise the cash needed for next year's spending.... leaving $328k of stocks in his taxable account. He then sells $138k of bonds in his IRA and buys $138k of stocks in his IRA. (emphasis added)

 

[Austin704]

No, I don't think you understood the example correctly. Look at PB's original example, where he very clearly states that the IRA money stays in the IRA (just changes form):

Right, but the subsequent example of taking $100k from taxable for tuition costs and selling IRA bonds is not clear. My point is that paying for everything out of a taxable account makes great sense until the money runs out... then one has to use tax-deferred to replenish and thus incur income taxes.

The further point was that to the extent $1 of taxable is subject to capital gains tax and is later replaced by a $1 of IRA money, it generates two tax events. Seems better to take the money out of the IRA and leave the taxable untouched in that scenario.

 

[Austin704]

No, he sells bonds/cash in his IRA and uses the proceeds to buy stocks in his IRA to maintain his AA across all of his accounts.

It is true that eventually the taxable account will expire as a result of spending, but that will happen irrespective of whether your asset placement is tax efficient or inefficient so it isn't really relevant to the decision. In fact, since historically stocks generate higher returns... the higher returns along with better tax efficiency would make the taxable account last longer than if it were in bonds.

Got it! Thanks.