fixed income vs equities in tax-deferred accounts

OK, you are in the 25% tax bracket. You have contributed to your 401(k) plan over the years and with some growth, it has $100K in it. Your 401(k) is split 50:50 stocks:bonds.

Then you get a bonus of $133.33K. You pay $33.33K in taxes leaving you with $100K in a checking account.

You now have $100K in a checking account and $100K in your 401(k). You want 50% equities and 50% bonds split up among the $200K because that's your asset allocation and that's what you had before your bonus. You can split them any which way among your remaining $200K. What way would give you the most money years later after withdrawing and spending the money? I answered this above.

You can obscure things all you want. We are not talking about putting $200K in one place or $50K here and $150K. We are not talking about not maxing out one's 401(k) contributions. We are simply talking about starting with $200K split evenly between your checking account and your 401(k). You may not wish to talk about that, but that's your choice.
 
LOL! said:
OK, you are in the 25% tax bracket. You have contributed to your 401(k) plan over the years and with some growth, it has $100K in it. Your 401(k) is split 50:50 stocks:bonds.

Then you get a bonus of $133.33K. You pay $33.33K in taxes leaving you with $100K in a checking account.

You now have $100K in a checking account and $100K in your 401(k). You want 50% equities and 50% bonds split up among the $200K because that's your asset allocation and that's what you had before your bonus. You can split them any which way among your remaining $200K. What way would give you the most money years later after withdrawing and spending the money? I answered this above.

You can obscure things all you want. We are not talking about putting $200K in one place or $50K here and $150K. We are not talking about not maxing out one's 401(k) contributions. We are simply talking about starting with $200K split evenly between your checking account and your 401(k). You may not wish to talk about that, but that's your choice.
Click to expand...

LOL!, it sounds like you will stay with your opinion no matter what I say at this point. That's fine. Perhaps the same can be said of me (although I hope to keep an open mind still... LOL!)

For the benefit of others who might be reading the thread, I will point out your mistake again...

Truth is you don't have 200K! What you have is 100k after tax money and 100k on which you still have to pay taxes. 100k bonds in 401k and 100k stocks in your after-tax account is NOT a correct 50/50 split! To correctly split your allocation 50/50 you have to actually allocate 87.5k in your taxable account vs 100k in your 401(k) + 22.5k in your after-tax account. That's the real 50-50 split.

It's analogous to saying you have 100k in Canadian dollars and 100k in US dollars, so let's split them 50-50... By LOL reasoning, you would say 100k in canadian dollars should go in one investment and 100k in US$ should go into another because both are "100k" and they both have "dollars" in their name. You give no consideration to the fact that they are actually worth different amounts to begin with, because in US you have to convert Canadian$ to US$ to make use of it and it won't be 1:1 (most likely)... just like with pre-tax dollars - you have to convert them to after-tax dollars first before making use of them...

So, all LOL's comparisons of 100k of one kind of dollars and 100k of another kind of dollars are effectively:
case (1): 100k real after-tax $ in stocks and 87.5k real after-tax $ in bonds (growing tax deferred) vs
case (2): 100k real after-tax $ in bonds and 87.5k real after-tax $ in stocks (growing tax-deferred)
 
Lakedog said:
One big advantage for holding equities in a taxable account is that you can take advantage of tax loss harvesting. Also, although future dividend and cap gains tax rates are uncertain, both have generally been lower than ordinary income tax rates. Lots to think about on this topic...
Click to expand...

Good point about tax-loss harvesting. Remember that it lowers your basis, and thus defers your taxes to your future cap gains tax rate but does not eliminate them, unless your future cap gains tax rate is 0%.. So, as to how huge of an advantage it is, it might be subject for another spreadsheet :).

Meanwhile, in my examples, I already assume 0% tax rate for all cap gains, although I think more than 0% is still likely since dividends still do exist...

As for dividend / cap gains tax rates being lower than income tax rate, I agree and the example I gave takes those as inputs.

So, you can just take the simple spreadsheet (or of course, create your own), plug in your assumptions and get the results... I think it's really that simple once you are convinced you got the right model.

As I am playing with it, I am finding that in most cases when fixed investments really underperform equities and when you looks at longer periods of time, it makes more sense to push more equities into tax-deferred accounts and fixed ones into taxable accounts. As you get closer to using the funds, the tax-deferred compounding effect is becoming less important compared to the tax-inefficiency of fixed investments; and even then it's often better to keep higher-growth tax-deferred. So far I've seen not too many cases, when you have only a few years left before withdrawing the money when you should start switching the positions the other way...
 
smjsl/jdw.......

Perhaps this is the reason for LOL's beliefs......
Principles of Tax-Efficient Fund Placement - Bogleheads
There are some academic papers footnoted at the bottom. Way over my head. Perhaps they might be of interest to you so you help us reconcile their ideas w/ your spreadsheet. btw.....VG also has a wiki on tax-adjusted asset allocation that agrees w/ your idea.

Still think it would be useful to have a discussion on the bogleheads.org forum discussing your ideas.
 
It is pretty obvious that I will always believe that a 15% tax rate is less than a 25% tax rate.
 
@kaneohe: I will investigate this question further and let you know what I find out.
 
Of course many of us feel that equities in taxable is a mighty fine way of passing our estate to the kids on a step-up tax basis. This trumps most of everything said above for us, at least.:)

Cheers,

charlie
 
where to keep what all depends on whether your goal is pass on your wealth or live off it as well as whether the equities in your taxable account spin off lots of dividends


if i was planning on not selling my funds in my taxable account and passing them on eventually then low dividend paying index funds would be my first choice for equities .... never paying any taxes on the gains and the kids getting them tax free is the best deal around.

if the funds spin off regular taxable dividends then you have to analyze these numbers as there will be taxes paid all along and the inheritance factor is eroded slightly.

roth and roth conversions would be the next best place.... the biggest gainers namely the equities should be here . my equities buckets have 15 year time frames so they still have lots of growing time.

being i will need withdrawls to live on , and the gains are low, and the time frame much shorter im not so sure converting my bonds to a roth is worth doing at this point (age 57)

i think ill just leave the bond funds in my taxable account and 401k as just that , pay the taxes as i spend it down and leave the equities in both the taxable accounts and the roths to do their growing for many years if not forever.


ill spend the regular ira bond fund money and 401k bond fund money first dwindling down the mandatory withdrawls on the bond funds early on and if tax rates rise off in the future i would already have spent down a big part of that thru the years and payed the taxes all along while tax rates were on sale..
 
finally someone brought up this topic. here is my real life strategy.
All tax defered acct on trading. By the way, I always fully invest on equity. For me, equity means penny stocks, :)
All cash acct on very conservative invest, basically mm.

Anyone here on my side?
 
I have not forgotten about this question and promised to post a follow up. So, here it is. I did quite a bit of investigations including getting some answers directly from academics. Thanks to kaneohe for the link to Boglehead article which references a few papers at the end (Principles of Tax-Efficient Fund Placement - Bogleheads). I ended up studying them to some degree. This also led me to following paper, which had a lot nicely explained details:
http://spwfe.fpanet.org:10005/public/Unclassified%20Records/FPA%20Journal%20July%202007%20-%20Calculating%20After-Tax%20Asset%20Allocation%20Is%20Key%20to%20Determining%20R.pdf

I think I have a much deeper appreciation now for what is going on and here it is...

Turned out it's not a simple topic unfortunately, so sorry for the long post, but here is a quick summary

- In most cases it looks like stocks that do not generate much of income are better to be held in taxable account and bonds in tax-deferred. (See below for a summary of how this is derived and therefore the assumptions made.)

- Dollars in tax-deferred accounts are different from dollars in taxable accounts. Correct value of 1 dollar in tax-deferred account is $(1-tn), where tn is the tax you will pay at the end for withdrawing that dollar. This should in part affect how you think about asset allocation.

- Stocks in tax-deferred accounts is a different investment then stocks in taxable accounts because real returns and risk are different for the two. Same applies to bonds.

- Questions I have not resolved (yet?): Accounting for stock dividends in the model will make it more likely that stocks should be in tax-deferred accounts, however to what degree this is true needs to be measured / estimated. On the opposite side, the model had to assume a capital gains tax after each year in taxable account (explained below), and extending this to N years would make stocks in taxable account more preferrable - again degree of this is unknown.

Finally, above conclusion is reached with using standard deviation as the model for risk. There are known problems with modeling risk as standard deviation, and it's unclear to me what the outcome would be if another model were applied (or perhaps there is no better model today, which is why researchers use standard deviation).

Some glory details for those interested...

(1) I was correct in that dollars should be valued differently in tax-deferred and after-tax accounts. William Reichenstein papers referenced on the Boglehead's page address this point in detail and I posted my explanation of this fact earlier in this thread. Another paper (http://wpweb2.tepper.cmu.edu/spatt/location.pdf) mentions this in passing and just works with after-tax dollars in tax-deferred accounts assuming you already made the conversion.

Note that while you do not know your future tax rate (tn), thinking of dollars in your tax-deferred 401(k)/TIRA accounts as dollars in your taxable account effectively assumes your tax rate will be 0% (which is true only if you plan to die before the withdrawals).

So, if your future tax rate for 401(k)/TIRA withdrawal is 20%, then to make your asset allocations the same between investments A and B in taxable and tax-deferred accounts, you have to have for every $1000 in tax-deferred account in investment A, $800 in taxable account for investment B.

Note that conversion from nominal pre-tax dollars to after-tax dollars also affects risk and return as explained in (2b) below.

(2) All my calculations are correct in the OP. So in fact, keeping stocks for N years in tax-deferred account would give you higher ending wealth then the opposite scenario. However, I missed 2 important pieces.

(2a) One was actually mentioned by LOL! but I did not give it enough weight at the time with all the other discussion. This relates to rebalancing. If I tried to maintain the same asset-allocation, I would also have to rebalance every year. Otherwise, with each passing year, I am increasing overall risk of the portfolio. I thought it might be non-trivial to put this into the model, but really it's simple - just consider a single year returns. Assuming you rebalance after a year, next year will follow the same "laws" and arrive as same "conclusions". So, just looking at 1 year is what's needed, but remember that minor differnces in 1 year will compund exponentially later one and therefore should not be dismissed even thought they are minor.

Now, an exception to above logic is that if in taxable account you pay taxes only after N years for stocks, how do you account for this when only looking at 1 year? One approach is to assume you pay capital gain tax rate after the 1 year for the earning of that year. However, a more correct variation would make it a lesser tax (since this tax is deferred over multiple years), but by how much?? Seems like this would depend on number of years, the returns on this rebalanced model, etc. For now, I assumed paying the tax after each year on the earning of that year, but some adjustment is needed.

(2b) A much more important part that was missing is my (lack of) accounting for risk. Interestingly, risk and return of stocks in taxable and tax-deferred accounts is different. This is because of taxes again. (See table 3 in the spwfe.fpanet.org paper I mentioned above and explanation for it.) While I had accounted for return differences, I did not account for risk. In short:

- In taxable account with tax t for your investment, your dollar earns R*(1-t) with the risk of SD*(1-t) for an investment with return R and standard deviation SD (measuring risk).

- In tax-deferred account, your after-tax dollar will earn full return R at the full risk SD. (Short explanation: say your nominal pre-tax $1 dollar produces $(1+X), which after taxes tn will give you $(1+X)*(1-tn). Now, recall that nominal $1 is the same as $(1-tn) real after-tax dollars. Thus, your original $(1-tn) after-tax dollars grew to $(1-tn)*(1+X).. In other words, each after-tax dollar grew by a factor of (1+X) giving it the full return of X. Same logic applies to standard deviation.)

What this means is that stocks (and non-zero-risk bonds) in tax-deferred accounts will produce higher returns but with higher risk. In other words, there are no longer just stock and bond investments when looking at taxable and tax-deferred accounts. Instead, there are 4 kinds of investments:

- Real after-tax dollar in taxable accounts can be invested in StocksPreTax and/or BondsPreTax

- Real after-tax dollar in tax-deferred accounts can be invested in StocksAfterTax and/or BondsAfterTax

Each will have its own returns and risk with the (1-t) factor differentiating PreTax and AfterTax investments.

(3) It no longer makes sense to me to say what an asset allocation is in terms of percentage in stocks vs bonds, since both stocks and bonds have to be qualified as indicated above. For example, (after converting to principal to after-tax dollars), $1000-StocksPreTax and $1000-BondsAfterTax allocation is different from $1000-StocksAfterTax and $1000-BondsPreTax. Claiming that both are 50/50 stock-bonds allocation is misleading. They have different risk and return characteristics.

(4) To decide whether it's best to hold StocksPreTax+BondsAfterTax or StocksAfterTax+BondsPreTax, the following technique can be used (it's an extension of a technique in the http://wpweb2.tepper.cmu.edu/spatt/location.pdf paper where they consider bonds which are risk-free).

(4a) Find out a ratio of tax-deferred and taxable amounts such that standard deviation SD of both combinations is the same. In other words, find ratio between after-tax dollars in taxable and tax-deferred accounts to make risk the same.

For example, say "tc" is tax on capital gains and "to" is ordinary income tax. If bonds are completely risk-free with SDbonds = 0, then for every $1 in tax-deferred account, consider having $1/(1-tc) in taxable account. Then,
- portfolio 1: $1-StocksAfterTax + $1/(1-tc)-BondsPreTax. SDportfolio = SDstocks * [1 / (1+1/(1-tc))] = [(1-tc)/(2-tc)]*SDstocks
- portfolio 2: $1-BondsAfterTax + $1/(1-tc)-StocksPreTax. SDportfolio = [SDstocks * (1-tc)] * [ (1/(1-tc)) / (1+1/(1-tc))] = [(1-tc)/(2-tc)]*SDstocks

(4b) Find out whether portfolio 1 or portfolio 2 has higher expected return (ER). Whichever one has higher return indicates which combination is better since for every portfolio with opposite combination, one could switch stocks and bonds in the proportion found in 4(a) without changing SD and obtaining higher returns. In above example with 0-risk bond, expected returns are:

- portfolio 1: $1-StocksAfterTax + $1/(1-tc)-BondsPreTax. ERportfolio = ERstocks + ERbonds*(1-to)/(1-tc)

- portfolio 2: $1-BondsAfterTax + $1/(1-tc)-StocksPreTax. ERportfolio = ERbonds + ERstocks*(1-tc)/(1-tc) = ERbonds + ERstocks

Since ordinary tax to is expected to be greater than capital gains tax tc, portfolio 2 should be preferred to portfolio 1 for risk-free bonds.

(5) Now, do the same results apply to non-risk-free bonds? I put together a spreadsheet which computes (4a) and (4b) for this more general case. I found that in most cases the answer is the same, but in some combinations it's not. However such combinations are not under "normal" conditions. For example, with 20% cap gains tax, 25% ordinary tax, 8% stock returns with 15% SD, and 4% bond returns with 6% SD (and 0.1 correlation), stocks should be in taxable account. However, moving SD of bonds from 6% to 11% makes them better candidates for taxable account with rest of parameters being the same.
 
smjsl..............I must confess to not understanding much (perhaps most:confused:) of what you said which is the same feeling I got when I tried to read the Bogleheads references but it sounds you got something out of that and so I am glad to have been part matchmaker there. Thanks for the followup......often you learn when you are forced to prepare a presentation so I'll take the credit for that too :) . The concept of AA corrected for tax effects is something I learned from you so thanks for that.
 
No problem kaneohe, and thanks to you too - you deserved those credits indeed ;-)

Perhaps my post was more technical then it should have been. Let me mention a couple of things that might make it easier to understand.

Whenever you try to understand if one portfolio is better than another you have to assume what your portfolio ingredients return. For example, people often assume based on historical record that stocks will have higher returns than bonds. So, you could say invest everything in stocks and nothing in bonds and you will get highest resulting wealth. While this is true (historically speaking), the issue of course if that stocks are riskier, and so somehow you also have to account for risk when evaluating how good a portfolio is. Researchers measure risk in standard deviation today (i.e. how widely actual returns vary around the expected returns).

Now in my OP I had two portfolios which while they invested same amounts of real money into "stocks" and "bonds", the investments actually had different risk profiles because stocks (and bonds) invested in taxable accounts are actually less risky then stocks in tax-deferred ones. So in my original OP, higher-risk portfolio had higher returns, which is not surprising. (Plus it was getting riskier and riskier as years were passing by due to no rebalancing.)

So, once this is taken into account, it turns out that in most cases it might indeed be better to have stocks in taxable accounts... Now, this again assumes a certain model. Presumably this model is better and more correct than my original one, but it still has some limitations that I mentioned above (i.e. it does not account for stock dividends but taxes stock returns each year at capital gains rate, plus it uses the standard deviation to equate risk of two portfolios).
 
smjsl.......thanks for the layman's version. That helped.
 
it still boils down to what you plan to do with the money...if its money your passing on that will be left over nothing beats having those nice growing equities in a roth.

while equities in a taxable account is nice for passing stepped up tax free money to heirs the ability to have 100 years or more of tax free compounding that can go on for generations in a roth trumps all...


inheriting the taxable account has the tax free compounding stop there, thats why i intend to keep only equities in my roth...


once thats filled with as much as i can do ill fill up the taxable account with equities next..

any traditional ira and 401k money in bonds will stay that way and ill be spending that down second to cash in my taxable account but i will also hold the left over bonds in my taxable account too. i wouldnt want to waste any of my higher growth roth money on bonds which might have more limited potential to grow if markets go back to normal........


sooooo bottom line, equities in the roth,,, equities in my taxable--- shorter term bonds in my taxable and traditional ira's ,rest in taxable cash.




if i was going to spend every penny i would do it differently
 
Since a non-spousal inherited Roth has required minimum distributions, how does it go on for hundreds of years?

OTOH, I can see how a taxable account could go on tax-free because each time it gets inherited the investments could get a stepped up basis.

But stocks in Roth if you have room for all fixed income in 401(k) or traditional IRA makes sense ... as long as the stocks don't lose money and/or become worthless.
 
LOL! I had the same question myself..........non-spouse inheritor can name beneficiaries but doesn't RMD schedule stay fixed based on original inheritor.....I suppose if a newborn was original inheritor.........but that still would be pushing it. Actually what was said was a hundred yrs or more (not hundreds of yrs) so a combination of spouse inheriting and then a newborn could get you over a hundred.
 
From Farimark.com: Inherited Roth IRA

For a [Roth IRA] beneficiary other than a spouse, distributions must satisfy one of the following rules:

  • Rule 1: Receive the entire distribution by December 31 of the fifth year following the year of the owner's death.
  • Rule 2: Receive the entire distribution over your life, or over a period not extending beyond your life.
The original owner may have specified which rule applies in the document used to set up the Roth IRA. More often, the choice is left to the beneficiary. If the choice is yours, you have to choose by December 31 of the year following the year the death occurred, because that's the last day to start receiving distributions under Rule 2.
Click to expand...
 
THE ANSWER IS: because the gains in your equities should surpass in growth the required distributions ...these roths can go on a very very long time. each generation can actually end up with more then they started. the distributions are pretty small if your grand kids are beneficiares as well. dont forget rmds are based over their lifetime all the while compounding at a far greater rate. roths rmd's are based on the lifetime of the beneficiaries .

thats why you need the historical power of equities in the roths and not bonds.. although the last decade didnt hold true. non the less i think longer term equities will still win out.


http://www.fairmark.com/rothira/inherit.htm
 
depending when you start yours and if grandchildren are beneficiaries i think it will go over 100
 
kaneohe said:
Mathjak....I think what LOL! was trying to say is that you can't get over a hundred yrs stretch w/ a non-spouse beneficiary only. Hopefully this is the right table......it shows a max of 82+ yrs stretch (still pretty long tho)
Single Life Expectancy Table for Inherited IRAs
Click to expand...


thats just one person, the gains usually far out pace the withdrawls so its possible for your beneficiary to even end up with more then they even inherited.. i forget the numbers in ed slots book he used but they were mind blowing.. so you got your lifetime to compound tax free, your beneficiaries lifetime and if your beneficiary is a grand child that money would probley go on forever to be passed on ...it all depends on the gains outpacing the rmds......
 
mathjak........wasn't questioning the fact that gains could far outpace withdrawals. Just the fact that it would go on forever WITHIN the Roth. I think the table I referenced shows that a newborn would have to use an initial lifetime in the RMD of 82.4 yrs and then reduce it by 1 each yr (small words on the top). After 82 (or 83?) iterations the divisor becomes less than 1 which means the Roth is over. Since the non-spouse beneficiary can name new beneficiaries but the RMD calculation does not change when the first beneficiary dies, the Roth ends at that point. As you stated, the Roth can go over a hundred yrs if you start counting when you started it plus more for a spouse beneficiary plus the final 82or 83 yrs if you have the first non-spouse beneficiary be
a newborn..........but it can't go on forever as a Roth. Still you could have a pretty big pile of dough there in a taxable account.
 
exactly, yes counting your own and grandchildren i think ed slott came up with 103 or 106 years but thats not counting your heirs funding their own roth with the tax free rmd's so that keeps the clock going too... none the less its a very powerful tool for passing tax free money...

unlike the 2nd best which is appreciated equities in a taxable account which steps up in basis but looses first place because it dosnt compound tax free for the heir and there may be taxable dividends and interest along the way unlike the roth.
 
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