Tax efficient asset allocation

[Gumby]

One thing I have been doing recently is thinking about optimizing where my money is located with respect to taxes. And I have found it is a little more complicated than just saying "put everything in your Roth because it doesn't get taxed." To explain, let's quickly summarize tax treatment of each option.

1. tIRA - Tax is deferred until withdrawal. However, every capital gain, all interest and all dividends received in that account will be treated as ordinary income when I withdraw them. I can't take advantage of capital losses to offset capital gains or ordinary income, I can't take a credit for foreign taxes paid, I don't get a lower tax rate for qualified dividends and capital gains.

2. Taxable - I get taxed every year, but I can offset capital gains and limited ordinary ordinary income with capital losses, and I get a lower tax rate on capital gains and qualified dividends (0% or 15% depending on my income)

3. Roth -- nothing gets taxed. I find it helpful to quantify the tax avoidance benefit. It is my marginal tax rate for ordinary income and 0% or 15% for capital gains or qualified dividends.

So, all other things being equal, how do I allocate my assets?
I put things like my high interest CD's, which generate only ordinary income, first in my Roth (no tax) and second in my IRA (taxed the same as in taxable account). I put things that will generate capital gains or losses and qualified dividends, or for which I will pay foreign taxes, in my taxable account. I can put things that generate ordinary income, like non-qualified dividends and interest in my tIRA because it will be taxed the same (eventually) as if it were in my taxable account, and equities if I must to meet my allocation goals.

Now, assume that I have my taxable account full of nothing but stock paying qualified dividends, but it is not sufficient to match my desired equities allocation. All the rest of my money is in either tIRA or Roth. Where do I put the rest of the equities? I think I should put them, to the extent possible, in my Roth, because every day they remain in my tIRA they are converting capital gains and qualified dividends into eventual ordinary income.

Finally, here's what is proving to be a real brain twister, which was inspired by another thread. Assume I've done the tax rate arbitrage analysis and I'm trying to drain my IRA before I have to take RMDs so I do a Roth conversion Should I pay the taxes out of the conversion or put it all in the Roth and take the taxes out of my taxable account? Either way, I will have less in my portfolio overall because I just had to pay taxes on a tIRA distribution. The question is what would be best going forward?

Here are the possibilities:

1. I sell equities in my tIRA, convert that entire amount and buy dividend paying equities in my Roth. I sell the same equities in my taxable account where I have been paying 0% on qualified dividends due to my income, so I can pay the tax. Going forward, there is no change in my taxation vis a vis those dividends, they still get taxed at 0%. If there is also a capital gain on the equities I have sold, I have to realize that now and take the tax consequences of that. If I leave them in my taxable account my heirs will get a step up basis.

2. If I pay taxes from the tIRA distribution and convert the net amount, I will have less stock and hence less qualifying dividends in my Roth, but it will stay in my taxable. Assuming my income remains the same, the tax treatment remains the same for those dividends.

In this situation, I see a benefit from paying taxes out of the distribution.

However, what if I am already at my desired equities position and I am just moving ordinary interest and dividend producers around?

1. I convert the whole amount and pay the taxes from taxable. To maintain the same allocation, I'm going to have to buy some more equities in my Roth to make up for the ones I've sold in my taxable in order to pay the tax. The rest of the conversion I can put toward fixed income - generating what otherwise would be ordinary income. As above, I may have to realize capital gains and my heirs wont get a step up.

2. I pay taxes from the distribution and convert the net. Then, I still have the same amount of equities, because I neither sold any from my taxable account nor bought any in the Roth. I'll have less fixed income in the Roth.

Again, I see an advantage to paying taxes out of the distribution in this situation.


I'm interested in whether people see these issues in the same light.

 

[GrayHare]

Looks like two possibilities: 1) all of tIRA rollover winds up in Roth with tax paid from regular account, or 2) part of tIRA winds up in Roth, and part pays the taxes, leaving more in regular account. I like #1 because it ends up with more in Roth (tax free) and less in my regular account (taxed).

 

[mrfeh]

https://www.bogleheads.org/wiki/Tax-efficient_fund_placement

 

[qwerty3656]

Funding the taxes out of taxable is going to get you the bigger Roth balance at the end of the day. Its hard to see how that is worse in the long run.

 

[Gumby]

Funding the taxes out of taxable is going to get you the bigger Roth balance at the end of the day. Its hard to see how that is worse in the long run.

That is the intuitive answer and one that until very recently I would have given too. But I am no longer sure it is the correct one based on the scenarios described in my original post.

 

[Gotadimple]

I see a nuance here that you may not have defined. Type of investment product.

Are your 'stocks' in individual stocks? Mutual Funds? ETFs? Are the mutual funds index funds? Are the ETFs based on broadly followed indices?

So the short answer to asset location (for me) is:
Taxable: Foreign stock ETFs producing dividends as well as foreign taxes which can be recaptured on your income tax. Add in a money market fund to hold all distributions and provide some flexibility for any rebalancing needed during the year. Pay taxes on T-IRA distributions from this account.

Tax deferred: bonds, primarily ETFs for the lower expense ratio. Or a bond ladder (which takes more management but doesn't incur management expenses). A broad market stock ETF to provide growth, and a money market fund to hold dividend payments. ETFs generally don't produce capital gains. Everything is taxed as ordinary income. Have a strategy for depleting this investment to fund retirement (RMDs, QCDs, general distributions, Roth conversions, etc.)

Tax-free: Mostly stocks in a mix of ETFs depending on your definition of your asset allocation (large, small, emerging) tempered by a small investment in bond fund(s) to tamp down volatility. A money market to receive dividend payments, provide flexibility for rebalancing, or mitigate taxes if you prefer to hold T-IRA distributions lower but need the cash to live on.

 

[GrayHare]

1) Withdrawals from a tIRA are subject to tax at ordinary rate. There is no way to avoid that. Those rates are scheduled to increase in a couple years. 2) Withdrawals from taxable investments are subject to tax at capital gains rate, but can be avoided partially or entirely by tax loss harvesting. If your situation is such that #1 tax rate is less than #2 tax rate (which I can't envision), then yes, pay tax with tIRA dollars.

 

[Finance Dave]

Wouldn't the answer depend on how each "grouping" of investments does in the coming year (which we can't predict accurately)? For example, if the market drops 30%, it would have been wise to take the funds from the grouping that has the highest % of equities...thus avoiding the 30% drop on the amount you withdrew to pay for the taxes on the conversion.

I do like the way you've framed the issue, and I have to consider similar things our our case. For us, we don't own much in the way of "individual" securities, just broad indexes/indices?. We keep our growth investments in our Roth accounts, and coincidentally the balances in our Roths are about where we are comfortable in terms of AA...so we don't keep much equities in our taxable accounts.

 

[SevenUp]

Funding the taxes out of taxable is going to get you the bigger Roth balance at the end of the day. Its hard to see how that is worse in the long run.

That is the intuitive answer and one that until very recently I would have given too. But I am no longer sure it is the correct one based on the scenarios described in my original post.

In the original post it appears there is a change in asset allocation when you move money from traditional to Roth. If so, that may overwhelm any nuance regarding the source of the tax payment.

Assuming the same asset allocation in both traditional and Roth (if only for the converted amount), then paying the taxes from cash flow is better as qwerty3656 suggests. If you have to sell some investments and incur capital gain taxes, then it depends on how much extra tax you have to pay.

The "Traditional plus taxable" vs. Roth part of the Bogleheads wiki goes into more detail.

 

[Exchme]

There is nothing wrong with holding the same asset allocation in all 3 types of accounts. Folks get wrapped up in trying to be "tax efficient" by putting bonds in tax deferred, stocks in Roth/taxable, but don't notice that they have increased their risk because gains/losses in tax deferred are shared with the government, but in Roth it's all on you. That extra risk is precisely where the return comes from. You could achieve the same extra return by simply increasing your allocation to stocks in all accounts.

As to other points in the OP, it doesn't seem likely to me to be optimal to drain tax deferred prior to RMDs. The best strategy for Roth conversions is usually to equalize the marginal tax cost of getting the money out of tax deferred. Plus tax deferred is a good way to pay for long term care if you need it, is nice to have charitable bequests or QCDs too.

Roth conversions are generally better if taxes are paid from taxable as that reduces future tax drag. But the amount of capital gains taxes that have to be paid and the time before one passes and the heirs get a step up basis do matter.

 

[Gumby]

There is nothing wrong with holding the same asset allocation in all 3 types of accounts. Folks get wrapped up in trying to be "tax efficient" by putting bonds in tax deferred, stocks in Roth/taxable, but don't notice that they have increased their risk because gains/losses in tax deferred are shared with the government, but in Roth it's all on you. That extra risk is precisely where the return comes from. You could achieve the same extra return by simply increasing your allocation to stocks in all accounts.

As to other points in the OP, it doesn't seem likely to me to be optimal to drain tax deferred prior to RMDs. The best strategy for Roth conversions is usually to equalize the marginal tax cost of getting the money out of tax deferred. Plus tax deferred is a good way to pay for long term care if you need it, is nice to have charitable bequests or QCDs too.

Roth conversions are generally better if taxes are paid from taxable as that reduces future tax drag. But the amount of capital gains taxes that have to be paid and the time before one passes and the heirs get a step up basis do matter.

Apologies. I was imprecise in my wording. I meant drain in the sense of reduce, not completely empty, for the very reasons you list.

 

[GrayHare]

Planning for cost basis step up, while a nice idea, is made complicated by changing tax laws. I suppose you could put all the relevant factors into a spreadsheet, including estimated tax rates of your tIRA beneficiaries, and play with the numbers, but I suspect the uncertainty about future tax rates, plus compounding over time, would quickly exceed any potential savings from optimizing the payment of rollover taxes now.

 

[MarieIG]

During my employment (unfortunately) for the most part I followed a tax maximization strategy by ignoring my taxable accounts and just walking down the hall and requesting additional withholding from my paycheck. That did come home to roost - and I have been working on becoming a bit more tax efficient.

I am trying to keep CDs in my traditional IRA for now (although I did slip up with [-]one[/-] two over at NFCU) as they are subject to State, Federal and NIIT.

I do have some funds in T bills from the sale of our house, as those funds are to be earmarked for a retirement house. When they mature, I will put those funds into a tax exempt MM (NY & Federal).

The holdings in my Roth don't match my taxable account. I have ditched all funds in my taxable which throw off capital gains distributions and have replaced them with ETFs. I don't have REITs in my taxable and am trying to slowly reinvest higher dividend payers into more broad-based ETFs (when they are a reasonable valuation). I convert shares in kind when the market is down (there was some converting in kind going on in October) and cash when the market is up.

At least for this year and next year, I am going to use divvies and interest from taxable accounts to pay the tax to cover the conversions (so I'm not selling holdings with embedded gains). I do have some tax lost harvesting available (which I took to offset the sale of my sub-par, high cost, tax-spewing funds) but am not sure that I have anything I want to sell at the moment. Going back - I also played around with i-orp re: Roth conversions.

Thus far, when DH takes money out of his "fun money account" (traditional IRA) he (ok, not he/ it's really me) has money withheld from that account to cover the taxes. I am fine with that account being drained by the time DH is 70 and able to collect SS and would like it to be drained by the time he is subject to RMD. I made a small conversion from his fun money account to at least start a Roth for him this year - and I paid the taxes on those from my taxable.

I had considered your strategy about paying taxes out of the traditional, and will revisit that in the future, in particular with regard to DH's 401k. I would like to keep a bit of funds in my traditional for future QCDs.

Full disclosure - I'm not terribly strict with my AA although I'm not planning to be out of equities - and I do like to keep a bit of dry powder on hand for taxes and market opportunities.

 

[thefist]

Here’s a few more items to consider:
1) at least until 2026, the 12% ordinary bracket is lower than 15% LTCG. This is certainly income dependent (for use of 0).
2) Treasuries are state tax exempt, so if you have state tax, then locating treasuries in taxable can make sense. REIT and corporate bonds would go in TIRA.
3) Even if you’re an indexer, you could further optimize by buying value and growth separately, such as VTV and VUG. Or maybe in your case, VUG and a dividend fund. Put the growth in taxable to reduce the forced dividend income

 

[target2019]

If you pay the Roth conversion tax from the converted amount, I believe the consensus wisdom is that you negate the long-term benefit. Many threads go into that, in extreme detail.

Part of my monthly look at investments includes a sheet where specific amounts are listed with the fund and its category. We have about 20 investments in 9 accounts. I have additional columns where I can add or subtract money. With a toggle, the AA is recalculated. So, this useful to witness the AA change with a conversion. Problem one was that I had no Total US Stock fund in the Roth to receive the conversion. So a decision was made to add that fund. I'm not relating this to convince you of anything, except to look closely at portfolio changes. And of course YMMV since everyone's details are different.

We are not shooting for everything in Roth. We're trying to increase those Roth accounts with reasonable conversions each year.

 

[SevenUp]

If you pay the Roth conversion tax from the converted amount, I believe the consensus wisdom is that you negate the long-term benefit.

"Negate" is probably too strong. "Somewhat reduce" is probably more apt.

 

[Al18]

When I made last years Roth IRA conversion, the Fidelity rep mentioned I could do an in-kind conversion. I did not give this much thought at the time. Seeing my IRA balance continue to increase last year, I’m think of doing an in-kind conversion of my fastest increasing mutual fund, rather than conversion of money in my Money Market fund.

 

[pb4uski]

I think you are on the right track.

In short, equities in taxable since qualified dividends and LTCG are tax preferenced and foreign taxes paid get a credit that goes to waste if foreign equities are held in tax-deferred and tax-free accounts and if equities allocation exceed taxable account balance, then remainder of equities are held in tax-free accounts since their higher growth is then tax free.

Fixed income that generate ordinary income and are lower growth in tax-deferred accounts.

If fixed income allocation exceeds tax-deferred accounts, then excess can either go into Roth or converted to tax-free munis in taxable account.

And pay Roth conversion taxes out of taxable account money... it is like putting taxable account money in the Roth when compared to paying for taxes on Roth conversion out of the conversion amount. However, this may be less attractive where taxable is all equities in that if you have to redeem equities to pay the Roth conversion tax you might also have capital gains taxes on the redemption vs no tax if you pay the Roth conversion tax out of the conversion and get stepped up basis. No clear answer in that scenario.

 

[Gumby]

I think you are on the right track.

In short, equities in taxable since qualified dividends and LTCG are tax preferenced and foreign taxes paid get a credit that goes to waste if foreign equities are held in tax-deferred and tax-free accounts and if equities allocation exceed taxable account balance, then remainder of equities are held in tax-free accounts since their higher growth is then tax free.

Fixed income that generate ordinary income and are lower growth in tax-deferred accounts.

If fixed income allocation exceeds tax-deferred accounts, then excess can either go into Roth or converted to tax-free munis in taxable account.

And pay Roth conversion taxes out of taxable account money... it is like putting taxable account money in the Roth when compared to paying for taxes on Roth conversion out of the conversion amount. However, this may be less attractive where taxable is all equities in that if you have to redeem equities to pay the Roth conversion tax you might also have capital gains taxes on the redemption vs no tax if you pay the Roth conversion tax out of the conversion and get stepped up basis. No clear answer in that scenario.

We are on the same wavelength. I had always thought that it would be better to pay taxes on the conversion out of taxable, if you can, because it's like getting a free Roth contribution when you wouldn't otherwise be eligible. But that last scenario recently popped into my head and, as I thought more about it, I concluded it was not the slam dunk I once thought. It depends on one's particular allocation of assets.

I think it's healthy to challenge myself sometimes and question things that I have long believed to be true.

 

[OldShooter]

Wouldn't the answer depend on how each "grouping" of investments does in the coming year (which we can't predict accurately)? For example, if the market drops 30%, it would have been wise to take the funds from the grouping that has the highest % of equities...thus avoiding the 30% drop on the amount you withdrew to pay for the taxes on the conversion.
...

That seems pretty consistent with Will Rogers' advice: "If it don't go up, don't buy it."