Expat trying to understand bond allocation in a taxable fund

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northernisland
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Expat trying to understand bond allocation in a taxable fund

Post by northernisland »

I'm a lowish income expat living in Asia, which limits my ability to fund a Roth (only when I go back to the states every few year and have taxable income) and removes any tax benefit for a 401k.

Since at some point we'll want to return to the States (but will probably be five years and could be twenty) I want a generic diversified portfolio that could eventually fund a house down payment, cars, etc. Right now I have Vanguard's 500 and international stock funds and I'd like to add a bond fund.

I've seen several times on the forum that it's bad to have bonds in a taxable account. Is this true of bond funds also? Would it be true in a low tax bracket? Can you give me advice on any benefit for a state-specific fund? (We're nominally NJ residents, but as expats won't pay tax there this year.) We are looking to "buy and hold" with minimal tinkering and hopefully no extra paperwork.

Thank you for helping a newbie! Book recommendations, website links, or other help are welcome.
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fredflinstone
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Post by fredflinstone »

Welcome to the Bogleheads Forum! If you have not already done so, you should definitely read a few of the books on the Boglehead recommended reading list:

http://www.bogleheads.org/readbooks.htm

You are right to be thinking about buying bonds, and you are right to be concerned about the tax implications. this wiki might be helpful:

http://www.bogleheads.org/wiki/Principl ... _Placement

in terms of tax efficiency, there is no difference between owning individual bonds and a bond fund. in terms of tax complexity certain types of bonds, e.g., TIPS, are (much) easier to own in a fund.

U.S. residents who own a national muni bond fund pay local and state income taxes on the interest payments, but not federal income taxes.

U.S. residents who own a state muni bond fund pay neither local nor state nor federal income taxes on the interest payments, assuming they buy a fund for the state in which they are a resident. Note that state muni bonds funds are less diversified than national muni bond funds and, as such, are riskier.

U.S. residents who own a treasury bond fund or TIPS fund pay federal income taxes on the interest payments but do not pay state or local income taxes. Treasuries and TIPS have the lowest credit risk of any type of bonds.

U.S. residents who own a corporate bond fund pay federal, state, and local income taxes on the interest payments.

Since you are in a low income tax bracket, tax-efficiency of your bonds is less important than for someone in a high income tax bracket. Do you expect to be in a low income tax bracket for the rest of your life?

I think a U.S. Treasury Bond Fund would probably be a good choice for you. It has the lowest credit risk of any type of bond fund and is only moderately tax-inefficient (i.e. you would not have to pay local or state income taxes on the interest payments). You would have to pay federal tax on the interest payments, but because your tax bracket is low this would not be too painful.

Other reasonable choices would be a national municipal bond fund or a New Jersey municipal bond fund. These are riskier than treasuries, but more tax-efficient.

Another question for you to think about is what duration of bond is appropriate for you. Most people on this Forum recommend an intermediate-duration fund, but assuming you continue to have an equity-heavy portfolio you might want to consider a long-term fund. Long-term bonds are volatile but they have a higher expected return than intermediate-term bonds and in equity-heavy portfolios they do a better job than intermediate-term bonds of reducing the volatility of your overall portfolio.
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northernisland
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thanks!

Post by northernisland »

Fred, this is very helpful. I have read the wiki and will reread. I've been reading a lot, but it still takes a while to figure out the different issues. Your explanation was actually much more helpful. I think I am getting a sense for how things work. Will the taxes be paid yearly then (on dividends), as with bank account interest, but also have capital gains when I sell?

I am thinking of buying the NJ LT Tax-Exempt Investor bonds, which are down a bit now. They seem like perhaps the least complicated for what I want to do now. I don't mind some risk, and I like the idea that it would reduce volatility. Is it right that they are optimized for NJ but if I later live in, say, OH, the worst case scenario is merely that I lose some of the tax exemption?

I think the challenge for us is the indeterminacy of length before we use the money. My salary will be pretty static here (although excellent medical and pension). My goal would be to move the accounts to cash in the calendar year before we return to the States.
joruva
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Post by joruva »

If you're in Asia and can't contribute to a Roth IRA, I'd assume you're taking FEIE which allows $92,900 in earned income to excluded from taxes in 2011. Since you are under this value, the Standard Deduction ($5,800) and Personal Exemption ($3,700) give a total of $9,500 additional tax relief for filing single in 2011. You threw a "we" in there--it's even higher if you're married.

This means you can earn $9,500 in dividends and capital gains tax free. It's going to be very hard to get this amount in dividends, so I would invest in your bond fund of choice and stay away from muni-bonds. I've seen it suggested that you should look at your portfolio as a whole and not just specific asset classes in isolation. In other words, invest in high quality bonds that will rise in value when equities are taking a dive. If I had the fund available in my 401k, I would choose VBIIX‎ - Vanguard Interm-Term Bond since it lacks mortgage backed securities.

Can you contribute to a 401k? Does it have a match? If so I would contribute up to the match at a minimum. And don't be so quick to dismiss your 401k without running some numbers. If you have 30 years before retirement, the tax free compounding may work in your favor, especially if you return to the US sooner than later. This article explains how taxes work on the 401k withdrawals:
http://thefinancebuff.com/case-against-roth-401k.html
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northernisland
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Post by northernisland »

Joruva, this is helpful. I hadn't understood how the Standard Deduction and Personal Exemption affected dividends and capital gains. Maybe I'll go with the total bond fund, which was my initial default choice. I'm not anticipating a lot in the fund to start with--maybe 5 or 10 thousand dollars. It also helps to realize how capital gains would work if I wanted to sell funds off later. Since I am married, this means we should be safely be in a low-tax range.

My plan is to keep 35,000-45,000 in Vanguard in the three taxable funds (500/international/bonds) as a nest egg should we go back to the States long term. However, every few years when we go back for three to six months I could move money into a Roth or the 403b.

My wife and I both work for the same employer and the 403 is through Fidelity, but there's no match. If we do a better job saving than anticipated, we'll look at the 403b more closely. Thank you for the link to the article.

We are in our mid-30s, so are trying to figure out a longterm plan. We have an emergency account, individual Roths, and some old 401ks. We also have small 529s started for our kids (as I understand it this is another tax-preferred account that doesn't require us to be in the States). Eventually I'll ask for whole portfolio help, but how to invest in a bond fund was the most pressing question.
Last edited by northernisland on Mon Feb 28, 2011 10:10 am, edited 1 time in total.
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fredflinstone
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Post by fredflinstone »

joruva wrote:If you're in Asia and can't contribute to a Roth IRA, I'd assume you're taking FEIE which allows $92,900 in earned income to excluded from taxes in 2011. Since you are under this value, the Standard Deduction ($5,800) and Personal Exemption ($3,700) give a total of $9,500 additional tax relief for filing single in 2011. You threw a "we" in there--it's even higher if you're married.

This means you can earn $9,500 in dividends and capital gains tax free.
I didn't realize this. If this is correct, then, yes, you should probably invest in either an intermediate- or long-term treasury fund.
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grabiner
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Post by grabiner »

fredflinstone wrote:
joruva wrote:If you're in Asia and can't contribute to a Roth IRA, I'd assume you're taking FEIE which allows $92,900 in earned income to excluded from taxes in 2011. Since you are under this value, the Standard Deduction ($5,800) and Personal Exemption ($3,700) give a total of $9,500 additional tax relief for filing single in 2011. You threw a "we" in there--it's even higher if you're married.

This means you can earn $9,500 in dividends and capital gains tax free.
I didn't realize this. If this is correct, then, yes, you should probably invest in either an intermediate- or long-term treasury fund.
Sorry, it doesn't work this way; check the Foreign Earned Income Tax Worksheet in the Form 1040 instructions. If you exclude X dollars of foreign earned income and your remaining income is Y dollars, the tax you pay is the difference between the tax on X+Y and the tax on X, not the raw tax on Y. Thus your investment income is taxed at the same rate as if you paid tax on all your foreign income.
Wiki David Grabiner
plats
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Post by plats »

grabiner wrote:Sorry, it doesn't work this way; check the Foreign Earned Income Tax Worksheet in the Form 1040 instructions. If you exclude X dollars of foreign earned income and your remaining income is Y dollars, the tax you pay is the difference between the tax on X+Y and the tax on X, not the raw tax on Y. Thus your investment income is taxed at the same rate as if you paid tax on all your foreign income.
It does work this way if your passive income is below your deductions and exemptions. Your Y income entered on Line 1 of the Foreign Earned Income Tax Worksheet is from 1040 Line 43, which would be reduced to zero. Anything over zero is, as you stated, taxed at the higher rates.
joruva
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Post by joruva »

northernisland wrote:Joruva, this is helpful. I hadn't understood how the Standard Deduction and Personal Exemption affected dividends and capital gains. Maybe I'll go with the total bond fund, which was my initial default choice. I'm not anticipating a lot in the fund to start with--maybe 5 or 10 thousand dollars. It also helps to realize how capital gains would work if I wanted to sell funds off later. Since I am married, this means we should be safely be in a low-tax range.

My plan is to keep 35,000-45,000 in Vanguard in the three taxable funds (500/international/bonds) as a nest egg should we go back to the States long term. However, every few years when we go back for three to six months I could move money into a Roth or the 403b.

My wife and I both work for the same employer and the 403 is through Fidelity, but there's no match. If we do a better job saving than anticipated, we'll look at the 403b more closely. Thank you for the link to the article.

We are in our mid-30s, so are trying to figure out a longterm plan. We have an emergency account, individual Roths, and some old 401ks. We also have small 529s started for our kids (as I understand it this is another tax-preferred account that doesn't require us to be in the States). Eventually I'll ask for whole portfolio help, but how to invest in a bond fund was the most pressing question.
It's very borderline whether or not you will come out ahead contributing to the 403b accounts. At mid-thirties your asset allocation may be around 35% bonds and 65% stock depending on your need and ability to take risk. Many people recommend 10% of your equities to be REIT, which is 6.5% at this allocation. If your 403b accounts have good bond and REIT funds (i.e. low expense ratios), you may want to use the 403b for the bond and REIT (41.5%) and the rest of your asset allocation is invested in a taxable account. This way you tax-shelter the most tax inefficient funds and get a good mix of tax deferred and taxable investments.

If you're planning to live overseas forever, forget the 403b. If you may move back, investing in the 403b may not be a bad idea. Maybe the best option is to invest solely in a taxable account for now. Once you move back the US you can max out all retirement accounts and withdraw from taxable investments if you need to supplement your income. Unfortunately this has been a gray area for me also. I have 32 years before I can even withdraw from my 401k, and I may move back to the US within a few years, so I've decided to contribute even though it's not reducing my taxes now.

One last thing: while qualifying for the FEIE, if in December you only have a small amount in dividends, bank account interest, and capital gains, but you're sitting on unrealized capital gains, you can sell realize capital gains to get as close as possible to the standard deduction and personal exemption amounts (leave some room for error as index funds distribute dividends and capital gains late December). This way you can buy funds at a higher cost basis which may allow you to tax-loss harvest in the future. Since you're married you and your spouse should get $19,000 in 2011 for standard deduction and personal exemption (check your taxes). Re-balancing taxable accounts while taking FEIE is much less painful than while living in the US.
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