Article: Why you should Hold Bonds in a Taxable Account

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Article: Why you should Hold Bonds in a Taxable Account

Postby ThinSlicer » Tue Dec 25, 2012 2:07 am

Hi All!

Long time lurker, first time poster here.

I recently read the article "Why you should Hold Bonds in a Taxable Account" by Gil Hanoch and wanted your opinions and perspective on it. I know it goes against standard Boglehead advice, and I am having trouble determining if the author's perspective makes any sense.

http://www.qualityasset.com/articles/2012-12%20Why%20you%20should%20Hold%20Bonds%20in%20a%20Taxable%20Account.htm

Summary

The rule of thumb: “hold bonds in retirement accounts, due to their worse tax treatment”, does not hold for investors that optimize their bond and stock investments, for two main reasons: (1) when withdrawing bonds from the retirement account during stock declines you lose the tax benefit forever; (2) the higher growth of stocks results in higher tax amounts over time.


Thanks,
ThinSlicer
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Re: Article: Why you should Hold Bonds in a Taxable Account

Postby Noobvestor » Tue Dec 25, 2012 12:17 pm

ThinSlicer wrote:Hi All!

Long time lurker, first time poster here.

I recently read the article "Why you should Hold Bonds in a Taxable Account" by Gil Hanoch and wanted your opinions and perspective on it. I know it goes against standard Boglehead advice, and I am having trouble determining if the author's perspective makes any sense.

http://www.qualityasset.com/articles/2012-12%20Why%20you%20should%20Hold%20Bonds%20in%20a%20Taxable%20Account.htm

Summary

The rule of thumb: “hold bonds in retirement accounts, due to their worse tax treatment”, does not hold for investors that optimize their bond and stock investments, for two main reasons: (1) when withdrawing bonds from the retirement account during stock declines you lose the tax benefit forever; (2) the higher growth of stocks results in higher tax amounts over time.


Thanks,
ThinSlicer


Hi Thinslice-

Welcome, belatedly perhaps, to the forum!

If you search around, you'll find other discussions (and a good Wiki section) on the stock/bond placement issue. At a glance, my reaction to the two points you quoted is as follows:

1) That's a curious if/then scenario, but it's just one scenario - hard to say what stocks/bonds will be doing that far from now. The longer you can delay taxes, in general, the better, so kicking it down the line is a good default regardless, which leads me to ...

2) Stock growth is taxed differently from bond growth - you pay on basically all taxable bond growth as it all comes out in coupon payments, but much less on stock growth because only some of it comes out in the form of dividends.

That said, there are a lot of individual circumstances to consider, including what type of retirement account we are talking about and what a person's portfolio is. By necessity, I hold some bonds in taxable and some in tax-advantaged, but I'm very conscious of what I buy in taxable (munis and I Bonds and EE bonds) accordingly.
"In the absence of clarity, diversification is the only logical strategy" -= Larry Swedroe
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Re: Article: Why you should Hold Bonds in a Taxable Account

Postby Liquid » Tue Dec 25, 2012 12:27 pm

I think this article makes a good point. Many Bogleheads focus on tax rate rather then tax amount, which can be a (very) costly choice.
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Re: Article: Why you should Hold Bonds in a Taxable Account

Postby livesoft » Tue Dec 25, 2012 12:29 pm

The author dispels their own notion by referring to their footnote 1:
There is a sophistication that can help you get around this limitation, but is not very practical due to its complexity and excessive trading. 1

I see nothing sophisticated nor impractical nor complex about the idea expressed in footnote 1. There is no excessive trading either. It seems to me that someone wrote an objection to the idea in the article at some point and the author threw in the statement I quoted and the footnote in order to argue against that objection. However, I am unimpressed. The footnote restates what has been in the Bogleheads wiki for years: Wiki article link: Placing Cash Needs in a Tax-Advantaged Account

There are reasons for bonds in a taxable account that have been better expressed by Rick Ferri and tfb here on the forum (see viewtopic.php?f=1&t=104265 for some discussion and links of tfb's arguments). Ferri's arguments IMHO are mostly of a behavioral finance nature and not a math nature: Hist clients sleep better at night if they don't see volatility in taxable accounts.

So whatever floats your boat. My boat is floating in a sea of 0% tax rate on my taxable holdings because of previous carryover losses and preferential treatment of long-term (5-year) capital gains.
Last edited by livesoft on Tue Dec 25, 2012 12:32 pm, edited 1 time in total.
It's all about short-term opportunistic rebalancing due to a short-term change in one's asset allocation, uh, I mean opportunistic rebalancing, uh I mean rebalancing, uh I mean market timing.
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Re: Article: Why you should Hold Bonds in a Taxable Account

Postby grabiner » Tue Dec 25, 2012 12:31 pm

The underlying points are correct: stocks lose less of their value to taxes each year, but since stocks are expected to grow faster than bonds, they will eventually lose more of their total value. If your time horizon is long enough, then it is better to tax-defer stocks. However, with most assumptions, "long enough" is more than your lifetime.

The article made two unreasonable assumptions which favor stocks in tax-deferred. It assumed a 15% growth rate for stocks, which is far above the historical rate. And it understated the amount of tax deferral you can get with an index fund: if stocks have a 2% yield, the tax is 0.40% each year (with their assumed 20% combined tax rate), and the capital-gains tax when you sell can be divided by the full number of years you hold the stocks, for an effective rate likely to be about 0.7%.

It also made two assumptions which favor bonds in tax-deferred. Bonds are assumed to have 5% yield, which is historically reasonable but far above current rates. And if you hold bonds in a taxable account in a 40% combined tax bracket, you wouldn't hold corporate bonds taxed at 40%, but municipal bonds, probably from your own state. Given current yields, it might actually make sense to put municipal bonds in a taxable account, with the intention of switching (and selling the bonds for a capital loss) when rates rise.

The third point, about losing the tax deferral when you sell bonds, doesn't make sense.

Given that you use your bonds whenever there are stock declines (assumption #1 at the top), as soon as you experience a stock decline, you would withdraw the money, and would not be able to put it back in. This would result in losing the retirement account tax benefit forever, due to a single stock decline.


And you lose the same benefit if your retirement account is all stocks and you sell stocks from that account during a rising market.

There is a sophistication that can help you get around this limitation, but is not very practical due to its complexity and excessive trading:

Say you need $10k from bonds during a stock decline. You can do the following:

Taxable account: sell $10k stocks

Retirement account: sell $10k bonds, buy $10k stocks

Once your stock portfolio recovers, you can move the stocks in the retirement account back to bonds (sell $10k stocks, buy $10k bonds)


This is only "excessive trading" if you have a lot of different individual bonds and stocks. If you have a bond fund, or a bond portfolio of Treasuries, you can sell bonds and buy a stock index fund or ETF in your IRA with a few mouse clicks.
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Re: Article: Why you should Hold Bonds in a Taxable Account

Postby Bob's not my name » Tue Dec 25, 2012 12:42 pm

See this recent thread for further discussion: viewtopic.php?f=10&t=106053
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Re: Article: Why you should Hold Bonds in a Taxable Account

Postby ThinSlicer » Thu Dec 27, 2012 5:10 am

Thanks everybody, you were all very helpful in helping me understand this!
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