stock vs bond in 401k vs taxable

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stock vs bond in 401k vs taxable

Postby vanbucky » Mon Jul 11, 2011 1:40 pm

Let's say I want to invest $10,000 ($13,333 pretax) in 401k and another $10,000 in a regular taxable account. I want a 50/50 allocation of stock fund and bond fund.

The stock fund return is 10%, no dividends, all capital gains.
The bond fund return is 5%, all dividends, no capital gains.
The tax rate is 25% for eternity.

Most articles I've read suggest to put the higher dividend investments in tax-deferred and lower dividend in taxable. But I think that only makes sense if you are comparing 2 investments with the same return.

According to my calculations with the above scenario (attempting to use historically realistic numbers), you would best off putting $13,333 pretax in the stock fund in 401k, and $10,000 in bond fund in taxable account.

I think this is because the stock fund's 10% return is higher than the bond fund's 5% return, so the capital gains tax advantage in 401k outweighs the dividends advantage.

Am I correct about this? Or are there some things I'm overlooking?
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Postby DSInvestor » Mon Jul 11, 2011 1:54 pm

Welcome to the forum. If you can max out the 401(k) for 16.5K and also contribute to IRAs (5K for you and another 5K for your spouse), you can side step the taxable account. If you're eligible for Roth IRA, that would be better than taxable account. Contributions to taxable accounts and Roth IRA are made with after tax money but Roth IRA offers tax free growth and withdrawals.

I recommend investing in taxable accounts only after maxing out tax advantaged accounts.

1. What tax bracket are you in? If you're in a high tax bracket fed and state, there will be significant loss to taxation if you place taxable bonds in taxable accounts as the bond income is taxable as ordinary income every year. The income from your taxable investments will be reported to you and IRS in 1099-DIV.

2. Stocks in the taxable account are effectively tax deferred as capital gains are only an issue when you sell shares. If you have held the stocks for longer than 1 yr, that would be a long term holding. Long term capital gains are taxed at lower rates than ordinary income.

3. Withdrawals from tax deferred accounts are taxed as ordinary income even if you hold stocks in the tax deferred accounts. If you will have other income in retirement to consume your lowest tax brackets, your withdrawals from tax deferred accounts will be taxed at higher marginal rates. Run your numbers carefully here.

Wiki article link: Principles of Tax-Efficient Fund Placement
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Fund location ?

Postby Taylor Larimore » Mon Jul 11, 2011 3:03 pm

Hi Van:
Welcome to the Bogleheads Forum where our investments are based Mr. Bogle's wisdom combined with academic research.

Vanguard did an extensive study of Asset Location and arrived at this conclusion:

"If an investor's primary goal is to maximize after-tax return, then, in general, an optimal portfolio, from an asset location perspective, would hold broad market index equity funds/ETFs or tax-managed equity funds in taxable accounts and taxable bond funds in tax-deferred accounts."


Asset Location for Taxable Investors by Vanguard Investment Counseling & Research
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Postby vanbucky » Mon Jul 11, 2011 3:25 pm

Thanks for your reply.

I recommend investing in taxable accounts only after maxing out tax advantaged accounts.


Actually, I'm not so much interested in personal investment advice. This is more for learning learning theoretical principles. I have read the Principles of Tax Efficient Fund Placement, and I'm not totally in agreement with Step 2, that's why I'm posting about this. (Sorry, I realized later that there is a separate forum for theory, I should have posted this there)

1. What tax bracket are you in?


For this scenario, assume 25% income rate forever. 15% long term capital gains.

2. Stocks in the taxable account are effectively tax deferred as capital gains are only an issue when you sell shares.


Yes, but aren't capital gains in taxable account effectively double taxed? First as income tax, second as capital gains.

3. Withdrawals from tax deferred accounts are taxed as ordinary income even if you hold stocks in the tax deferred accounts. Run your numbers carefully here.


I posted my calculations for the 2 scenarios, taking into consideration income tax and withdrawal. According to my calculations, Scenario 1 (stock fund in taxable acct, bond fund in 401k/Roth) will result in $85k after 20 years. Scenario 2 (bond fund in taxable, stock fund in 401k/Roth) will result in $88k after 20 years. That seems contrary to the general advice.

Doh, the forum is not letting me post the link because I'm too new. =(
Last edited by vanbucky on Mon Jul 11, 2011 5:49 pm, edited 1 time in total.
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Re: stock vs bond in 401k vs taxable

Postby YDNAL » Mon Jul 11, 2011 3:39 pm

vanbucky wrote:Let's say I want to invest $10,000 ($13,333 pretax) in 401k and another $10,000 in a regular taxable account. I want a 50/50 allocation of stock fund and bond fund.

The stock fund return is 10%, no dividends, all capital gains. (my emphasis)
The bond fund return is 5%, all dividends, no capital gains.
The tax rate is 25% for eternity.

Most articles I've read suggest to put the higher dividend investments in tax-deferred and lower dividend in taxable. But I think that only makes sense if you are comparing 2 investments with the same return.

According to my calculations with the above scenario (attempting to use historically realistic numbers), you would best off putting $13,333 pretax in the stock fund in 401k, and $10,000 in bond fund in taxable account.

I think this is because the stock fund's 10% return is higher than the bond fund's 5% return, so the capital gains tax advantage in 401k outweighs the dividends advantage.

Am I correct about this? Or are there some things I'm overlooking?

Undistributed (edit) Stock capital gains (Taxable) that you reinvest for eternity - taking a clue from your suggested tax rate - are NOT taxed unless sold.

Bond dividends are taxed as ordinary income.
Last edited by YDNAL on Mon Jul 11, 2011 4:24 pm, edited 1 time in total.
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Re: Fund location ?

Postby vanbucky » Mon Jul 11, 2011 3:58 pm

Taylor Larimore wrote:Hi Van:
Vanguard did an extensive study of Asset Location and arrived at this conclusion:

"If an investor's primary goal is to maximize after-tax return, then, in general, an optimal portfolio, from an asset location perspective, would hold broad market index equity funds/ETFs or tax-managed equity funds in taxable accounts and taxable bond funds in tax-deferred accounts."


Asset Location for Taxable Investors by Vanguard Investment Counseling & Research


wow, that was a great article, very similar scenarios to what I was looking at.

[edits in blue]
What I noted this is a comparison of Taxable vs Non-Deductible Tax Deferred (which would be like Non-Deductible Traditional IRA). Not 401k/Roth IRA. There's a huge difference!

When I plugged in the Taxable vs Non-Deductible Traditional IRA scenarios into my spreadsheet, then yes, I agree with the article that Scenario 1 (stock fund in taxable, bond fund in Non-Deductible Traditional IRA) is superior.

But look at the article's Scenario 1 and 2. If you do not tax on liquidation of the tax-deferred account (like for Roth IRA), you will end up with $1,067,500 vs $1,066,250 respectively. That is only a 0.1% difference.

The article is also assuming the max 35% income tax bracket. If you use a 25% income tax for the calculations, Scenario 2 will be superior.

So my conclusion based on this article is that for a 25% income tax bracket (which seems more likely for the average individual), comparing taxable vs Roth/401k, scenario 2 (bond in taxable, stock in Roth/401k) is superior.

I agree with Bogle's philosophies, but I also want to make sure I'm applying them in the proper context.
Last edited by vanbucky on Mon Jul 11, 2011 5:47 pm, edited 1 time in total.
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Postby vanbucky » Mon Jul 11, 2011 4:32 pm

OK, I am able to post the link now. Here is my spreadsheet:
https://spreadsheets.google.com/spreads ... E&hl=en_US

I changed the calculations to use Roth instead of 401k, and $500k as the initial investment, so that it will be easier to compare to the Vanguard article. You can download it as Excel and tweak the numbers as you like.

The assumptions are: income tax rate = 25%, long term cap gains tax = 15%, stock return of 10%, bond return of 5%.

My conclusion is that with the above assumptions, after 10 years, scenario 2 (bond in taxable, stock in Roth) is better by 2.8%. And that the articles saying the other way around are comparing Taxable to Traditional IRA, with 35% tax bracket.
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401k vs Roth returns ?

Postby Taylor Larimore » Mon Jul 11, 2011 4:52 pm

Hi Van:

What I noted is that this is a comparison of Taxable vs Tax Deferred (which would be like Traditional IRA). Not 401k/Roth. There's a huge difference!


Not as much difference as we might imagine.

If equal amounts are invested in a Traditional 401k and Roth IRA, and have the same investment returns, and no change in income tax rates, the investor will have the same amount of after-tax money when withdrawn.
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Re: 401k vs Roth returns ?

Postby vanbucky » Mon Jul 11, 2011 5:39 pm

Taylor Larimore wrote:If equal amounts are invested in a Traditional 401k and Roth IRA, and have the same investment returns, and no change in income tax rates, the investor will have the same amount of after-tax money when withdrawn.


I actually said "Traditional IRA vs Roth (IRA)". But I actually meant "non-deductible Traditional IRA". Sorry for the confusion.

If you look at the scenarios, in the tax-deferred account, they are investing the same amount as the taxable account: $500,000. Therefore I concluded that this example was more comparable to a non-deductible Traditional IRA.

If you're going to compare to Roth IRA, then you should not deduct taxes upon liquidation. If you're going to compare to a pretax account (401k, traditional IRA), then the should have invested a pretax amount (like $769,230). In either case, Scenario 2 would be superior or about equal to Scenario 1 (depending on tax bracket).
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Re: stock vs bond in 401k vs taxable

Postby grabiner » Mon Jul 11, 2011 8:40 pm

vanbucky wrote:According to my calculations with the above scenario (attempting to use historically realistic numbers), you would best off putting $13,333 pretax in the stock fund in 401k, and $10,000 in bond fund in taxable account.

I think this is because the stock fund's 10% return is higher than the bond fund's 5% return, so the capital gains tax advantage in 401k outweighs the dividends advantage.

Am I correct about this? Or are there some things I'm overlooking?


If you put the stocks in the 401(k), you are taking on more risk. $13,333 in a 401(k) is worth the same as $10,000 in a Roth IRA, which is worth much more than $10,000 in a taxable account. Thus, if you have $13,333 in a 401(k) and $10,000 in a taxable account, your portfolio is effectively more than 50% in the 401(k).

In practice, the taxes on a taxable account and 401(k) are about equal; the 401(k) will lose 25% of its value to taxes on withdrawals, while the taxable account (if invested in stock) will lose a bit to dividend taxes every year, and 15% of its gains to taxes on capital gains.

Here's what I get if both accounts are $10K, and the stock fund returns 10% with a 2% qualified dividend yield for 30 years.

$10K in tax-deferred bonds: $43,219, $32,415 after tax
$10K in taxable stock (growing at 9.7%): $160,768 including $124,345 of unrealized gains and $26,423 of reinvested dividends, $142,116 after tax
Total: $174,531
If stock has no capital gains (growing at 1.7%): $16,581 in taxable, no tax due, total $48,996, which is 71.9% less

$10K in tax-deferred stock: $174,494, $130,871 after tax
$10K in taxable bonds (growing at 3.75%): $30,175, no tax due on withdrawal
Total: $161,046
If stock has no capital gains (growing at 2% in tax-deferred): $18,114 in tax-deferred, $13,585 after tax, total $43,760, which is 72.8% less

So you come out ahead with stocks in taxable, and the risk is about the same now; if the stock market returns 2% rather than the expected 10% (and it could do that in a bad 30-year period), you lose about the same fraction of your portfolio either way.

For bonds in taxable to come out ahead, you need to earn 5.04% on municipal bonds of the same risk level as the bonds you hold in your 401(k). (Total Bond Market does have a lower yield than municipal-bond funds right now, but that's because of risk issues; Total Bond Market includes a lot of Treasuries and GNMAs. Intermediate-Term Investment Grade has a higher yield than Intermediate-Term Tax-Exempt.)
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Postby abuss368 » Mon Jul 11, 2011 8:51 pm

Consider the Vanguard Intermediate Term Tax Exempt Bond fund for your taxable account.
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Re: stock vs bond in 401k vs taxable

Postby vanbucky » Mon Jul 11, 2011 9:51 pm

Thanks for your response, my spreadsheet confirms all your numbers too.

grabiner wrote:If you put the stocks in the 401(k), you are taking on more risk. $13,333 in a 401(k) is worth the same as $10,000 in a Roth IRA, which is worth much more than $10,000 in a taxable account. Thus, if you have $13,333 in a 401(k) and $10,000 in a taxable account, your portfolio is effectively more than 50% in the 401(k).


Ah ha, I think this is the root issue! From my perspective, I was allocating 50/50 allocation according to the pretax value. Are you saying that is not valid? Instead, I should have calculated x/0.75 + x = 26666, which results in x = $11,428. So I should have allocated $11,428 to each account instead?

I had also created another spreadsheet comparing Taxable vs Roth IRA using $500,000 each, which I posted online:
https://spreadsheets.google.com/spreads ... n_US#gid=0

What I really want to confirm is: Would you agree that if you put $500k bond in taxable account and $500k stock in Roth IRA, you would have more money than vice versa? (Disregarding allocation, risk, worth).

Now, I know that applying your principle from above, it would be more fair to compare $571,428 in taxable and $428,571 in Roth IRA right? I see what you're saying. I'm not sure if that extremely critical point is made clear in articles or understood and applied correctly though.
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Re: stock vs bond in 401k vs taxable

Postby grabiner » Tue Jul 12, 2011 12:15 am

vanbucky wrote:What I really want to confirm is: Would you agree that if you put $500k bond in taxable account and $500k stock in Roth IRA, you would have more money than vice versa? (Disregarding allocation, risk, worth).


Yes, this is probably correct; the higher expected growth of the Roth IRA leads to a higher end value, with more risk. (It depends on the time involved)

Now, I know that applying your principle from above, it would be more fair to compare $571,428 in taxable and $428,571 in Roth IRA right? I see what you're saying. I'm not sure if that extremely critical point is made clear in articles or understood and applied correctly though.


The theory is discussed in Tax-Adjusted Asset Allocation on the wiki, which also links to several papers.
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Re: stock vs bond in 401k vs taxable

Postby vanbucky » Tue Jul 12, 2011 1:49 pm

grabiner wrote:The theory is discussed in Tax-Adjusted Asset Allocation on the wiki, which also links to several papers.


Thanks for everyone's responses, it has been most helpful. My final conclusion out of all this is that in general, it is better to put bond fund in 401k/Roth and stock fund in taxable account, given that you use equivalent after-tax worth. If you don't pay careful attention to that (like my example), then you may produce the opposite result.
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The intelligent investor . .

Postby Taylor Larimore » Tue Jul 12, 2011 2:06 pm

Hi Van:

Monday you wrote:

You would be best off putting $13,333 pretax in the stock fund in 401k, and $10,000 in bond fund in taxable account.


Tuesday you wrote the opposite:

My final conclusion out of all this is that in general, it is better to put the bond fund in the 401k/Roth and stock fund in the taxable account


When presented with new evidence, the intelligent investor changes his/her mind.

Congratulations!
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Just to clarify...

Postby medt » Tue Jul 12, 2011 11:18 pm

vanbucky wrote:

"Yes, but aren't capital gains in taxable account effectively double taxed? First as income tax, second as capital gains."


No, only your initial investment is taxed at ordinary tax rate. One's capital gains only (not your initial investment again) are taxed either at ordinary tax rate if held less than a year, or at 15% federal (plus state tax) if held longer than one year.

P.S. Very good post.
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