Trying to make sense of adding bonds
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Trying to make sense of adding bonds
Hello,
I am 24 hours old, and a a very high earner (relative to my age and location), with high savings (again relative to my age and location), and am currently 100% stock. I have recently though that phasing into somewhere between 10%-20% range in bonds may be prudent. This is not in any way an attempt to market time, but more so another step towards creating a stable, reliable allocation that I will be comfortable with for an extremely long time. Some of the things I've read imply that when you go from 100/0 to 90/10...80/20, etc, the return is not hindered substantially...but the volatility goes down substantially.
Heres my issue. At my age, job security, income, etc, its seems extraordinarily unlikely that I will need to tap my portfolio due to a loss of job, crisis, etc. Keep in mind that I maintain a substantial emergency fund outside of the portfolio (Easily one years expenses, maybe 1.5 years). My understanding is that Bonds are a killer from a tax perspective. . Is having bonds in taxable a really bad idea? If I do have them should they primarily be in the Roth portion? Or even in taxable, and am I more concerned than I need to be about the negative tax consequences of bonds in a taxable account? Sorry for the vagueness of my question, but I guess I'm trying to see if the bonds/taxes issue is a minor thing not to worry too much about, or a substantial factor worth considering. Thanks.
I am 24 hours old, and a a very high earner (relative to my age and location), with high savings (again relative to my age and location), and am currently 100% stock. I have recently though that phasing into somewhere between 10%-20% range in bonds may be prudent. This is not in any way an attempt to market time, but more so another step towards creating a stable, reliable allocation that I will be comfortable with for an extremely long time. Some of the things I've read imply that when you go from 100/0 to 90/10...80/20, etc, the return is not hindered substantially...but the volatility goes down substantially.
Heres my issue. At my age, job security, income, etc, its seems extraordinarily unlikely that I will need to tap my portfolio due to a loss of job, crisis, etc. Keep in mind that I maintain a substantial emergency fund outside of the portfolio (Easily one years expenses, maybe 1.5 years). My understanding is that Bonds are a killer from a tax perspective. . Is having bonds in taxable a really bad idea? If I do have them should they primarily be in the Roth portion? Or even in taxable, and am I more concerned than I need to be about the negative tax consequences of bonds in a taxable account? Sorry for the vagueness of my question, but I guess I'm trying to see if the bonds/taxes issue is a minor thing not to worry too much about, or a substantial factor worth considering. Thanks.
Re: Trying to make sense of adding bonds
I personally think the line between an large emergency fund and bonds is extremely blurry. So as much as I am a fan of at least 20% bonds for anyone, you might be there already.SpartanBull wrote:Keep in mind that I maintain a substantial emergency fund outside of the portfolio (Easily one years expenses, maybe 1.5 years).
It's by no means a killer, particular at the present low yields (Note: your EF is "killing" you almost as badly as we speak, either you have it in a good 1% savings account that's almost up there in bond yield territory, or you're foregoing all of that rather than the tax part by being in a poor savings account. You be the judge of how much of a "killing" that is)SpartanBull wrote:My understanding is that Bonds are a killer from a tax perspective. . Is having bonds in taxable a really bad idea? If I do have them should they primarily be in the Roth portion? Or even in taxable, and am I more concerned than I need to be about the negative tax consequences of bonds in a taxable account? Sorry for the vagueness of my question, but I guess I'm trying to see if the bonds/taxes issue is a minor thing not to worry too much about, or a substantial factor worth considering.
I would consider bonds in Roth first. Then in taxable, muni bonds (which you can think of as capping your tax rate to about 25%, in the form of lower yields that the average buyer demands because of their tax deduction), or if your marginal rate is 25% or below, regular non-exempt bonds. Or bank CDs are also a good substitute right now.
The primary function of bonds in your portfolio is to reduce volatility and to make those worst case scenarios (like what I was seeing on the horizon in 2008, despite thinking myself in a good place before the crisis started) quite a bit better, at the cost of the best scenarios (stocks greatly outperform bonds) being a little worse. This is a good tradeoff for me. The effect of taxes is small compared to this primary function, and can be optimized quite a bit using munis and tax advantaged accounts.
Re: Trying to make sense of adding bonds
First, congratulations on thinking about retirement on your second day on earth! (Your post says 24 hours old)
I have a few comments.
First: Bonds in taxable is like throwing your money in a fire. You get some benefit, but you lose a lot of money. If you are going to have bonds in taxable, you will look to municipal bonds (or i-bonds, but there is a limit to how much you can put in i-bonds). Look these up to see if they are good options for you.
Second: Bonds to NOT go in Roth for high income individuals. You would first want them to go in any traditional space if you decide to put them in your tax advantaged space. Why? You never pay taxes on Roth assets again. Never. You pay taxes on traditional when you withdraw. If one account will be $500,000 at retirement, while the other is $750,000, which would you want to pay taxes on? The smaller one, right? SO: Your assets with the highest expected rate of return go in Roth space.
Third: There is a great blog for doctors that translates well to higher income individuals called the WhiteCoatInvestor by board member emergdoc. His premise is that my first comment about bonds in taxable is wrong. It is an interesting view worth considering. Link here: http://whitecoatinvestor.com/asset-loca ... n-taxable/
Fourth: I am using an alternative strategy that I first heard on this board (I believe by Alan Roth in a post somewhere?) called the reverse bond. A reverse bond is using a set long-term debt (basically student loan or mortgage) and to pay it down. In this (and in many normal) interest rate environment, your debt costs more than bonds generate. Student loans are bankruptcy proof, and most on this board do not plan on forgoing the mortgage, so they are two debts that one would want to consider paying down. (A bond is a loan from you to someone else, so why not pay off your loans?) You get a better rate of return than with bonds, and you get freedom faster.
AT THE END (This is a very important part), when the debt is paid off, you will continue to pay the payment towards the debt into bonds (which will hopefully return a higher return than they are now). That is, if you use your mortgage to pay down in lieu of bonds, and you pay said mortgage off in 20 years (presuming it was a 30 year mortgage), you will continue paying the mortgage payment for the next ten years. That money will go into muni bonds (or you can buy stocks with it in taxable and convert the same taxable stock in your tax advantaged space to bonds. IE Payment of $2,000 from the mortgage buys $2,000 of a total stock market fund, and you simultaneously buy a total bond market fund by exchanging $2,000 of the total stock market fund held in your retirement account). Please note that without the recapture, you are not using an alternative bond strategy, you are just staying 100% stocks and paying down debt. The idea is that you are temporarily putting that money to better use, but will later put it back where it belongs.
CAVEAT: You should not implement this strategy unless you are maxing out your tax advantaged space first. ONLY after maxing out tax advantaged space is this strategy potentially a good idea. If you are not maxing out tax advantaged space, you are giving up on tax advantaged space that is precious to a high income earner.
Advantages: You are able to get a better return on the utility of your money.
Disadvantages: 1) You cannot use your mortgage to rebalance. 2) You lose liquidity. This money is tied to the house. 3) You have to be willing to stick to the recapture part at the end. If you fail to do so, you have failed to implement this strategy. 4) IF for some reason you lose the house, you could lose money you have set aside in this manner.
In my situation, this worked out to be a better financial strategy. I understand the risks involved with the disadvantages, and I am willing to accept those risks for the better utility of my money. (And for me, I kept stalling on adding bonds. I was 100% stocks, and without this strategy, I would still be at 100% stocks.)
I have a few comments.
First: Bonds in taxable is like throwing your money in a fire. You get some benefit, but you lose a lot of money. If you are going to have bonds in taxable, you will look to municipal bonds (or i-bonds, but there is a limit to how much you can put in i-bonds). Look these up to see if they are good options for you.
Second: Bonds to NOT go in Roth for high income individuals. You would first want them to go in any traditional space if you decide to put them in your tax advantaged space. Why? You never pay taxes on Roth assets again. Never. You pay taxes on traditional when you withdraw. If one account will be $500,000 at retirement, while the other is $750,000, which would you want to pay taxes on? The smaller one, right? SO: Your assets with the highest expected rate of return go in Roth space.
Third: There is a great blog for doctors that translates well to higher income individuals called the WhiteCoatInvestor by board member emergdoc. His premise is that my first comment about bonds in taxable is wrong. It is an interesting view worth considering. Link here: http://whitecoatinvestor.com/asset-loca ... n-taxable/
Fourth: I am using an alternative strategy that I first heard on this board (I believe by Alan Roth in a post somewhere?) called the reverse bond. A reverse bond is using a set long-term debt (basically student loan or mortgage) and to pay it down. In this (and in many normal) interest rate environment, your debt costs more than bonds generate. Student loans are bankruptcy proof, and most on this board do not plan on forgoing the mortgage, so they are two debts that one would want to consider paying down. (A bond is a loan from you to someone else, so why not pay off your loans?) You get a better rate of return than with bonds, and you get freedom faster.
AT THE END (This is a very important part), when the debt is paid off, you will continue to pay the payment towards the debt into bonds (which will hopefully return a higher return than they are now). That is, if you use your mortgage to pay down in lieu of bonds, and you pay said mortgage off in 20 years (presuming it was a 30 year mortgage), you will continue paying the mortgage payment for the next ten years. That money will go into muni bonds (or you can buy stocks with it in taxable and convert the same taxable stock in your tax advantaged space to bonds. IE Payment of $2,000 from the mortgage buys $2,000 of a total stock market fund, and you simultaneously buy a total bond market fund by exchanging $2,000 of the total stock market fund held in your retirement account). Please note that without the recapture, you are not using an alternative bond strategy, you are just staying 100% stocks and paying down debt. The idea is that you are temporarily putting that money to better use, but will later put it back where it belongs.
CAVEAT: You should not implement this strategy unless you are maxing out your tax advantaged space first. ONLY after maxing out tax advantaged space is this strategy potentially a good idea. If you are not maxing out tax advantaged space, you are giving up on tax advantaged space that is precious to a high income earner.
Advantages: You are able to get a better return on the utility of your money.
Disadvantages: 1) You cannot use your mortgage to rebalance. 2) You lose liquidity. This money is tied to the house. 3) You have to be willing to stick to the recapture part at the end. If you fail to do so, you have failed to implement this strategy. 4) IF for some reason you lose the house, you could lose money you have set aside in this manner.
In my situation, this worked out to be a better financial strategy. I understand the risks involved with the disadvantages, and I am willing to accept those risks for the better utility of my money. (And for me, I kept stalling on adding bonds. I was 100% stocks, and without this strategy, I would still be at 100% stocks.)
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.
Re: Trying to make sense of adding bonds
A few points to dispute:
The differentiating factors for Roth are: 1) the absence of RMDs, which can indeed point to keeping higher growth assets there for some individuals, and 2) tax arbitrage now vs retirement. Absolute taxes paid is NOT an advantage if one considers risk in addition to return.
More on this in the Wiki: https://www.bogleheads.org/wiki/Tax-adj ... allocation
That said, I do think that presently the conclusion is murkier than it used to be and whether tax-advantaged should be used for bonds depends greatly on horizon, tax rates and even assumptions about disposition of capital gains. My own strategy has been to use more CDs in taxable, because their present advantage vs market bonds probably tilts the balance for me. I don't think the WCI article makes the right case for it, though.
Sorry, but this is not correct. The current discussion seems to be taxable-vs-Roth, but if it came to be tax-deferred vs Roth the rationale above would NOT work, because it ignores risk. In response to your question, I can ask "what's more risky, a portfolio with $500k bonds that will be taxed 25%, or one of the same size with $500k that will be taxed zero", and the safer is obviously the latter. It's unfair to compare these portfolios on return -- one of them is not matching the chosen level of risk.Dulocracy wrote: Second: Bonds to NOT go in Roth for high income individuals. You would first want them to go in any traditional space if you decide to put them in your tax advantaged space. Why? You never pay taxes on Roth assets again. Never. You pay taxes on traditional when you withdraw. If one account will be $500,000 at retirement, while the other is $750,000, which would you want to pay taxes on? The smaller one, right? SO: Your assets with the highest expected rate of return go in Roth space.
The differentiating factors for Roth are: 1) the absence of RMDs, which can indeed point to keeping higher growth assets there for some individuals, and 2) tax arbitrage now vs retirement. Absolute taxes paid is NOT an advantage if one considers risk in addition to return.
More on this in the Wiki: https://www.bogleheads.org/wiki/Tax-adj ... allocation
The WCI article has two major flaws: 1) the risk considerations above: it declares the winner an obviously riskier portfolio, and 2) a little more speculatively, it assumes that historical stock returns will be the same despite low bond yields. In other words, the return of bonds being relatively well determined, we can all see that they won't match historical. But the returns of stocks are unknowable, so the article uses historical. I think this is the wrong thing to do and stock returns will be muted precisely because [weak] competition from bonds has almost certainly lead to higher prices than normal.Dulocracy wrote:Third: There is a great blog for doctors that translates well to higher income individuals called the WhiteCoatInvestor by board member emergdoc. His premise is that my first comment about bonds in taxable is wrong. It is an interesting view worth considering. Link here: http://whitecoatinvestor.com/asset-loca ... n-taxable/
That said, I do think that presently the conclusion is murkier than it used to be and whether tax-advantaged should be used for bonds depends greatly on horizon, tax rates and even assumptions about disposition of capital gains. My own strategy has been to use more CDs in taxable, because their present advantage vs market bonds probably tilts the balance for me. I don't think the WCI article makes the right case for it, though.
This is very reasonable, but I'd caution that the loss of liquidity is quite extreme. Past mortgage prepayment (your "bond investment") do not even excuse you from future mortgage payments (until mortgage is paid off), let alone the other things you can pay for by selling bonds in a crisis. This makes me very nervous and I've chosen to not prepay and hold bonds despite the apparent difference in yield. Then there are the tax advantages as well.Dulocracy wrote: Advantages: You are able to get a better return on the utility of your money.
Disadvantages: 1) You cannot use your mortgage to rebalance. 2) You lose liquidity. This money is tied to the house. 3) You have to be willing to stick to the recapture part at the end. If you fail to do so, you have failed to implement this strategy. 4) IF for some reason you lose the house, you could lose money you have set aside in this manner.
- dratkinson
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Re: Trying to make sense of adding bonds
Simple problem. Simple solution. Suggest you invest in VWITX/VWIUX (Vanguard's intermediate-term national muni bond fund). Why? Intermediate-term bonds are said to provide the highest risk-adjusted return.SpartanBull wrote:Hello,
I am 24 hours old, ... very high earner ... with high savings ... currently 100% stock. I have recently though that phasing into somewhere between 10%-20% range in bonds may be prudent. .... extraordinarily unlikely that I will need to tap my portfolio due to a loss of job, crisis, etc. ... maintain a substantial emergency fund outside of the portfolio ...
But I much prefer VWLTX/VWLUX (Vanguard's long-term national muni bond fund). Why? Because of it's higher yield. And I don't worry about the extra risk. Why? Because I'm not planning to sell anytime soon, so not worried about the additional interest-rate risk that drives price fluctuations and would manifest the extra risk as a lower price if I sold in a rising interest-rate environment. (Phew! What a mouthful.)
Why a muni bond fund, either or both?
--Both's dividends are federally tax-exempt. (If appropriate, single-state muni dividends would be both fed and state tax-exempt.)
--Both taxable-equivalent yields are acceptable to me in the 25% fed tax bracket, and improve as your tax bracket increases.
--Both are exempted from IRS 6-mo holding period requirement to protect tax-exempt dividends. Meaning shares are easily redeemed.
--No annual purchase limit.
--VWITX's price spread is <50-cents/yr, VWLT's is <$1/yr.
--Both perform multiple duties: portion of your bond allocation, largest tier of your formal EF, dry powder, a place to send extra money so you are not tempted to churn CC/accounts to play rate-chasing games.
Most forum members recommend that we have no less than 25-30% bonds starting out. In your case, you can probably withstand 100% stocks, but having some bonds, especially tax-exempt bonds, is really nice. Why?
--You always have a place to send excess cash for higher yield.
--Reduces your investing risk and smooths out returns.
--Dry powder for rebalancing into stocks during market dips.
--As you extend your formal investing into taxable accounts, munis go hand-in-glove with you to maintain your desired AA.
--If you like, you can maintain the same AA in all your accounts: stocks and taxable bonds in tax-advantaged accounts, stocks and munis in taxable account.
May all your problems be so simple to solve.
d.r.a., not dr.a. | I'm a novice investor; you are forewarned.
Re: Trying to make sense of adding bonds
ogd wrote:A few points to dispute:
Sorry, but this is not correct. The current discussion seems to be taxable-vs-Roth, but if it came to be tax-deferred vs Roth the rationale above would NOT work, because it ignores risk. In response to your question, I can ask "what's more risky, a portfolio with $500k bonds that will be taxed 25%, or one of the same size with $500k that will be taxed zero", and the safer is obviously the latter. It's unfair to compare these portfolios on return -- one of them is not matching the chosen level of risk.Dulocracy wrote: Second: Bonds to NOT go in Roth for high income individuals. You would first want them to go in any traditional space if you decide to put them in your tax advantaged space. Why? You never pay taxes on Roth assets again. Never. You pay taxes on traditional when you withdraw. If one account will be $500,000 at retirement, while the other is $750,000, which would you want to pay taxes on? The smaller one, right? SO: Your assets with the highest expected rate of return go in Roth space.
I agree that the question was not traditional/Roth originally, but if OP has traditional space, it is worth considering. As far as changing the risk portfolio, most people do not maintain an exactly the same portfolio across accounts. Many of us cannot do so. (I have DFA in my 401k, but I am not willing to pay for access outside of it. Anyway, this is worth consideration when looking at the situation. Also, I wish I knew where, but I saw on this site a little ago where someone showed that the risk-adjusted return was still greater with the strategy that I mentioned (probably in large part due to current returns on bonds, but I honestly do not remember). I tried to find it again, but was unable to do so.
The differentiating factors for Roth are: 1) the absence of RMDs, which can indeed point to keeping higher growth assets there for some individuals, and 2) tax arbitrage now vs retirement. Absolute taxes paid is NOT an advantage if one considers risk in addition to return.
More on this in the Wiki: https://www.bogleheads.org/wiki/Tax-adj ... allocation
I am familiar with this. So, if I have stocks in taxable, I should be heavier on stocks because my bonds get better tax treatment? Of course, if I have bonds in traditional and stocks in Roth, I then need more bonds. Overall, with stocks in taxable and Roth space, and bonds in traditional, I would need to slide both ways, right? Of course, one could keep it simple and consider it a wash. (I am discussing the average boglehead's situation, not my own, which is admittedly different.)
The WCI article has two major flaws: 1) the risk considerations above: it declares the winner an obviously riskier portfolio, and 2) a little more speculatively, it assumes that historical stock returns will be the same despite low bond yields. In other words, the return of bonds being relatively well determined, we can all see that they won't match historical. But the returns of stocks are unknowable, so the article uses historical. I think this is the wrong thing to do and stock returns will be muted precisely because [weak] competition from bonds has almost certainly lead to higher prices than normal.Dulocracy wrote:Third: There is a great blog for doctors that translates well to higher income individuals called the WhiteCoatInvestor by board member emergdoc. His premise is that my first comment about bonds in taxable is wrong. It is an interesting view worth considering. Link here: http://whitecoatinvestor.com/asset-loca ... n-taxable/
That said, I do think that presently the conclusion is murkier than it used to be and whether tax-advantaged should be used for bonds depends greatly on horizon, tax rates and even assumptions about disposition of capital gains. My own strategy has been to use more CDs in taxable, because their present advantage vs market bonds probably tilts the balance for me. I don't think the WCI article makes the right case for it, though.
Please note that I referenced bonds in taxable as burning money. I proposed the WCI article as food for thought for consideration of the OP as an alternate view. As I am still undecided on that issue (because of the additional risk in Muni Bonds), I am not the one to defend the position.
This is very reasonable, but I'd caution that the loss of liquidity is quite extreme. Past mortgage prepayment (your "bond investment") do not even excuse you from future mortgage payments (until mortgage is paid off), let alone the other things you can pay for by selling bonds in a crisis. This makes me very nervous and I've chosen to not prepay and hold bonds despite the apparent difference in yield. Then there are the tax advantages as well.Dulocracy wrote: Advantages: You are able to get a better return on the utility of your money.
Disadvantages: 1) You cannot use your mortgage to rebalance. 2) You lose liquidity. This money is tied to the house. 3) You have to be willing to stick to the recapture part at the end. If you fail to do so, you have failed to implement this strategy. 4) IF for some reason you lose the house, you could lose money you have set aside in this manner.
That covers 2 and 4 of disadvantages above. I understand the risks, and I readily admit this is not the strategy for most people. It only makes sense for a very small portion of those on this site (and a smaller portion of those not on this site).
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.
- abuss368
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Re: Trying to make sense of adding bonds
In my opinion all investment portfolios should include an allocation to bonds to provide safety and income. Bonds are invaluable to rebalancing purposes and also to weather the storm of financial trauma in the markets.
Any short or intermediate term low cost and diversified bond fund will do the job.
Any short or intermediate term low cost and diversified bond fund will do the job.
John C. Bogle: “Simplicity is the master key to financial success."
Re: Trying to make sense of adding bonds
I would suggest bonds are important for certain aspects of safety, that there is no rebalancing bonus*, and that they are not necessary for income**.abuss368 wrote:In my opinion all investment portfolios should include an allocation to bonds to provide safety and income. Bonds are invaluable to rebalancing purposes and also to weather the storm of financial trauma in the markets.
Any short or intermediate term low cost and diversified bond fund will do the job.
*If one holds bonds, then rebalancing is arguably a good idea that can create costs and dilemmas. It is not an opportunity.
**Income that can be derived from a portfolio is not related to dividends and interest paid on investments. In any case, at least right now, bonds pay less in income than stocks do, broadly speaking. As of now only four Vanguard bond funds yield SEC higher than the highest yielding stock fund and those involve long term risk or junk bond risk. Most of the bond funds pay out about the same or less than diversified stock funds now. Bond income when it is paid in taxable accounts is not tax efficient unless it comes from tax exempt bonds. People will look at this differently if bond returns eventually go back up, but the issue will also depend on inflation at the time.
- abuss368
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Re: Trying to make sense of adding bonds
Hi dbr,dbr wrote:I would suggest bonds are important for certain aspects of safety, that there is no rebalancing bonus*, and that they are not necessary for income**.abuss368 wrote:In my opinion all investment portfolios should include an allocation to bonds to provide safety and income. Bonds are invaluable to rebalancing purposes and also to weather the storm of financial trauma in the markets.
Any short or intermediate term low cost and diversified bond fund will do the job.
*If one holds bonds, then rebalancing is arguably a good idea that can create costs and dilemmas. It is not an opportunity.
**Income that can be derived from a portfolio is not related to dividends and interest paid on investments. In any case, at least right now, bonds pay less in income than stocks do, broadly speaking. As of now only four Vanguard bond funds yield SEC higher than the highest yielding stock fund and those involve long term risk or junk bond risk. Most of the bond funds pay out about the same or less than diversified stock funds now. Bond income when it is paid in taxable accounts is not tax efficient unless it comes from tax exempt bonds. People will look at this differently if bond returns eventually go back up, but the issue will also depend on inflation at the time.
I understand your message. I do however feel the re-balancing opportunity or bonus was especially prevalent during the financial crisis. In hindsight, I was thankful for the allocation to bonds and the possibly of re-balancing from both this pool of assets and also additional contributions to the investment portfolio.
Hopefully that makes sense.
Best.
John C. Bogle: “Simplicity is the master key to financial success."
- abuss368
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Re: Trying to make sense of adding bonds
Vanguard investment experts are recommending a two fund bond strategy in their research and presentations. That strategy includes Total Bond Index and Total International Bond Index funds.
John C. Bogle: “Simplicity is the master key to financial success."
Re: Trying to make sense of adding bonds
Do you have access to a tax-deferred investment space? E.g. 401K? Lots of Bogleheads would recommend putting bonds there. Gains in the 401K will eventually be taxed at retirement income levels regardless of what you put in there, and it frees up the Roth space (assuming you can still contribute to it, given your high income) for stocks.
- sunnywindy
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Re: Trying to make sense of adding bonds
If you are concerned about taxes, get a tax exempt bond ETF like Vanguard VTEB. If, in a few years, you want something different, sell it and buy something else. It's just that easy!
Remember, the choices you make now are not permanent and you can and will make changes as you get older and wiser.
Remember, the choices you make now are not permanent and you can and will make changes as you get older and wiser.
Powered by chocolate!
Re: Trying to make sense of adding bonds
I think there is also a psychological benefit to having a fund with a relatively stable price where you can see the dividends accumulating every month. I use mostly VWIUX and have some smaller positions in the limited term (VMLUX) and my state-specific long-term (VOHIX). If I were SpartanBull I would consider putting some of my emergency funds in something like that as 1.5 years of expenses in cash seems like a lot to me.dratkinson wrote:Simple problem. Simple solution. Suggest you invest in VWITX/VWIUX (Vanguard's intermediate-term national muni bond fund). Why? Intermediate-term bonds are said to provide the highest risk-adjusted return.SpartanBull wrote:Hello,
I am 24 hours old, ... very high earner ... with high savings ... currently 100% stock. I have recently though that phasing into somewhere between 10%-20% range in bonds may be prudent. .... extraordinarily unlikely that I will need to tap my portfolio due to a loss of job, crisis, etc. ... maintain a substantial emergency fund outside of the portfolio ...
But I much prefer VWLTX/VWLUX (Vanguard's long-term national muni bond fund). Why? Because of it's higher yield. And I don't worry about the extra risk. Why? Because I'm not planning to sell anytime soon, so not worried about the additional interest-rate risk that drives price fluctuations and would manifest the extra risk as a lower price if I sold in a rising interest-rate environment. (Phew! What a mouthful.)
Why a muni bond fund, either or both?
--Both's dividends are federally tax-exempt. (If appropriate, single-state muni dividends would be both fed and state tax-exempt.)
--Both taxable-equivalent yields are acceptable to me in the 25% fed tax bracket, and improve as your tax bracket increases.
--Both are exempted from IRS 6-mo holding period requirement to protect tax-exempt dividends. Meaning shares are easily redeemed.
--No annual purchase limit.
--VWITX's price spread is <50-cents/yr, VWLT's is <$1/yr.
--Both perform multiple duties: portion of your bond allocation, largest tier of your formal EF, dry powder, a place to send extra money so you are not tempted to churn CC/accounts to play rate-chasing games.
Most forum members recommend that we have no less than 25-30% bonds starting out. In your case, you can probably withstand 100% stocks, but having some bonds, especially tax-exempt bonds, is really nice. Why?
--You always have a place to send excess cash for higher yield.
--Reduces your investing risk and smooths out returns.
--Dry powder for rebalancing into stocks during market dips.
--As you extend your formal investing into taxable accounts, munis go hand-in-glove with you to maintain your desired AA.
--If you like, you can maintain the same AA in all your accounts: stocks and taxable bonds in tax-advantaged accounts, stocks and munis in taxable account.
May all your problems be so simple to solve.
Re: Trying to make sense of adding bonds
Well, damn. I was gonna go from 100/0 stocks/bonds to 80/20 until I read this topic and started looking up how bond yields are taxed. Not touching a bond except in my 401(k), then!
- dratkinson
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Re: Trying to make sense of adding bonds
Believe you've missed the suggestion to use municipal bond funds in taxable. Why? Because you can't get much lower than 0% fed/state tax.Tamalak wrote:Well, damn. I was gonna go from 100/0 stocks/bonds to 80/20 until I read this topic and started looking up how bond yields are taxed. Not touching a bond except in my 401(k), then!
See: https://www.bogleheads.org/wiki/Municipal_bonds
Find Wiki topic on recommended "books". Read one on bonds. Pay particular attention to the topic on municipal bonds. Due diligence is required to go the muni route as one* size does not fit all.
*Disclosure. Tweak bonds% in the 3-fund portfolio and one size does fit most. However it required >5 years for me to settle on a muni route that was approaching correct for me.
d.r.a., not dr.a. | I'm a novice investor; you are forewarned.
Re: Trying to make sense of adding bonds
Aren't municipal bonds all nearly cash? Low risk low yield?dratkinson wrote:Believe you've missed the suggestion to use municipal bond funds in taxable. Why? Because you can't get much lower than 0% fed/state tax.Tamalak wrote:Well, damn. I was gonna go from 100/0 stocks/bonds to 80/20 until I read this topic and started looking up how bond yields are taxed. Not touching a bond except in my 401(k), then!
See: https://www.bogleheads.org/wiki/Municipal_bonds
Find Wiki topic on recommended "books". Read one on bonds. Pay particular attention to the topic on municipal bonds. Due diligence is required to go the muni route as one* size does not fit all.
*Disclosure. Tweak bonds% in the 3-fund portfolio and one size does fit most. However it required >5 years for me to settle on a muni route that was approaching correct for me.
If I were to get bonds I would want relatively high-yield high-risk ones like VWEHX so my money actually works for me. Even though they're risky, they're still bonds and would have the effect of diversification against stocks. But it seems like VWEHX and its siblings would get devoured by taxes in a taxable account.
- dratkinson
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- Location: Centennial CO
Re: Trying to make sense of adding bonds
Junk bonds. VWEHX is a high-yield (junk*) bond fund. Read the Wiki topic on junk bond funds. Why? Because they display equity-like risk. Meaning, when the stock market goes through a correction, so too do junk bonds. Which is exactly the opposite of what you want. Why? Because (risky) junk bonds + (risky) stocks = bad diversification. (* As junk bonds go, VWEHX is not that junky so is safer than most.)Tamalak wrote:Aren't municipal bonds all nearly cash? No, depends upon the fund manager. Read the prospectus and annual report to see what s/he's doing. Low risk low yield? Maybe. Maybe not. Depends upon the fund. Read the prospectus... some are okay, but some are scary. Find my topic on WTCOX; in it I link to a scary muni prospectus.dratkinson wrote:Believe you've missed the suggestion to use municipal bond funds in taxable. Why? Because you can't get much lower than 0% fed/state tax.Tamalak wrote:Well, damn. I was gonna go from 100/0 stocks/bonds to 80/20 until I read this topic and started looking up how bond yields are taxed. Not touching a bond except in my 401(k), then!
See: https://www.bogleheads.org/wiki/Municipal_bonds
Find Wiki topic on recommended "books". Read one on bonds. Pay particular attention to the topic on municipal bonds. Due diligence is required to go the muni route as one* size does not fit all.
*Disclosure. Tweak bonds% in the 3-fund portfolio and one size does fit most. However it required >5 years for me to settle on a muni route that was approaching correct for me.
If I were to get bonds I would want relatively high-yield high-risk ones like VWEHX so my money actually works for me. Even though they're risky, they're still bonds and would have the effect of diversification against stocks. But it seems like VWEHX and its siblings would get devoured by taxes in a taxable account. No, munis are tax-exempt so do not get eaten by taxes.
As bonds are to provide safety (stability) to our investments, most forum members recommend using only safe bonds (least risk: treasuries, munis, TBM, shorter-term corporate ... long-term corporate, junk bond :most risk), and taking your equity risk with pure equities. Translation: if you want more risk/yield, then decrease your allocation to pure safe bonds and increase it to pure risky equities.
However, there is a Wiki sub-topic which does recommend a small allocation to junk bond. Finding it is left as a student exercise.
Muni. Munis are tax exempt which boosts their low yield*. Depending upon the fund selected and your federal and state tax brackets, a muni fund can produce more after-tax income than TBM. (* The tax benefit is to allow municipalities to borrow at lower rates. However, the tax benefit raises the after-tax yield to the owner. You can compute a muni's taxable-equivalent yield (TEY) as a quick first approximation of its appropriateness for you. But you must compete your due diligence to determine if the first approximation holds.)
For more on munis, see my three posts starting here: viewtopic.php?p=2787993#p2787993. Get your "SEC yield" information from Vanguard as it's accurate.
Read the Wiki topic on municipal bonds. Read the referenced external links.
Read a Wiki-recommended book on bonds. Pay particular attention to the topic on muni bonds.
As you must do more work (due diligence) to go the muni route, selecting the correct one(s) for your situation is not as simple as choosing TBM when you replicate a 3-fund portfolio.
Edit. Completeness.
Last edited by dratkinson on Fri Oct 07, 2016 3:35 pm, edited 1 time in total.
d.r.a., not dr.a. | I'm a novice investor; you are forewarned.
- in_reality
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Re: Trying to make sense of adding bonds
Do you or anyone else know how discussion on International bonds went at Boglehead 16? I've heard it alluded to but not any details...abuss368 wrote:Vanguard investment experts are recommending a two fund bond strategy in their research and presentations. That strategy includes Total Bond Index and Total International Bond Index funds.
Re: Trying to make sense of adding bonds
The rationale I mentioned about higher return with stocks in Roth being due to higher risk (compared to traditional or, somewhat less so, taxable) holds whether or not one actually tax adjusts their holdings. Even if you don't -- one can simply look at the higher risk it took to achieve the higher return of stocks-in-Roth and reason that they didn't get a better deal, only a fair one -- more return for more risk.Dulocracy wrote: I agree that the question was not traditional/Roth originally, but if OP has traditional space, it is worth considering. As far as changing the risk portfolio, most people do not maintain an exactly the same portfolio across accounts. Many of us cannot do so. (I have DFA in my 401k, but I am not willing to pay for access outside of it. Anyway, this is worth consideration when looking at the situation. Also, I wish I knew where, but I saw on this site a little ago where someone showed that the risk-adjusted return was still greater with the strategy that I mentioned (probably in large part due to current returns on bonds, but I honestly do not remember). I tried to find it again, but was unable to do so.
...
I am familiar with this. So, if I have stocks in taxable, I should be heavier on stocks because my bonds get better tax treatment? Of course, if I have bonds in traditional and stocks in Roth, I then need more bonds. Overall, with stocks in taxable and Roth space, and bonds in traditional, I would need to slide both ways, right? Of course, one could keep it simple and consider it a wash. (I am discussing the average boglehead's situation, not my own, which is admittedly different.)
It's indeed possible that stocks-in-tax-advantaged (traditional too, not just Roth) is a better strategy at current low yields, under some tax brackets and return/holding period assumptions, but it's not a slam dunk and one cannot use the "absolute taxes paid" (aka "taxes paid on a higher amount") rationale because it doesn't consider risk. You really have to simulate this in detail. I remember (but also can't find) the thread you mentioned, and I remember that the true source of the gain in that simulation spreadsheet was the expansion of tax-advantaged space, which after a long horizon came to hold more bonds than the taxable account. But, again, it depends on return assumptions.
Re: Trying to make sense of adding bonds
That explanation makes sense. I am glad I am not crazy, as I spent much too much time looking for that post.ogd wrote:I remember (but also can't find) the thread you mentioned, and I remember that the true source of the gain in that simulation spreadsheet was the expansion of tax-advantaged space, which after a long horizon came to hold more bonds than the taxable account. But, again, it depends on return assumptions.
Here is why I disagree generally with the idea that putting your riskiest assets in Roth is increasing risk: You can rebalance the accounts by exchanging funds. By that, I mean that, in the future, you can simply trade one fund for the other. Just because I have my highest return assets in Roth space now does NOT mean I have to have them there in retirement. Let me use a distribution as an example.
Presume I have a small cap value fund in my Roth space. I have bonds in Traditional. I have RMDs that require minimum distribution, which I take. I simultaneously take out the money from my Traditional space AND exchange the small value fund into a bond fund in the Roth space. I have, by way of that exchange, "sold" small value.
Because one is not stuck with one's asset allocation, and as assets can be exchanged at the end, during the time of growth, I want my asset with the greatest expected return in Roth space. Nothing prevents me from rebalancing accounts later so that the bonds are in Roth at retirement.
Termed another way: I have an asset allocation. Because what funds are held where is a fluid thing, I want to expand the tax advantaged space as much as possible. I will use the asset class with the most "muscle" or ability to expand it (highest expected return). Then, I can always trade later. As Roth space tends to be smaller than traditional for most people, if you have 75% Traditional space and 25% Roth, it is easy to sell fund A in the Roth space and buy an equal amount of fund A in traditional, while switching fund B out for fund A. You then used the higher expected return asset to expand your tax advantaged space, while being able to rebalance in the end, negating the risk issue you raise (an issue that only shows up at the time of distribution).
Interestingly, you noted above that it is this very expansion of tax advantaged space that allowed the advantage to this strategy in the other case. The expansion of the tax advantaged space is the very reason that I prefer this strategy. By being flexible in distribution, the issue of altered risk goes away. (As you note, each individual situation is different, and if someone is using muni-bonds instead of total bond, TIPS, or whathaveyou, that particular decision will impact the risk.)
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.
Re: Trying to make sense of adding bonds
Well, this is a trick that essentially uses the fact that risk didn't manifest, in the rear view mirror, to make some of it go away and argue that you got extra return with no extra risk. It's roughly equivalent to this: I hold 100% stocks until retirement. Then I switch to 100% cash, and I point out that I got large returns with a riskless position. I didn't, of course. If risk did manifest and my retirement got hurt, I'd feel the 100% stocks. If stocks in Roth did poorly, it will hurt me X% more than if stocks in Traditional did poorly, and shifting before retirement wouldn't help with that hurt.Dulocracy wrote: Here is why I disagree generally with the idea that putting your riskiest assets in Roth is increasing risk: You can rebalance the accounts by exchanging funds. By that, I mean that, in the future, you can simply trade one fund for the other. Just because I have my highest return assets in Roth space now does NOT mean I have to have them there in retirement. Let me use a distribution as an example.
Presume I have a small cap value fund in my Roth space. I have bonds in Traditional. I have RMDs that require minimum distribution, which I take. I simultaneously take out the money from my Traditional space AND exchange the small value fund into a bond fund in the Roth space. I have, by way of that exchange, "sold" small value.
Because one is not stuck with one's asset allocation, and as assets can be exchanged at the end, during the time of growth, I want my asset with the greatest expected return in Roth space. Nothing prevents me from rebalancing accounts later so that the bonds are in Roth at retirement.
If you think that it's highly unlikely that stocks will do worse than bonds over that long term, then why hold bonds at all is the question (with a different set of answers).
To put it in tax-adjusted allocation terms -- when you move bonds from Traditional to Roth with a projected 25% tax rate, you should transform $100 bonds Traditional into $75 of bonds Roth to keep the same level of risk, or viceversa. That preserves the fact that your portfolio is more risky until withdrawal time, when it's plain visible that the Traditional you are withdrawing is less valuable than the Roth.
Note that ^THIS^ is a Roth-vs-Traditional discussion.
I do not dispute that this is valid and can in some (even many) circumstances lead to bonds in taxable outperforming because stocks-in-tax-advantaged expands the tax-advantaged space enough to overwhelm the higher tax drag along the way. BUT this is a harder argument that requires simulation and only works under some return / horizon assumptions; your initial "will never pay taxes again" argument is not the way to do it. AND (very importantly) it applies to tax-deferred just as well as tax-free: the expansion of Traditional is (after tax adjustment per the risk argument above) just as valuable as the expansion of Roth. ^THIS^ is a taxable-vs-tax-advantaged discussion.Dulocracy wrote: I want to expand the tax advantaged space as much as possible.
To conclude: "stocks always go in Roth" mostly applies to a Roth-vs-Traditional discussion, and then only weakly because of trying to avoid high RMDs and therefore high tax brackets if stocks do well, and not because of the amount of taxes paid. "Should stocks go in tax-advantaged" (of both kinds) is a different discussion and may indeed be a "yes" or mostly indifferent at present bond yields.
Re: Trying to make sense of adding bonds
I underlined my main points to be more clear about what it is that I am arguing.ogd wrote:Well, this is a trick that essentially uses the fact that risk didn't manifest, in the rear view mirror, to make some of it go away and argue that you got extra return with no extra risk. It's roughly equivalent to this: I hold 100% stocks until retirement. Then I switch to 100% cash, and I point out that I got large returns with a riskless position. I didn't, of course. If risk did manifest and my retirement got hurt, I'd feel the 100% stocks. If stocks in Roth did poorly, it will hurt me X% more than if stocks in Traditional did poorly, and shifting before retirement wouldn't help with that hurt.Dulocracy wrote: Here is why I disagree generally with the idea that putting your riskiest assets in Roth is increasing risk: You can rebalance the accounts by exchanging funds. By that, I mean that, in the future, you can simply trade one fund for the other. Just because I have my highest return assets in Roth space now does NOT mean I have to have them there in retirement. Let me use a distribution as an example.
Presume I have a small cap value fund in my Roth space. I have bonds in Traditional. I have RMDs that require minimum distribution, which I take. I simultaneously take out the money from my Traditional space AND exchange the small value fund into a bond fund in the Roth space. I have, by way of that exchange, "sold" small value.
Because one is not stuck with one's asset allocation, and as assets can be exchanged at the end, during the time of growth, I want my asset with the greatest expected return in Roth space. Nothing prevents me from rebalancing accounts later so that the bonds are in Roth at retirement.
One would presume intelligent planning. If I can live without touching my Roth money for 20 years at retirement, even if I face a 50% drop, I will likely be ok and the stocks will recover. If I am approaching retirement and will need the Roth money, I need to have a good plan in place to start transitioning to a safer asset allocation (whether that money is in Roth, traditional, or taxable, I believe this to be the case.) Essentially, if you get to retirement and you have to sell an underperforming asset to live, your asset allocation was wrong, no matter what location that asset inhabits.
If you think that it's highly unlikely that stocks will do worse than bonds over that long term, then why hold bonds at all is the question (with a different set of answers).
To put it in tax-adjusted allocation terms -- when you move bonds from Traditional to Roth with a projected 25% tax rate, you should transform $100 bonds Traditional into $75 of bonds Roth to keep the same level of risk, or viceversa. That preserves the fact that your portfolio is more risky until withdrawal time, when it's plain visible that the Traditional you are withdrawing is less valuable than the Roth.
Note that ^THIS^ is a Roth-vs-Traditional discussion. Yes it is. And no it isnt. I used an example of RMDs, so my specific example referenced a Roth vs traditional scenario. I should have used an example with taxable for this particular discussion. Let me correct the error. If I have an asset in taxable, such as a bond fund, I can sell said bond fund in order to get money. I can then convert the small value money in Roth space to a bond fund. (I am personally ok with selling munis and then converting to total bond, which I believe would make your portfolio even less risky). The concept is the same. One can still switch the fund out. The important part of this strategy is that you can switch out the fund within the Roth space. Where the fund is that was sold is irrelevant, so long as you can exchange one fund for another in the Roth space to maintain the desired asset allocation.
I do not dispute that this is valid and can in some (even many) circumstances lead to bonds in taxable outperforming because stocks-in-tax-advantaged expands the tax-advantaged space enough to overwhelm the higher tax drag along the way. BUT this is a harder argument that requires simulation and only works under some return / horizon assumptions; your initial "will never pay taxes again" argument is not the way to do it.Dulocracy wrote: I want to expand the tax advantaged space as much as possible.
I am not following you. You never pay taxes on Roth money again. Expanding that space as much as possible makes sense both for RMDs (a traditional/Roth discussion I thought we wanted to avoid) and for the simple fact that the more money one has that is in tax free space, the less one pays in taxes on one's money.
AND (very importantly) it applies to tax-deferred just as well as tax-free: the expansion of Traditional is (after tax adjustment per the risk argument above) just as valuable as the expansion of Roth. ^THIS^ is a taxable-vs-tax-advantaged discussion.
I may be missing your point, so feel free to let me know. Traditional, however, is not just as valuable as Roth, so expansion of traditional is not as valuable as the expansion of Roth. You previously stated that traditional was worth about 75% of Roth. To be frank, if I am given two accounts, one of $50,000 and one of $100,000, and I am asked which one I want to pay taxes on (and which one I want tax free), I am going to choose to pay taxes on the one that is smaller. Therefore, to me, expansion of Roth space IS more important than expansion of traditional.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.
Re: Trying to make sense of adding bonds
Let's talk numbers because our discussion is too abstract.Dulocracy wrote:One can still switch the fund out. The important part of this strategy is that you can switch out the fund within the Roth space. Where the fund is that was sold is irrelevant, so long as you can exchange one fund for another in the Roth space to maintain the desired asset allocation.
Here's why switching the funds before withdrawal doesn't help address the risk issue. Say we're talking about $1M in Roth and $1M in Traditional, targetting a 50/50 stock/bond allocation. Let's also say, as per my objection to your switching funds in the good risk scenario, that risk does manifest and stocks return -20% over the holding interval, whereas bonds return 0% for simplicity (we can say it's real return to make that number more realistic).
Now I need to withdraw, paying 25% tax rate. The allocation with $1M stocks in Roth and $1M bonds in Traditional allows me to withdraw $800K stocks + $750K bonds = $1550K. The allocation with $1M bonds in Roth and $1M stocks in Traditional allows me to withdraw $1M bonds + $600K stocks = $1600K. I cannot fix this discrepancy with any shifting around before withdrawal - I genuinely have less money. Therefore, the two allocations are not the same level of risk because when risk manifested one was hurt more than the other; their returns in the good scenarios are not directly comparable without adjustment, and it's unfair to say that stocks-in-Roth does better in good (or typical) scenarios without noting that it had higher risk.
Instead, two allocations that are equivalent risk are something like: $1M bonds in Traditional and $125K bonds / $875K stocks in Roth, versus $1M stocks in Traditional and $125K stocks / $875K bonds in Roth. In the scenario above where risk manisfested these two both allow me to withdraw $1575K, so they are truly the same risk. In a good (-ish) scenario where stocks return +100% over the interval and bonds the same 0%, they both allow me to withdraw $2625K. So there was no advantage to stocks in Roth, despite the Traditional allocation "paying taxes on all that growth" -- except if RMDs and a bump in tax rate are involved.
That's why I'm saying RMDs are the only reason to prefer stocks in Roth, if one thinks they will be a problem. It's a much leaner argument than "not paying taxes on stock growth".
Expanded tax-deferred space can be assumed to have more money in it, since one didn't pay taxes originally and could invest more. So the choice is really between expanding Roth by $750K and expanding Traditional by $1M with the same % of stocks -- both of these expansions are just as valuable discounting RMDs.Dulocracy wrote: I am not following you. You never pay taxes on Roth money again. Expanding that space as much as possible makes sense both for RMDs (a traditional/Roth discussion I thought we wanted to avoid) and for the simple fact that the more money one has that is in tax free space, the less one pays in taxes on one's money.
Somewhat perpendicular: if one is hitting the limits (and Traditional can't be X% more than Roth due to higher contributions), then a combination of Traditional with taxable (above the limit) can outperform Roth for high tax bracket individuals: https://thefinancebuff.com/roth-401k-fo ... e-max.html .
P.S: I am realizing something now about the stocks-in-taxable discussion that I hadn't internalized before: it could well be the case that the possibility of expanding tax-advantaged being an advantage over the long term is matched by the possibility of shrinking it in the bad scenarios, so we shouldn't blindly count it as a certain positive. However, that's far too subtle a discussion for me or probably for this thread. I believe that more sophisticated posters like Ketawa or maybe livesoft were making that argument in the monster stocks-in-taxable thread. Which I still can't find despite another 5 minutes searching for it. Did it get political and shut down??
Re: Trying to make sense of adding bonds
ogd wrote: in the monster stocks-in-taxable thread. Which I still can't find despite another 5 minutes searching for it. Did it get political and shut down??
Found it, finally! The one I meant was: viewtopic.php?t=126556 . Don't have time to re-read all of it, but I'll try to refresh over future cups of coffee.Dulocracy wrote:I am glad I am not crazy, as I spent much too much time looking for that post.
Re: Trying to make sense of adding bonds
Aha! I have identified our main issue of dispute. You would be correct if one day someone simply pulled all of their money out of both accounts on the day of retirement. That is not the way it works, however. At retirement, one starts to draw down- slowly- over time (and one builds over time).ogd wrote:Let's talk numbers because our discussion is too abstract.Dulocracy wrote:One can still switch the fund out. The important part of this strategy is that you can switch out the fund within the Roth space. Where the fund is that was sold is irrelevant, so long as you can exchange one fund for another in the Roth space to maintain the desired asset allocation.
Here's why switching the funds before withdrawal doesn't help address the risk issue. Say we're talking about $1M in Roth and $1M in Traditional, targetting a 50/50 stock/bond allocation. Let's also say, as per my objection to your switching funds in the good risk scenario, that risk does manifest and stocks return -20% over the holding interval, whereas bonds return 0% for simplicity (we can say it's real return to make that number more realistic).
Now I need to withdraw, paying 25% tax rate. The allocation with $1M stocks in Roth and $1M bonds in Traditional allows me to withdraw $800K stocks + $750K bonds = $1550K. The allocation with $1M bonds in Roth and $1M stocks in Traditional allows me to withdraw $1M bonds + $600K stocks = $1600K. I cannot fix this discrepancy with any shifting around before withdrawal - I genuinely have less money. Therefore, the two allocations are not the same level of risk because when risk manifested one was hurt more than the other; their returns in the good scenarios are not directly comparable without adjustment, and it's unfair to say that stocks-in-Roth does better in good (or typical) scenarios without noting that it had higher risk.
Instead, two allocations that are equivalent risk are something like: $1M bonds in Traditional and $125K bonds / $875K stocks in Roth, versus $1M stocks in Traditional and $125K stocks / $875K bonds in Roth. In the scenario above where risk manisfested these two both allow me to withdraw $1575K, so they are truly the same risk. In a good (-ish) scenario where stocks return +100% over the interval and bonds the same 0%, they both allow me to withdraw $2625K. So there was no advantage to stocks in Roth, despite the Traditional allocation "paying taxes on all that growth" -- except if RMDs and a bump in tax rate are involved.
That's why I'm saying RMDs are the only reason to prefer stocks in Roth, if one thinks they will be a problem. It's a much leaner argument than "not paying taxes on stock growth".
Expanded tax-deferred space can be assumed to have more money in it, since one didn't pay taxes originally and could invest more. So the choice is really between expanding Roth by $750K and expanding Traditional by $1M with the same % of stocks -- both of these expansions are just as valuable discounting RMDs.Dulocracy wrote: I am not following you. You never pay taxes on Roth money again. Expanding that space as much as possible makes sense both for RMDs (a traditional/Roth discussion I thought we wanted to avoid) and for the simple fact that the more money one has that is in tax free space, the less one pays in taxes on one's money.
Somewhat perpendicular: if one is hitting the limits (and Traditional can't be X% more than Roth due to higher contributions), then a combination of Traditional with taxable (above the limit) can outperform Roth for high tax bracket individuals: https://thefinancebuff.com/roth-401k-fo ... e-max.html .
P.S: I am realizing something now about the stocks-in-taxable discussion that I hadn't internalized before: it could well be the case that the possibility of expanding tax-advantaged being an advantage over the long term is matched by the possibility of shrinking it in the bad scenarios, so we shouldn't blindly count it as a certain positive. However, that's far too subtle a discussion for me or probably for this thread. I believe that more sophisticated posters like Ketawa or maybe livesoft were making that argument in the monster stocks-in-taxable thread. Which I still can't find despite another 5 minutes searching for it. Did it get political and shut down??
As I have indicated, my strategy of using equities in Roth space is one of accumulation. Let us say 5 years out from retirement, one would want to swap things around so that one's asset allocation is matched. This 5 year buffer would allow one to either protect one's account, or, alternatively, wheather the brunt of a downturn while in working years.
I should point out that, with a 50/50 allocation, bonds would seep into the expanding Roth space. What IS important to note is that, because of the expanding Roth space, even with the losses, it is entirely likely that this space would be larger after 40+ years of accumulation (presuming someone did not start until their late 20's to save). Using a compound interest calculator (to follow your lead in keeping it simple and not choosing funds), I get 12,000 a year savings at 5% interest as just over $1.5 million. Let us presume that the increase over time went to bonds and they wound up with $500,000 in bonds. Rough numbers, but you get the idea. Obviously, they started 100% stock, and at retirement are 50/50 stock bonds, meaning that Roth space (where they put their stock) is $1,500,000, and Traditional space is $500,000. In order to have the desired allocation, you would have $1,000,000 in stock in Roth and $500,000 in bonds in Roth, with the other $500,000 in bonds being in taxable.
Presuming the 20% decline in equities, you have $1,300,000 in Roth space and $500,000 in Traditional. One could draw down from the bonds in either account.
Here comes the interesting part. Let us presume something went horribly awry, and you are at the bottom of the market, and you somehow have $800,000 in Roth and $1,000,000 in Traditional. Let us presume that somehow, there was a 70% drop in that previous market. Now, do you think the markets will come back? Typically they do. Typically, that is within a 10 year time period. So, you are really heavy in bonds. You need to get back to your old asset allocation. You are gunshy. You cannot bring yourself to rebalance into stocks. No worries! To get back to 50/50, you simply draw down off of your bonds year after year until your stocks come back. Presuming someone needs to withdraw $25,000 a year (again using easy numbers), this gives you eight years of drawing down in order to wait things out before you are 50/50 again. As many bogleheads us a flexible strategy in retirement for withdrawals, the point of bonds is to be able to draw down bonds when stocks are low, and then rebalance when they go up. You would still have enough bonds to wait an additional 24 years before running out of bonds for stocks to go up.
What if you DID rebalance into stocks? As stocks climb (after this 70% drop, they better), you have more money because you bought so low. You can then sell bonds and stocks in traditional... stocks at a profit, and bonds at the 0% gain.
The point is, if you plan properly, you can greatly expand Roth space. You should have the best of both of these scenarios (larger Roth space at retirment (switched to an overall stock/bond mix maybe 5 years out), AND the ability to draw down bonds and wait out a dip in stocks. (After all, what is the point of that much bonds if not to allow one to wait out a downturn?)
I will also point out that this scenario did not address taxable at all. Presumably, with this portfolio, there are CD's or muni bonds one can draw off of in retirement as well. If one only has equities in taxable, one can still use a strategy of using the income off of those equities to assist (even with a total market fund that does not focus on dividends).
There are multiple strategies to this scenario, but over time, one should be able to expand Roth space with higher expected return assets held over a long duration. One can minimize risk by switching 5 years or so out to balancing both accounts with stocks/bonds. If a downturn happens during that time, one's account can recover during those 5 years to help minimize downtime in a retirement. In the above scenario, even in the worst case scenario, you would have an additional 8 years (or double your money drawn down and call it 4 years) to allow the account to naturally rebalance. You then have a long time that you can live on bonds before stocks are needed.
This is in addition to the ability to easily buy in one fund and sell in the other. Even in the scenario above with only a 5% real return (which is low), one could immediately rebalance to 50/50 at the bottom of the market, and you would have $1,300,000 in Roth and $500,000 in Traditional divided equally. Even with that loss, because of the growth of the account in the accumulation phase, you have a larger Roth space. That would mean $650,000 in Bonds and $650,000 in stocks in Roth and $250,000 in Bonds and $250,000 in stocks. What is interesting is that EVEN IF you make sure both accounts are at your desired allocation, you are better off having maximized the Roth space.
Let us look at what happens in a recovery, however. (I am oversimplifying this, but you will get the idea). A recovery would require a 25% bonus to get back to square one (20% down needs 25% to get back up, as it now takes one of the four remaining parts to make up the whole five that first existed). So, to get a market recovery, we move the needle and then rebalance. In Roth, 25% of 650,000 is %162,500. In traditional, 25% of $250,000 is $62,500. This leaves you with $1,462,500 in Roth and $562,500 in Traditional, amounting to a much better outcome than if you kept it 50/50 the entire time and had a recovery with equal amounts in each account (but the same overall dollar number).
That is WITH rebalancing the accounts to a desired allocation in both accounts after a drop. If you did NOT do that and left the accounts as they were, a recovery would bring you back to the $1,500,000/$500,000 mix.
Of course, some money would be taken out along the way, which would alter the numbers a bit, but you see how the ability to grow the assets over time will expand the space, and the ability to be flexible within the two accounts can let one move money around as they see fit to get the best result. It is not without effort, but it is unlikely that an equal asset allocation across all assets would beat a strategic one given a long timeframe for buildup and a long timeframe for payout.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.
Re: Trying to make sense of adding bonds
Dulocracy: I appreciate the long reply, but this is not the big source of our contention. You are essentially arguing that although a riskier allocation hurt before retirement, it will eventually recover and not look as bad. Well, if your confidence is that high in stocks you should simply have less bonds to begin with.Dulocracy wrote:Aha! I have identified our main issue of dispute. You would be correct if one day someone simply pulled all of their money out of both accounts on the day of retirement. That is not the way it works, however. At retirement, one starts to draw down- slowly- over time (and one builds over time).
What happens after retirement can be shown not to matter for my risk argument in one of several ways. I can ask you to assess risk if the bad scenario looks like: -20% stocks like in my original post, then 0% thereafter, forever. OR if you're gonna say it's unlikely, I can have retiree B who uses bonds in Roth pledge to switch at retirement to the exact allocation (at every step) of retiree A who used stocks in Roth -- thereby making B's advantage in the bad scenario permanent (no way for retiree A to catch up).
Or I can simply ask you, rather than comparing risk of two allocations I consider different, to consider as equivalent to the allocation $1M stocks in Roth / $1M bonds in tax-deferred (A), under a 25% withdrawal rate assumption, an allocation of $825K bonds / $125 stocks in Roth , and $1M stocks in taxable (B), keeping the tax-adjusted proportions the same in any further rebalancing or shifting aound. These two allocations can be shown to have the same risk because they will allow the same amount of withdrawals in the bad scenario (despite A superficially looking like it has more bonds), and you can also show that they allow the same amount of withdrawals in good scenarios where stocks do much better than bonds. So there is no reason for one to prefer A to B or viceversa and it should be down to other factors (like RMDs or availability of good funds).
The bottom line is that Roth space is worth no more no less than tax-deferred space discounted by withdrawal tax rate. When one puts at risk $X of Roth space by investing in stocks, it's the same as putting at risk $X / 0.75 (i.e. $X * 1.33) of Traditional space. This is whether or not one the taxation of bonds is actually visible at withdrawal (which you were attempting to hide by shifting money around).
The one true argument for using high growth assets in Roth is to avoid RMDs that are not needed to live on, but bump one's tax rate unnecessarily. Avoiding high absolute tax amounts can be shown with proper discounting to not make a difference.
Re: Trying to make sense of adding bonds
ogd wrote:Dulocracy: I appreciate the long reply, but this is not the big source of our contention. You are essentially arguing that although a riskier allocation hurt before retirement, it will eventually recover and not look as bad. Well, if your confidence is that high in stocks you should simply have less bonds to begin with.Dulocracy wrote:Aha! I have identified our main issue of dispute. You would be correct if one day someone simply pulled all of their money out of both accounts on the day of retirement. That is not the way it works, however. At retirement, one starts to draw down- slowly- over time (and one builds over time).
Incorrect. It is because I have confidence in stocks to recover but am prudent enough to understand that this takes time that I need the bonds to cover the gap for a recovery. What I AM saying is that 1) The contribution to higher performing assets in Roth space over a long duration is likely going to expand that space enough so that it is larger even after the drop you propose, and that 2) A good plan will take into account drops and how to use the safer bonds in the portfolio in order to ride out those troubles. (Please note that MOST portfolios experience a downturn in the 20-30 years of potential retirement).
What happens after retirement can be shown not to matter for my risk argument in one of several ways. I can ask you to assess risk if the bad scenario looks like: -20% stocks like in my original post, then 0% thereafter, forever. OR if you're gonna say it's unlikely, I can have retiree B who uses bonds in Roth pledge to switch at retirement to the exact allocation (at every step) of retiree A who used stocks in Roth -- thereby making B's advantage in the bad scenario permanent (no way for retiree A to catch up).
If we are presuming that there was a 20% dip in stocks, and then stocks never made a profit again for the next 30 years, we have two things: 1) Something terrible happened that likely would be more pressing to the country and world than the issue of stocks and 2) we have left the realm or realistic retirement planning. One could also put all of their retirement money into gold, bullets, and liquor on the off chance that zombies come about, but that is also not a likely scenario.
Or I can simply ask you, rather than comparing risk of two allocations I consider different, to consider as equivalent to the allocation $1M stocks in Roth / $1M bonds in tax-deferred (A), under a 25% withdrawal rate assumption, an allocation of $825K bonds / $125 stocks in Roth , and $1M stocks in taxable (B), keeping the tax-adjusted proportions the same in any further rebalancing or shifting aound. These two allocations can be shown to have the same risk because they will allow the same amount of withdrawals in the bad scenario (despite A superficially looking like it has more bonds), and you can also show that they allow the same amount of withdrawals in good scenarios where stocks do much better than bonds. So there is no reason for one to prefer A to B or viceversa and it should be down to other factors (like RMDs or availability of good funds).
Again, you are arbitrarily dividing the portfolio 50/50, despite the fact that stocks and bonds do not act that way if you use them as I suggest over a long duration. If you were to say that at the time of retirement (or 5 years before, as I am suggesting) one should rebalance all portfolios to have the same asset allocation, I would agree. That is NOT what we are discussing, however. We are discussing the accumulation phase, during which time I assert it is best to use assets that will expand the Roth space if there is a long duration.
I do not think we are really able to continue the discussion productively if we have to consider traditional risks of stocks, but not traditional performance over a long duration. You are saying to ignore the benefits of a strategy you do not like, while pointing out the risks that are directly tied to those benefits. The fact is, a 50/50 split between Roth and Traditional ($1m and $1m in your example) is not what is likely to occur with the strategy that I discussed. The whole point of putting higher producing assets in Roth is that you expand that space over a long duration. Sure, if you are retiring in two years and are just getting started, you have a different scenario (although, how did you get $1m in Roth and $1m in traditional). Even with 20 years out, funneling equities into Roth is likely to be your best scenario. To say that we are going to ignore the traditional returns of equities being much higher, but still focus on the traditional volatility is willfully ignoring half the picture. That would be like me saying that I wanted to consider the returns, but ignore the volatility. Both are essential to the conversation.
The bottom line is that Roth space is worth no more no less than tax-deferred space discounted by withdrawal tax rate. When one puts at risk $X of Roth space by investing in stocks, it's the same as putting at risk $X / 0.75 (i.e. $X * 1.33) of Traditional space. This is whether or not one the taxation of bonds is actually visible at withdrawal (which you were attempting to hide by shifting money around).
The one true argument for using high growth assets in Roth is to avoid RMDs that are not needed to live on, but bump one's tax rate unnecessarily. Avoiding high absolute tax amounts can be shown with proper discounting to not make a difference.
These positions are logically inconsistent. "Sure, RMDs are lower, as the Roth space will be larger, but it will have no impact on taxes paid." Roth space takes up more of the portfolio, so the RMDs are lower. Ergo, Roth space takes up more of the portfolio, so there is more money on which one will never pay taxes. Let us put it another way. In your scenario, you show $1m in Roth and $1m in Traditional. In mine, there is $1.5 mil in Roth (Technically it was 1,534,000, but we are using easy numbers) and $500,000 in Traditional. Not only are RMDs lower, but if you use every penny and die when it is gone, you will have paid taxes on $500,000 rather than on $1mil.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.
Re: Trying to make sense of adding bonds
Yes, we're talking past each other. I am not ignoring any benefits, just pointing out that the (prospective, even likely) benefits are due to a higher risk position and once we adjust the allocation for that extra risk the benefits are the same. I am merely using the bad risk scenario as a test for the hypothesis that stocks-in-Roth has higher risk given same amounts, which turns out to be true. Somehow this discussion has degenerated into a mash of arguments about rebalancing, moving funds before withdrawal, the long-term rebound of stocks, etc.Dulocracy wrote:I do not think we are really able to continue the discussion productively if we have to consider traditional risks of stocks, but not traditional performance over a long duration. You are saying to ignore the benefits of a strategy you do not like, while pointing out the risks that are directly tied to those benefits.
I can only point again to the Tax adjusted asset allocation wiki. I think once you internalize that, it will all be clear.
I acknowledged that RMDs may be an issue that favor growth in Roth, but it's due to the possibility of a forced increase of the tax bracket (i.e. rate paid at withdrawal) when RMDs are large. It's a possibility for some individuals, not a certainty, and in any event the increases from one bracket to another are small. This valid argument is both less likely and much less consequential than the incorrect argument about whether stock growth is taxed or not, which ignores risk and goes away after adjustment for risk.Dulocracy wrote:These positions are logically inconsistent. "Sure, RMDs are lower, as the Roth space will be larger, but it will have no impact on taxes paid."ogd wrote:The one true argument for using high growth assets in Roth is to avoid RMDs that are not needed to live on, but bump one's tax rate unnecessarily. Avoiding high absolute tax amounts can be shown with proper discounting to not make a difference.
Re: Trying to make sense of adding bonds
I have tried to keep it civil, and I ask that you do the same.ogd wrote: I think once you internalize that, it will all be clear.
I fully understand tax-adjusted asset allocation. To be clear, this is relevant at the time that money is taken out of an account. Until that time, the accounts are fluid.
I can buy $100,000 in bonds in one account, while simultaneously selling $100,000 in bonds in the other, which is effectively moving bonds from one account to the other. There are no taxes on these transfers, and they can be done at any time.
You argue that the strategy that I mention can reduce RMDs. How does that happen if it does not expand Roth space? Do you disagree that there is a difference in paying taxes on accounts that are $1mil traditional and $1mil Roth vs. paying taxes on $500,000 traditional and $1.5mil Roth? The difference in the size of RMDs can only happen if there is more money in the Roth account.
Do you disagree that over a long duration, stocks outperform bonds? You keep talking about the risk, I would like to know if you acknowledge that they tend to outperform over long durations.
If you agree, then would not it make sense for us to put our higher performing assets in Roth space to grow as much as we can grow them up until a point of safety (like 5 years out, as I earlier suggested)? Why not have the Roth account grow more, and then transfer funds as described at the beginning? Buy and sell bonds and stock to create the desired asset allocation, which would THEN be equal across all accounts?
Again, I laid out with some specificity of how to us the bonds on this situation to make sure that if there is a downturn, you have a strategy to avoid selling while stocks are lower.
Yes, I do presume an eventual recovery. Assuming a 20% loss and then 30 years of 0% gain is simply unrealistic.
Using this strategy, you have expanded your Roth space, meaning lower RMD's AND fewer taxes paid. Because you rebalanced to your asset allocation, you do NOT have higher risk, as both accounts have the proper percentages. You lost nothing as you never sold when down. You simply have more Roth space.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.
Re: Trying to make sense of adding bonds
Nope, it is relevant all along the way. You have put your Roth space at risk during the accumulation phase. That can cost you real withdrawal power that you cannot get back by moving money between accounts. That movement is merely a disguise, to enable you to say that you didn't pay taxes on bonds per se. This is irrelevant -- what matters is the portfolio amount that was at risk, and what that portfolio amount will be after withdrawal taxes are paid.Dulocracy wrote:I fully understand tax-adjusted asset allocation. To be clear, this is relevant at the time that money is taken out of an account. Until that time, the accounts are fluid.
An extension of this argument can be used to argue for a higher stock allocation, which we are not doing here.Dulocracy wrote:Yes, I do presume an eventual recovery. Assuming a 20% loss and then 30 years of 0% gain is simply unrealistic.
But no matter -- I have explicitly mentioned that if you find this unrealistic (even if it was done in the context of a risk test, where the unlikely is the point of the argument), I've provided two other ways in which it becomes clear that a retiree with stocks in Roth had a riskier position and could end up paying for it. One was to have the bonds-in-Roth retiree B switch to mimicking the exact distribution of the stocks-in-Roth guy A, only with more money in Roth because he lost less Roth space. Then there is no way for A to catch up, proving that B took less risk over the accumulation period regardless of any stock rebound later.
The other is what I'd like you to respond most. If you like a $1M stocks in Roth and $1M bonds in Traditional and think you will pay 25% in retirement, do you have any problems with a $825K bonds / $125K stocks in Roth, and $1M stocks in Traditional being equivalent? It can be shown to allow the same withdrawals in both a good and a bad scenario. That is the essence of Tax-adjusted allocation.
Now some people's objection to Tax adjusted allocation is, I don't know what that 25% is, so I don't know what I should tax adjust to. But note that that is really an uncertainty about your asset allocation: if you put bonds in Traditional, their risk-reducing power might be more or less than you think. So a 50/50 allocation with bonds in Traditional is really "something between 50/50 and 62/38 stocks to bonds", depending on whether I pay 0 - 39% taxes at withdrawal. The only way to remove that uncertainty is to have 50/50 in both Roth and Traditional, then you truly know that your bonds will be as powerful as your stocks after taxes.
In other words, if you don't know the X% needed for tax adjustment, that doesn't mean it's zero. It exists and will have an impact on your risk position, you just don't know it. Take your best guess and adjust by that, or use a mirror allocation but that might be suboptimal.
The points below are minor compared to the above.
"Tend to", yes. The unlikely is why we even have bonds at all.Dulocracy wrote:Do you disagree that over a long duration, stocks outperform bonds? You keep talking about the risk, I would like to know if you acknowledge that they tend to outperform over long durations.
Let's leave RMDs out of this now. I've acknowledged the benefit if large RMDs would bump up the tax rate and if they are not needed for spending their presumed reinvestment into taxable would also cost future taxes. The size of the Roth is relevant only if it helps with this issue. That's all I'm gonna say about RMDs.Dulocracy wrote:You argue that the strategy that I mention can reduce RMDs.
Re: Trying to make sense of adding bonds
I went through extensive explanation of how this would work, and how one can use the fluidity available between Roth and Traditional accounts to mitigate risk and avoid bad things happening in a downturn, so I will not belabor that here.ogd wrote: Nope, it is relevant all along the way.
You creatively edited my post to leave out the relevant parts and to put in a few quotes that were not the point at all (more in a bit on that). I will sum up my argument countering this one. Risk AND Return are relevant along the way. Expanding Roth space is not guaranteed using equities (you picked up on several of my remarks indicating that this), however, over a longer duration of 30-40 years, it is highly likely that equities will out perform bonds. Ergo, it is extremely likely that Roth space would best be served by holding equities there, so as to expand this space.
As far as your math, if you took a picture of one moment in time, I would agree If you were gambling on the market without a plan and decided to withdraw every penny at the exact same moment in time, you would be absolutely correct. As in reality, you build wealth over time and likewise spend it down over time, I believe there are many useful strategies promoted on this site of mitigating risk in the retirement accounts, taking advantage of the ability to "switch" funds between accounts by buying in one and selling in the other at the same time.
Let's leave RMDs out of this now. I've acknowledged the benefit if large RMDs would bump up the tax rate and if they are not needed for spending their presumed reinvestment into taxable would also cost future taxes. The size of the Roth is relevant only if it helps with this issue. That's all I'm gonna say about RMDs.Dulocracy wrote:You argue that the strategy that I mention can reduce RMDs.
Good. Because RMDs are the distraction. You quoted me on the RMDs, and I was not talking about RMDs. I was talking about logic. You conceded RMDs would be less with my strategy. RMDs could not possibly be less if you did not use the strategy of putting bonds in Roth to expand Roth space (as traditional would be smaller). In my example, you then use the ability in the retirement accounts to rebalance the asset allocation across all accounts (to avoid the problem pointed out in your math). Risk is now the same, but you have more space in Roth. If you conceded that Roth space is larger and traditional is now smaller for the purpose of reducing RMDs (a topic we are not discussing again), you have admitted that Roth space is larger and Traditional is smaller. My point is that the second benefit is that you now pay less in taxes. Or, in your own words, you have more money that is in an account that is worth more and less money in the account that is worth less. This goes beyond RMDs as a second (and the most important) aspect of my argument.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.
Re: Trying to make sense of adding bonds
Hi Dulocracy -- would I be correct in summarizing that you have read and understand https://www.bogleheads.org/wiki/Tax-adj ... allocation , but your objection to the article is that you think that by switching funds before withdrawal you can avoid paying taxes on bonds, thereby invalidating the premise that bonds in tax-deferred have less risk fighting power?Dulocracy wrote:I went through extensive explanation of how this would work, and how one can use the fluidity available between Roth and Traditional accounts to mitigate risk and avoid bad things happening in a downturn, so I will not belabor that here.
If so, I suggest taking your objection up with the authors of the article, for example David Grabiner. Perhaps they can answer your objection better. For the record, my answer is that the adjustment is about the relative sizes of tax-deferred vs Roth space, and if risk manifests over the period where growth of Roth space, not of bonds per se, was expected, it is too late to fix it by switching around, and the hope that stocks will rebound is not a fix anymore than it would fix the higher risk of a higher stock allocation after stocks take a dive. But, like I said, it seems that I am not doing a good job of answering the objection. You should contact the authors of the article because, if valid, your objection would make the article incorrect.
I was absolutely not "conceding that Roth space is larger". I was simply saying that growth of Roth space is desirable only towards that goal of reducing RMDs. I don't know why you insist that there is a logic error in an argument that frames the goal, i.e. it's about "why prioritize Roth growth" not "has Roth growth occured". The second benefit (paying less absolute taxes) is not a real benefit if the core Tax-Adjusted Asset Allocation argument is correct, only a risk-return tradeoff.Dulocracy wrote: Good. Because RMDs are the distraction. You quoted me on the RMDs, and I was not talking about RMDs. I was talking about logic. You conceded RMDs would be less with my strategy. RMDs could not possibly be less if you did not use the strategy of putting bonds in Roth to expand Roth space (as traditional would be smaller). In my example, you then use the ability in the retirement accounts to rebalance the asset allocation across all accounts (to avoid the problem pointed out in your math). Risk is now the same, but you have more space in Roth. If you conceded that Roth space is larger and traditional is now smaller for the purpose of reducing RMDs (a topic we are not discussing again), you have admitted that Roth space is larger and Traditional is smaller. My point is that the second benefit is that you now pay less in taxes. Or, in your own words, you have more money that is in an account that is worth more and less money in the account that is worth less. This goes beyond RMDs as a second (and the most important) aspect of my argument.
Re: Trying to make sense of adding bonds
[quote="ogd"] But, like I said, it seems that I am not doing a good job of answering the objection. You should contact the authors of the article because, if valid, your objection would make the article incorrect.
Article quotes in blue, my comments in red
If all else is equal (and it often isn't because of limited 401(k) options), it is slightly better to put assets with higher expected returns in the Roth. If your traditional account has lower than expected returns and you fall into a lower tax bracket, the IRS will not give back the same share of the losses; if your traditional account has higher than expected returns, the IRS will take a larger share of the gains. In the Roth, you get the same percentage (100%) of all gains and losses. In addition, the Roth is protected against potential changes in tax rates, has more flexible rules for required minimum distributions, and is not counted as income for making Social Security taxable.
This shows why there is both an advantage from the RMD standpoint and a tax advantage, without discussing time of distribution, which we will come to. The article you promote also says higher expected return in Roth.
ALSO, the article DOES NOT COMMENT on time of distribution. Using the information presented in the article, one could devise a flexible strategy of withdrawal from the account to use a natural rebalancing (taking out bonds only, as stocks are down) until the stocks recover. For longer term recoveries, one may have to be flexible with what assets to take according to a pre-determined strategy. This requires an asset allocation that holds enough bonds to work. If one plans, one can avoid withdrawing during a downturn. Withdrawal is what triggers the loss- you have lost nothing as your account value fluctuates up and down until you lock in those losses. What I am talking about is not foreign on this board or in investing. I am proposing this strategy as an ADDITIONAL reason that higher performing assets go in Roth. I AGREE with the authors of that article that higher performing assets go in Roth for RMD and tax reasons. I am offering an additional strategy that would bolster that argument.
Article quotes in blue, my comments in red
If all else is equal (and it often isn't because of limited 401(k) options), it is slightly better to put assets with higher expected returns in the Roth. If your traditional account has lower than expected returns and you fall into a lower tax bracket, the IRS will not give back the same share of the losses; if your traditional account has higher than expected returns, the IRS will take a larger share of the gains. In the Roth, you get the same percentage (100%) of all gains and losses. In addition, the Roth is protected against potential changes in tax rates, has more flexible rules for required minimum distributions, and is not counted as income for making Social Security taxable.
This shows why there is both an advantage from the RMD standpoint and a tax advantage, without discussing time of distribution, which we will come to. The article you promote also says higher expected return in Roth.
ALSO, the article DOES NOT COMMENT on time of distribution. Using the information presented in the article, one could devise a flexible strategy of withdrawal from the account to use a natural rebalancing (taking out bonds only, as stocks are down) until the stocks recover. For longer term recoveries, one may have to be flexible with what assets to take according to a pre-determined strategy. This requires an asset allocation that holds enough bonds to work. If one plans, one can avoid withdrawing during a downturn. Withdrawal is what triggers the loss- you have lost nothing as your account value fluctuates up and down until you lock in those losses. What I am talking about is not foreign on this board or in investing. I am proposing this strategy as an ADDITIONAL reason that higher performing assets go in Roth. I AGREE with the authors of that article that higher performing assets go in Roth for RMD and tax reasons. I am offering an additional strategy that would bolster that argument.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.
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Re: Trying to make sense of adding bonds
That asset location analysis likely has some fairly significant flaws. For instance, a muni bond fund has higher risk than a bond index fund, so leavening the risk means a lower allocation to equities if holding munis.Third: There is a great blog for doctors that translates well to higher income individuals called the WhiteCoatInvestor by board member emergdoc. His premise is that my first comment about bonds in taxable is wrong. It is an interesting view worth considering. Link here: http://whitecoatinvestor.com/asset-loca ... n-taxable/
Munis also have a higher correlation to equities-- credit risk often enough shows up at the wrong time, i.e. when the economy is struggling and equities may be struggling.
And the tax rates used assume all withdrawals are taxed at the marginal rate rather than calculating the aggregate rate (which depends on spending needs, not account balance), so the tax drag on capital gains in the taxable account likely is overestimated significantly.
Finally, volatility in a Roth account is a greater risk than in a taxable account because tax-loss harvesting is not available to mitigate some of the risk. This last point may be a justification to hold a mixed portfolio in a Roth account to reduce volatility and capture rebalancing premiums in the Roth account, but I think in general it is difficult to devise a one-size-fits-all rule.
Re: Trying to make sense of adding bonds
jalbert wrote:That asset location analysis likely has some fairly significant flaws. For instance, a muni bond fund has higher risk than a bond index fund, so leavening the risk means a lower allocation to equities if holding munis.Third: There is a great blog for doctors that translates well to higher income individuals called the WhiteCoatInvestor by board member emergdoc. His premise is that my first comment about bonds in taxable is wrong. It is an interesting view worth considering. Link here: http://whitecoatinvestor.com/asset-loca ... n-taxable/
Munis also have a higher correlation to equities-- credit risk often enough shows up at the wrong time, i.e. when the economy is struggling and equities may be struggling.
And the tax rates used assume all withdrawals are taxed at the marginal rate rather than calculating the aggregate rate (which depends on spending needs, not account balance), so the tax drag on capital gains in the taxable account likely is overestimated significantly.
I agree. To be clear, I was proposing it as a counterpoint to what I had already said. When people ask for information, I like for them to have all sides to view. I am not the one to defend that strategy at this point, as I have not researched it and do not follow it currently.
Finally, volatility in a Roth account is a greater risk than in a taxable account because tax-loss harvesting is not available to mitigate some of the risk. This last point may be a justification to hold a mixed portfolio in a Roth account to reduce volatility and capture rebalancing premiums in the Roth account, but I think in general it is difficult to devise a one-size-fits-all rule.
Tax loss harvesting has its advantages, but I tend to think of it as something one does after maximizing tax advantaged space. Until one maximizes tax deferred space, I think it is best to keep pumping money into tax deferred. After tax deferred is maxed, I tend to believe that equities go in taxable (except for REITs) and bonds go in tax advantaged. Between tax deferred and Roth, if one has equities in tax advantaged, I would place those equities in Roth space.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.
Re: Trying to make sense of adding bonds
As I was saying -- please raise this "time of distribution" / "account fluidity" objection with the authors of the article so they can respond. Do note that flexible withdrawal and not selling stock at a loss can be used to simply argue for a higher stock allocation. It's really the "fluidity" where you differ the most, I think.Dulocracy wrote: ALSO, the article DOES NOT COMMENT on time of distribution. Using the information presented in the article, one could devise a flexible strategy of withdrawal from the account to use a natural rebalancing (taking out bonds only, as stocks are down) until the stocks recover. For longer term recoveries, one may have to be flexible with what assets to take according to a pre-determined strategy. This requires an asset allocation that holds enough bonds to work. If one plans, one can avoid withdrawing during a downturn. Withdrawal is what triggers the loss- you have lost nothing as your account value fluctuates up and down until you lock in those losses. What I am talking about is not foreign on this board or in investing. I am proposing this strategy as an ADDITIONAL reason that higher performing assets go in Roth. I AGREE with the authors of that article that higher performing assets go in Roth for RMD and tax reasons. I am offering an additional strategy that would bolster that argument.
I agree with this tax bracket argument -- note the "slight", we are talking about differences between brackets, not absolute taxes paid. The argument is closely related to the RMD advantage, the differences are relatively small and it may simply not apply to a specific individual if they are comfortably below the next bracket. Whereas the argument about "paying taxes on growth", which has the problem of not accounting for risk, leads to huge differences between stocks-in-Roth and stocks-in-tax-deferred.Wiki article wrote: If all else is equal (and it often isn't because of limited 401(k) options), it is slightly better to put assets with higher expected returns in the Roth. If your traditional account has lower than expected returns and you fall into a lower tax bracket, the IRS will not give back the same share of the losses; if your traditional account has higher than expected returns, the IRS will take a larger share of the gains. In the Roth, you get the same percentage (100%) of all gains and losses. In addition, the Roth is protected against potential changes in tax rates, has more flexible rules for required minimum distributions, and is not counted as income for making Social Security taxable.
Re: Trying to make sense of adding bonds
I was sincere: it really has been fun.ogd wrote:As I was saying -- please raise this "time of distribution" / "account fluidity" objection with the authors of the article so they can respond. Do note that flexible withdrawal and not selling stock at a loss can be used to simply argue for a higher stock allocation. It's really the "fluidity" where you differ the most, I think.Dulocracy wrote: ALSO, the article DOES NOT COMMENT on time of distribution. Using the information presented in the article, one could devise a flexible strategy of withdrawal from the account to use a natural rebalancing (taking out bonds only, as stocks are down) until the stocks recover. For longer term recoveries, one may have to be flexible with what assets to take according to a pre-determined strategy. This requires an asset allocation that holds enough bonds to work. If one plans, one can avoid withdrawing during a downturn. Withdrawal is what triggers the loss- you have lost nothing as your account value fluctuates up and down until you lock in those losses. What I am talking about is not foreign on this board or in investing. I am proposing this strategy as an ADDITIONAL reason that higher performing assets go in Roth. I AGREE with the authors of that article that higher performing assets go in Roth for RMD and tax reasons. I am offering an additional strategy that would bolster that argument.
It is the fluidity and the distribution over time that are important to my argument yes. As far as talking to the authors, if they want to chime in, I would be happy to discuss it, but I am not going to bother them. I am enjoying the discussion with you of the aspects left out of that article. I hope you also have enjoyed what has turned out to be a very good mental exercise.
I agree with this tax bracket argument -- note the "slight", we are talking about differences between brackets, not absolute taxes paid. The argument is closely related to the RMD advantage, the differences are relatively small and it may simply not apply to a specific individual if they are comfortably below the next bracket. Whereas the argument about "paying taxes on growth", which has the problem of not accounting for risk, leads to huge differences between stocks-in-Roth and stocks-in-tax-deferred.Wiki article wrote: If all else is equal (and it often isn't because of limited 401(k) options), it is slightly better to put assets with higher expected returns in the Roth. If your traditional account has lower than expected returns and you fall into a lower tax bracket, the IRS will not give back the same share of the losses; if your traditional account has higher than expected returns, the IRS will take a larger share of the gains. In the Roth, you get the same percentage (100%) of all gains and losses. In addition, the Roth is protected against potential changes in tax rates, has more flexible rules for required minimum distributions, and is not counted as income for making Social Security taxable.
The authors of that article agree with my statement that higher performing assets should go in Roth. If you disagree, you can debate them and ask them to change the article.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.
Re: Trying to make sense of adding bonds
The "slightly" makes all the difference though. Note that the article prioritizes this below the location of a better fund; e.g. if all you have is a 1%+ bond fund in 401k, but have a cheap stock index, which happens surprisingly often. Also (subtly) the tax adjustment argument makes it clear that one should not necessarily (or even usually) favor Roth vs Traditional contributions, which could be a much bigger deal since for most people their tax rate in retirement will be much lower. So if we say "stock growth in Roth is slightly better", and not immensely better as per the unadjusted numbers, people will consider the tax bracket situation first. I don't think you were making any arguments about contributions, but this is why I feel it's important to not overemphasize the Roth.Dulocracy wrote:...Wiki article wrote: If all else is equal (and it often isn't because of limited 401(k) options), it is slightly better to put assets with higher expected returns in the Roth. If your traditional account has lower than expected returns and you fall into a lower tax bracket, the IRS will not give back the same share of the losses; if your traditional account has higher than expected returns, the IRS will take a larger share of the gains. In the Roth, you get the same percentage (100%) of all gains and losses. In addition, the Roth is protected against potential changes in tax rates, has more flexible rules for required minimum distributions, and is not counted as income for making Social Security taxable.
The authors of that article agree with my statement that higher performing assets should go in Roth. If you disagree, you can debate them and ask them to change the article.
Re: Trying to make sense of adding bonds
I think we can agree to say that if one does not consider strategies of withdrawal or take into consideration that accumulation and withdrawal are over time, there is a slight advantage to Roth. You will not debate me on the other matter, so we will have to let that be.ogd wrote:The "slightly" makes all the difference though. Note that the article prioritizes this below the location of a better fund; e.g. if all you have is a 1%+ bond fund in 401k, but have a cheap stock index, which happens surprisingly often. Also (subtly) the tax adjustment argument makes it clear that one should not necessarily (or even usually) favor Roth vs Traditional contributions, which could be a much bigger deal since for most people their tax rate in retirement will be much lower. So if we say "stock growth in Roth is slightly better", and not immensely better as per the unadjusted numbers, people will consider the tax bracket situation first. I don't think you were making any arguments about contributions, but this is why I feel it's important to not overemphasize the Roth.Dulocracy wrote:...Wiki article wrote: If all else is equal (and it often isn't because of limited 401(k) options), it is slightly better to put assets with higher expected returns in the Roth. If your traditional account has lower than expected returns and you fall into a lower tax bracket, the IRS will not give back the same share of the losses; if your traditional account has higher than expected returns, the IRS will take a larger share of the gains. In the Roth, you get the same percentage (100%) of all gains and losses. In addition, the Roth is protected against potential changes in tax rates, has more flexible rules for required minimum distributions, and is not counted as income for making Social Security taxable.
The authors of that article agree with my statement that higher performing assets should go in Roth. If you disagree, you can debate them and ask them to change the article.
If you are ever interested in debating it, my premise is simply that:
1) Equities tend to outperform over the long run, and with a 30-40 year duration, you are very likely to have more money in the equities portion, EVEN IF there is a downturn at the time of retirement.
2) A flexible withdrawal strategy can be used to circumvent selling low during a down time to allow equities to recover before withdrawing them.
The above is extremely likely to increase the argument that equities go in Roth space, and my position is that the risk adjusted return of this strategy leans towards equity in Roth.
Unfortunately, the article does not address these issues, leaving us to entertain ourselves.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.
Re: Trying to make sense of adding bonds
But this exact argument can be used to argue for a higher equity allocation! As in, "if you want 50/50 because of risk, why not 60/40? Chances are you'll never sell stocks at a loss with 60/40 either."Dulocracy wrote:If you are ever interested in debating it, my premise is simply that:
1) Equities tend to outperform over the long run, and with a 30-40 year duration, you are very likely to have more money in the equities portion, EVEN IF there is a downturn at the time of retirement.
2) A flexible withdrawal strategy can be used to circumvent selling low during a down time to allow equities to recover before withdrawing them.
The above is extremely likely to increase the argument that equities go in Roth space, and my position is that the risk adjusted return of this strategy leans towards equity in Roth.
Unfortunately, the article does not address these issues, leaving us to entertain ourselves.
The only thing that you are getting with stocks-in-Roth is an allocation that still looks 50/50 if you don't tax adjust, but is as risky as 60/40 (for example) with bonds-in-Roth, in terms of what you can eventually withdraw, and about as rewarding too. Is it that important that unadjusted numbers look less risky, if the withdrawal power is the same in both good and bad scenarios?
Re: Trying to make sense of adding bonds
ogd wrote:But this exact argument can be used to argue for a higher equity allocation! As in, "if you want 50/50 because of risk, why not 60/40? Chances are you'll never sell stocks at a loss with 60/40 either."Dulocracy wrote:If you are ever interested in debating it, my premise is simply that:
1) Equities tend to outperform over the long run, and with a 30-40 year duration, you are very likely to have more money in the equities portion, EVEN IF there is a downturn at the time of retirement.
2) A flexible withdrawal strategy can be used to circumvent selling low during a down time to allow equities to recover before withdrawing them.
The above is extremely likely to increase the argument that equities go in Roth space, and my position is that the risk adjusted return of this strategy leans towards equity in Roth.
Unfortunately, the article does not address these issues, leaving us to entertain ourselves.
Not only am I not making that argument, I have made it clear that a healthy allocation to bonds is necessary for the strategy I mentioned to work.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.
Re: Trying to make sense of adding bonds
Probably foolish of me to try to join this debate now, but whatever.
As I understand, the discussion is about whether one should preferentially put bonds (or stock) in 401(k) or in Roth. But if one sticks to a pre-determined AA (e.g., hold age in bonds), and accounts for taxation - i.e., discounts his holdings in his 401(k) by his retirement income tax rate - then it makes no difference: you get the same amount in the end, regardless of returns and whether you put your stock in 401(k) or in Roth. Of course you don't quite know what your tax rate will be in retirement: just make your best guess.
The idea that you should load your stock in Roth assumes that you won't rebalance later, therefore causing the Roth to grow to a large size and therefore making your stock allocation very large. Most Bogleheads suggest rebalancing, so this suggestion doesn't make sense.
EDIT: Preferentially putting stock into your Roth (as opposed to 401(k)) will indeed cause you to finish with a larger Roth. Again, after taxes, your amount of money is the same. But all other things equal, I think I'd rather have a large Roth than a large 401(k), so I'd lean that way.
As I understand, the discussion is about whether one should preferentially put bonds (or stock) in 401(k) or in Roth. But if one sticks to a pre-determined AA (e.g., hold age in bonds), and accounts for taxation - i.e., discounts his holdings in his 401(k) by his retirement income tax rate - then it makes no difference: you get the same amount in the end, regardless of returns and whether you put your stock in 401(k) or in Roth. Of course you don't quite know what your tax rate will be in retirement: just make your best guess.
The idea that you should load your stock in Roth assumes that you won't rebalance later, therefore causing the Roth to grow to a large size and therefore making your stock allocation very large. Most Bogleheads suggest rebalancing, so this suggestion doesn't make sense.
EDIT: Preferentially putting stock into your Roth (as opposed to 401(k)) will indeed cause you to finish with a larger Roth. Again, after taxes, your amount of money is the same. But all other things equal, I think I'd rather have a large Roth than a large 401(k), so I'd lean that way.
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Re: Trying to make sense of adding bonds
The question isn't whether to max out tax advantaged space before taxable space, but what assets to locate in the two spaces once they are funded. State taxes also can play a large role in asset location determination.Tax loss harvesting has its advantages, but I tend to think of it as something one does after maximizing tax advantaged space. Until one maximizes tax deferred space, I think it is best to keep pumping money into tax deferred
Re: Trying to make sense of adding bonds
However, you take the risk as long as you have the investment in the Roth. Suppose that you have $10,000 in a traditional IRA and $10,000 in a Roth IRA, and you put one account in stock and one in bonds. If the stock market loses 50%, whichever account has the stock will decrease in value to $5000. You are better off with $10,000 in the Roth and $5000 in the traditional IRA than the other way around, so you took more risk with stocks in the Roth.Dulocracy wrote:Here is why I disagree generally with the idea that putting your riskiest assets in Roth is increasing risk: You can rebalance the accounts by exchanging funds. By that, I mean that, in the future, you can simply trade one fund for the other. Just because I have my highest return assets in Roth space now does NOT mean I have to have them there in retirement.
If you adjust for the relative value of the accounts, then there is no increase in risk, If you are in a 25% tax bracket and have $10,000 in a traditional IRA and $7500 in a Roth, then it is no greater risk to put stocks in either account; a 50% market decline will cost you 25% of the money you can spend in retirement, and you can reallocate if you wish.
Re: Trying to make sense of adding bonds
You can decide how much risk (and stock correlation) to take with bonds of either type. You can buy pre-refunded munis or Treasury bonds to reduce credit risk, or longer-term munis or bonds to increase interest-rate risk. It may be true that a typical muni fund is riskier than Total Bond Market Index, but that is not a reason to avoid munis; you should use munis or taxable bonds based on your tax situation, and then choose the appropriate risk level.jalbert wrote:That asset location analysis likely has some fairly significant flaws. For instance, a muni bond fund has higher risk than a bond index fund, so leavening the risk means a lower allocation to equities if holding munis.Third: There is a great blog for doctors that translates well to higher income individuals called the WhiteCoatInvestor by board member emergdoc. His premise is that my first comment about bonds in taxable is wrong. It is an interesting view worth considering. Link here: http://whitecoatinvestor.com/asset-loca ... n-taxable/
Munis also have a higher correlation to equities-- credit risk often enough shows up at the wrong time, i.e. when the economy is struggling and equities may be struggling.
The withdrawals which make a difference are likely to be taxed at your marginal rate. If your investments perform poorly and your taxable investment income is $60K rather than $70K, the $10K difference reduces your tax at close to the marginal rate.And the tax rates used assume all withdrawals are taxed at the marginal rate rather than calculating the aggregate rate (which depends on spending needs, not account balance), so the tax drag on capital gains in the taxable account likely is overestimated significantly.
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Re: Trying to make sense of adding bonds
The referenced analysis compares the total after tax wealth accumulation of the two strategies and uses the marginal tax rate as the tax drag on the two portfolios being compared. This would only be correct if all withdrawals were taxed at the marginal rate, which is not true. Moreover, there is alot of flexibility to manage the withdrawal process to mitigate the tax drag, something that sometimes only becomes clarified after entering the withdrawal phase.
Re: Trying to make sense of adding bonds
rbaldini wrote:Probably foolish of me to try to join this debate now, but whatever.
Not at all!
As I understand, the discussion is about whether one should preferentially put bonds (or stock) in 401(k) or in Roth. But if one sticks to a pre-determined AA (e.g., hold age in bonds), and accounts for taxation - i.e., discounts his holdings in his 401(k) by his retirement income tax rate - then it makes no difference: you get the same amount in the end, regardless of returns and whether you put your stock in 401(k) or in Roth. Of course you don't quite know what your tax rate will be in retirement: just make your best guess.
Yes, you have the same amount if you maintain your asset allocation. However, by putting higher expected return assets in Roth space, the argument is that you have the same amount, but more of it in Roth space. You have more tax-free money, and less money on which one must pay taxes.
The idea that you should load your stock in Roth assumes that you won't rebalance later, therefore causing the Roth to grow to a large size and therefore making your stock allocation very large. Most Bogleheads suggest rebalancing, so this suggestion doesn't make sense.
If you go back to the examples with numbers above, you will see that there is rebalancing. The individual has the same amount of money, as they maintained their asset allocation. More of it is in Roth, however. In that case, we had an example where he maintained the asset allocation, so some bonds had to migrate to Roth space, but all of his equities were in Roth. At the end, both portfolios had $2m, but one was divided $1m Roth and $1m in Tax deferred, while the other portfolio had $1.5m in Roth and $0.5m in tax deferred. This would mean several things. For the same Asset Allocation (and I am arguing risk profile if managed properly), the second individual has $500,000 more in money on which he would not have paid taxes. Also, having lower RMDs would force less money out of retirement vehicles AND possibly lower his tax bracket.
EDIT: Preferentially putting stock into your Roth (as opposed to 401(k)) will indeed cause you to finish with a larger Roth. Again, after taxes, your amount of money is the same. But all other things equal, I think I'd rather have a large Roth than a large 401(k), so I'd lean that way.
Agreed.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.
Re: Trying to make sense of adding bonds
I agree that there is some risk to this strategy. My point is that the risk adjusted return is greater using this strategy. That is, because of the methods used to mitigate risk, and because of the way that assets perform, one can wind up much better off with this strategy with a very low chance of winding up worse off. Just as you argue that it is a matter of evaluating whether a riskier muni bond fund is appropriate, one needs to look at this position as to whether or not it is appropriate. I would say that in almost every case (for a long term investor), putting more risk in Roth for more expected return is the right call.grabiner wrote:However, you take the risk as long as you have the investment in the Roth. Suppose that you have $10,000 in a traditional IRA and $10,000 in a Roth IRA, and you put one account in stock and one in bonds. If the stock market loses 50%, whichever account has the stock will decrease in value to $5000. You are better off with $10,000 in the Roth and $5000 in the traditional IRA than the other way around, so you took more risk with stocks in the Roth.Dulocracy wrote:Here is why I disagree generally with the idea that putting your riskiest assets in Roth is increasing risk: You can rebalance the accounts by exchanging funds. By that, I mean that, in the future, you can simply trade one fund for the other. Just because I have my highest return assets in Roth space now does NOT mean I have to have them there in retirement.
If you adjust for the relative value of the accounts, then there is no increase in risk, If you are in a 25% tax bracket and have $10,000 in a traditional IRA and $7500 in a Roth, then it is no greater risk to put stocks in either account; a 50% market decline will cost you 25% of the money you can spend in retirement, and you can reallocate if you wish.
The benefits (presuming one does not alter asset allocation, but just location) are as follows:
1) Less loss on the account due to taxes.
2) Lower RMDs, so you can keep money in tax advantaged accounts longer
3) Lower tax bracket because of the lower RMDs.
4) If it is a concern, a larger legacy left to heirs through the Roth.
Of course, we are talking about cost/benefit. Why do I think this is the best option, including risk in the formula?
First, let me identify what we are not talking about. It has been mentioned that someone could use some of the same arguments for a higher stock allocation. Let us take someone who is 90/10. Stocks crash. They are in a bad situation, not because of where the assets are located, but because they simply had the wrong asset allocation. Actually, in this case, having bonds in traditional and spending down the bonds first would give a higher chance of being able to recover Roth space, so yes, even if you royally screw up, this can be a better strategy. I am presuming that someone chooses the correct asset allocation, however, as that is a straw man argument that is not relevant to this discussion.
What mitigates the risk?
1) Over the long run, stocks outperform bonds. Even presuming a modest 5% annual real return, in the example above, it can be seen that over a long duration (30 to 40 years) that stocks will outperform. Not only that, but even with a crash, over this duration, stocks are typically STILL STRONGER than bonds.
2) As described, asset allocations in tax advantaged accounts are fluid. One rebalances at a set time prior to retirement at the desired asset allocation (50/50 in the examples above). My suggested time was 5 years out. Now, some people want to always rebalance, which means they are choosing not to use this strategy, but for those willing to suspend rebalancing in a more flexible draw-down strategy, even if a downturn occurs, they will be fine. That is, one simply draws down off of the bond allocation until the stock allocation recovers. Most downturns last at most 10 years, so changing 5 years out should cover half. I do not know about you, but I could live quite the long time off of $1m in bonds after that first year. Even for those who want to rebalance, a significant drop in stock means that withdrawals would be a form of natural rebalance. If one is not comfortable with my 5 years out, choose 10. Doing so would further reduce the risk of the strategy. There are so many ways of handling this that one could comfortably do so to wait out the downturn. A recap of those ways:
1) Use withdrawals from bonds as a way of naturally rebalancing.
2) Suspend rebalancing and take from bonds until the market recovers and then rebalance accross accounts to make them all equal weighted.
3) Continue rebalancing, meaning that you would purchase a block of stocks in traditional, and if you had to sell stocks, those go, protecting the Roth space until recovery.
No matter how you slice it, over a long duration, it just makes sense to put highest performing assets in Roth, as the risk of a meltdown is very, very low. If such a thing happens, it is likely that you are in a bad situation requiring bullets, whiskey, and gold anyway. In planning, I must have faith that the market will act somewhat like it did in the past, and the above strategy should last a good 20 years into retirement if one is flexible (using previously discussed numbers).
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.