Maintaining AA with uneven incoming cash flow

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hyde
Posts: 6
Joined: Thu Oct 26, 2017 10:52 am

Maintaining AA with uneven incoming cash flow

Post by hyde » Thu Oct 26, 2017 12:47 pm

Been reading for a while and learned a lot. I had a question about maintaining AA across Tax Advantaged and Taxable with uneven income streams. Thanks in advance for the advice.

Also, sorry ahead of time for being long winded.

Emergency funds: 4 Months

Debt:
$78k @ 1.75% - Car
$590k @ 3.875% - Mortgage (Bay Area)

Tax Filing Status: Single
Tax Rate: 39.5% Federal, 11.3% State
State of Residence: CA
Age: 35

Desired Asset allocation: 75% stocks / 25% bonds
Desired International allocation: 20% of stocks

Notes:
I'm in the mid six-figures for the total size. With ~70% in taxable using tax adjusted amounts. I'm tax adjusting assuming a 25% retirement tax rate, since I'm using Fidelity Brokerage Link for my 401k, and it combines the 401k Traditional and 401k Roth into a single account, and I can't specify which investments get the Traditional vs Roth.

I have DODIX in my 401k to maintain a minimal amount in the non-Brokerage Link account for fees. It's the only bond fund available their.

Current retirement assets:
Taxable - 58% of Total
0% cash
53% - FSTVX - Fidelity Total Market Index - ER 0.10%
15% - FTIPX - Fidelity Total International Index - ER 0.04%

401k Traditional + Roth - Tax Adjusted - 30% of Total
1% - DODIX - Dodge Income Intermediate Bond - ER 0.43%
12% - FIBAX - Fidelity Intermediate Treasury - ER 0.06%
6% - LQD - iShares Investment Grade Corporate Bonds - ER 0.15%
6% - SLQD - iShares 0-5 Year Investment Grade Corporate Bonds - ER 0.06%
5% - FSTVX - Fidelity Total Market Index - ER 0.10%

Roth IRA - 2% of Total
2% - FSTVX - Fidelity Total Market Index- ER 0.10%

Planned Contributions Going Forward:
$18k - 401k - Traditional
$4k - 401k - Company Match
$32k - 401k - After-Tax - In-plan Roth Rollover
?? - Taxable - ESPP/RSU Vests - Uneven

Company ESPP/RSU Plan:
Sell RSU Immediately to fund taxable
Sell ESPP once qualified if large gains, or immediately if tax difference between qualified and unqualified is minimal.

Questions:
1. I'm targeting bonds as 50% Intermediate Treasury, and 50% intermediate Investment Grade Corp after reading Larry Swedroe's book on Bond Strategies and reviewing various postings on the forum. This is to keep the amount relatively safe, and take more risk on the Equity side.
I wanted transaction free funds/etfs at Fidelity, so I decided to stick with LQD/SLQD split for the intermediate Corp. LQD has a 8.3 year duration, which was a little high, so I added SLQD (duration 2.28 years) to bring the average duration closer to 5 years. I read that this was an appropriate strategy to reduce the duration, but it would nice if someone can confirm or deny. Is there any hidden costs to doing it this way versus trying to find a single fund to match what I want?

2. I have a significant amount of ESPP that is current short term gains and almost all growth, so I'm waiting until next year to sell it when it becomes qualified and taxed as Capital Gains. I also have a large amount of RSUs vesting over the next 4 years (equivalent to my current total retirement investment after tax is applied). Due to their size relative to my investment accounts, if I considered them in my AA it would significantly skew the stock allocation towards my company. Even the ESPP I hold onto while waiting for it to become qualified gains would be significant. I'm just going to consider these future possible income, and not part of my retirement portfolio until I sell them, so they don't effect my AA. Is that a reasonable way to plan?

3. Since my ESPP/RSU cash flow is uneven, and only in Taxable, my current plan is to look forward to the next large vesting of ESPP/RSU, and put money in to hit the target AA at that time. In effect, my AA will be uneven in-between these large events. Or would just investing in Municipal Bonds in Taxable be a better solution to keep the AA more consistent? Eventually this won't be as much of an issue, but at least for the next few years the incoming investment $ from RSU/ESPP will be large enough to disrupt the tax efficient placement.

mega317
Posts: 1263
Joined: Tue Apr 19, 2016 10:55 am

Re: Maintaining AA with uneven incoming cash flow

Post by mega317 » Thu Oct 26, 2017 2:39 pm

1. Good plan.

2. This is interesting. I don't know the best answer. I'm inclined to count everything that's vested right now. The ESPP is your money to do what you want with. It is skewing your risk profile whether you like it or not. It may indeed make sense to wait until the gains become long-term. In that case I might increase my bond allocation. Then when you sell the ESPP you just replace it with a stock index fund. But it may also make sense just to pay the taxes and reduce your risk now, or do some of each mix.

3. I'm not clear on the question here. But if this is only going to be an issue for a couple years, you're young with a huge income, it probably doesn't matter what you do. In general muni bonds are worth looking at in your case because even your qualified dividends are highly taxed (20+11.3+3.8%=35%), so stocks are less tax-efficient for you than for most of us.

MotoTrojan
Posts: 866
Joined: Wed Feb 01, 2017 8:39 pm

Re: Maintaining AA with uneven incoming cash flow

Post by MotoTrojan » Thu Oct 26, 2017 8:44 pm

I have seen people add a 40-50% knockdown on illiquid private company stock, when considering it for their AA. I am 100% stock so I just manage my AA of liquid stock independently, even though the majority of my portfolio is in private shares that I can't, or rarely, can sell.

inbox788
Posts: 4194
Joined: Thu Mar 15, 2012 5:24 pm

Re: Maintaining AA with uneven incoming cash flow

Post by inbox788 » Thu Oct 26, 2017 9:53 pm

How significant is the ESPP? What percentage of your portfolio? Are you understanding the tax implications correctly? Particularly with grant dates and ordinary income vs. capital gains? Most RSU grants have limited benefit holding long term. Is the employer an SP500 company? Or small/micro Cap?

As long as the skew is limited, say less than 25% ESPP and for limited time, I'd simply ignore it and count your chickens after they hatch. Just sit on them and hatch them asap.

hyde
Posts: 6
Joined: Thu Oct 26, 2017 10:52 am

Re: Maintaining AA with uneven incoming cash flow

Post by hyde » Thu Oct 26, 2017 11:47 pm

mega317,
I did some rough calculations on replacing the Intermediate Corp with Municipal, so I could move the TSM into Tax Advantaged, but it seems like a wash. I'm going to do a more detailed back testing to see if that changes the results and will adjust if it helps.

inbox788,
The ESPP is worth around 20% of my total portfolio. It's a S&P 500 company. It's all be held under a year, and the cost basis is only about 10% of the ESPP value. It will get taxed as income, which is ~47%. If I hold until it is Qualified, around 1/2 in March 2018 and 1/2 in Sept 2018, that drops taxes down to ~32%. The difference in taxes is above $30k, so it's a lot of money, which is why I'm hesitant to sell it right away.

I've been selling my RSUs as soon as I get them to diversify, and it's only the ESPP I'm holding onto for tax reasons.

inbox788
Posts: 4194
Joined: Thu Mar 15, 2012 5:24 pm

Re: Maintaining AA with uneven incoming cash flow

Post by inbox788 » Fri Oct 27, 2017 11:10 am

hyde wrote:
Thu Oct 26, 2017 11:47 pm
The ESPP is worth around 20% of my total portfolio. It's a S&P 500 company. It's all be held under a year, and the cost basis is only about 10% of the ESPP value. It will get taxed as income, which is ~47%. If I hold until it is Qualified, around 1/2 in March 2018 and 1/2 in Sept 2018, that drops taxes down to ~32%. The difference in taxes is above $30k, so it's a lot of money, which is why I'm hesitant to sell it right away.

I've been selling my RSUs as soon as I get them to diversify, and it's only the ESPP I'm holding onto for tax reasons.
Having 20% in any single stock is high, but I worry less if it's a large cap blue chip in the SP500 than not. Once you've filled your buffer for the required holding period, you should expect this percentage to fall off. To me, the ESPP benefits usually outweigh the concentration risk.

I don't believe the understanding of cost basis of 10% and somehow getting some long term tax benefit is accurate. Be sure you understand each step of the transactions and which ones impact which taxes. It's complicated, but worth learning, so you can get out sooner and diversify. Note, you only pay taxes on the profits and you may have already paid some taxes along the way (i.e. share withholding). My understanding is that by holding to a Qualifying period, you convert the 15% discount (and lookback discount) to long term, so the overall tax impact may be much smaller, though still worthwhile.

https://communications.fidelity.com/sps ... icle1.html
https://turbotax.intuit.com/tax-tips/in ... /L8NgMFpFX
Last edited by inbox788 on Fri Oct 27, 2017 11:18 am, edited 1 time in total.

alex_686
Posts: 2614
Joined: Mon Feb 09, 2015 2:39 pm

Re: Maintaining AA with uneven incoming cash flow

Post by alex_686 » Fri Oct 27, 2017 11:16 am

hyde wrote:
Thu Oct 26, 2017 12:47 pm
I wanted transaction free funds/etfs at Fidelity, so I decided to stick with LQD/SLQD split for the intermediate Corp. LQD has a 8.3 year duration, which was a little high, so I added SLQD (duration 2.28 years) to bring the average duration closer to 5 years. I read that this was an appropriate strategy to reduce the duration, but it would nice if someone can confirm or deny. Is there any hidden costs to doing it this way versus trying to find a single fund to match what I want?
In theory this works. Duration assumes a parallel shift in the yield curve. In practice, maybe. IIRC about 50% of the shifts in the yield curve are parallel. You can get 5 year duration a couple of different ways. Bullet - all at 5. Level - durations spread across a wide spectrum. Or Barbell, which is what you are doing. Each works a little bit differently. Nothing wrong with what your doing - just recognize what you are doing.

hyde
Posts: 6
Joined: Thu Oct 26, 2017 10:52 am

Re: Maintaining AA with uneven incoming cash flow

Post by hyde » Fri Oct 27, 2017 12:22 pm

I think I calculated the ESPP tax right. Here's what I did, with the dates/prices normalized to simplify the example.

1/1/2015 - ESPP Offering Price Set - Stock Price @ $10
1/1/2017 - ESPP Purchase @ $8.50 (15% discount on $10 Offering Price). FMV is $80 this day
TODAY - 11/1/2017 - Current Price is $100.
1/1/2018 - ESPP becomes Qualified Disposition


In order to be qualified and taxed as capital gains (Situation 3 on TurboTax page), it needs to be held for at least 1 year and be 2 years from the Offering date. The 2 years from offering date is met right now, but the 1 year from purchase, so it doesn't qualify for that.

Situation 2 on the TurboTax page is only if you've held it for more than 1 year, but the Offering date was less than 2 years ago. So that doesn't apply for this situation.

Until 1/1/2018, it's Situation 1 on the TurboTax page (Disqualifying Disposition w/ short gains), which is $1.50 income (discount price) and $90.00 short term gains, and no taxes on my initial purchase price of $8.50. After 1/1/2018, it's income on $1.50 (discount price), and capital gains on $90.00.

Ron Scott
Posts: 389
Joined: Tue Apr 05, 2016 5:38 am

Re: Maintaining AA with uneven incoming cash flow

Post by Ron Scott » Fri Oct 27, 2017 5:30 pm

I think you're plan looks pretty good so take this with a grain of salt but I'd run the number on the mortgage and see if paying it down a bit made sense.
Also, what is your strategy for buying stock if the next downturn is relatively steep?

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Hyperborea
Posts: 383
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Location: Silicon Valley

Re: Maintaining AA with uneven incoming cash flow

Post by Hyperborea » Fri Oct 27, 2017 7:17 pm

3. This is going to depend on how you feel about it. I think there's only 3 good answers to when to sell the ESPP stock: 1) sell immediately; 2) sell when it turns into long term capital gains; 3) hold it like you would any stock but only if you would go out right now and spend your own cash to buy it.

I picked 2) almost all the time except when I worked for a foundering tech company and then I picked 1). I wouldn't count the company stock that you have in the ESPP or the unvested RSUs in your allocation just like I never counted bonuses until they paid out.

hyde
Posts: 6
Joined: Thu Oct 26, 2017 10:52 am

Re: Maintaining AA with uneven incoming cash flow

Post by hyde » Fri Oct 27, 2017 8:11 pm

The mortgage loan to value is around 70% assuming my purchase price from a few years ago (we've had significant rise in value since then). Since my tax rate is around 47%, that cuts the mortgage rate to around 2.05% after the tax deduction. I could pay down a significant amount (but not all of it) with my taxable investments, but I'd loose a lot of the liquidity of my net worth. Paying it down a small amount wouldn't help with much even if I refinance.

I think I'd rather have that money invested, and if I really needed it, I could get at it by selling some stock. Even if the stock went down 50%, it should be a few years of expenses for me, versus having to sell the house to get cash.

> Also, what is your strategy for buying stock if the next downturn is relatively steep?
I'm putting $54k a year into my 401k, which I can maintain without RSUs/ESPP @ my current salary. Then all the RSU/ESPP also get sold and put into my taxable investment account, with a small portion going to my individual IRA for backdoor Roth.

inbox788
Posts: 4194
Joined: Thu Mar 15, 2012 5:24 pm

Re: Maintaining AA with uneven incoming cash flow

Post by inbox788 » Sat Oct 28, 2017 6:15 pm

hyde wrote:
Fri Oct 27, 2017 12:22 pm
I think I calculated the ESPP tax right. Here's what I did, with the dates/prices normalized to simplify the example.

1/1/2015 - ESPP Offering Price Set - Stock Price @ $10
1/1/2017 - ESPP Purchase @ $8.50 (15% discount on $10 Offering Price). FMV is $80 this day
TODAY - 11/1/2017 - Current Price is $100.
1/1/2018 - ESPP becomes Qualified Disposition


In order to be qualified and taxed as capital gains (Situation 3 on TurboTax page), it needs to be held for at least 1 year and be 2 years from the Offering date. The 2 years from offering date is met right now, but the 1 year from purchase, so it doesn't qualify for that.

Situation 2 on the TurboTax page is only if you've held it for more than 1 year, but the Offering date was less than 2 years ago. So that doesn't apply for this situation.

Until 1/1/2018, it's Situation 1 on the TurboTax page (Disqualifying Disposition w/ short gains), which is $1.50 income (discount price) and $90.00 short term gains, and no taxes on my initial purchase price of $8.50. After 1/1/2018, it's income on $1.50 (discount price), and capital gains on $90.00.
The calculations appear [mostly] correct. It's a rare blue chip that grows 10X in a couple of years, so if this is your situation, then it does make sense to hold out till the long term gain qualification kick in. With ESPP at more stable/mature companies, the gains are usually more moderate. If you have this same problem with your current lots, it's a good problem to have.

[I do question $90 capital gains, and I would need to consider if any is subject to ordinary income treatment.]

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