Bond Placement and Tax Efficiency

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
Post Reply
User avatar
Topic Author
jotun
Posts: 63
Joined: Wed Sep 25, 2013 12:30 pm

Bond Placement and Tax Efficiency

Post by jotun »

Hi Bogleheads, I'm trying to determine the optimal placement of bonds in my portfolio. I'm now at the point where I could max out my tax-advantaged space (401k and Roth IRA) with bonds to maintain my desired AA of 20% bonds.

I've reviewed triceratops's great post on tax efficiency and used the provided spreadsheet to crunch the numbers. It seems clear that for me in a taxable account, bond funds will be twice as tax inefficient as the next most inefficient fund in my portfolio (VFSVX).

However, many other posts here and elsewhere seem to indicate it might be better to put equities in my Roth IRA instead of bonds. The posters' situations aren't quite the same as mine, but still food for thought.

Therefore, it seems like I have the following main options:
  • Fill my 401k and Roth IRA with bonds right now and for future contributions. When my AA is out of balance, I will buy TIPS, tax-managed bond funds in my taxable account, or other fixed-income options.
  • Fill my 401k with bonds, but use my Roth IRA for the next-least inefficient fund in my portfolio (VFSVX). Buy other tax-managed fixed-income options in my taxable account to maintain my desired AA.
I would appreciate some advice for my situation. I've also included my personal/portfolio information below. Note that I currently have a bit more bonds than I should for my AA (24% instead of 20%), but will be buying more equities in the near future to balance things out.

Thanks!


--------------------------------------------------------------------------------------------------------
Basic Facts and AA
--------------------------------------------------------------------------------------------------------

Emergency funds: 9 months in Ally (1.2% interest)
Debt: None
Tax Filing Status: Single
Tax Rate: 28% Federal, 0% State
State of Residence: Washington State
Age: 31
Target Retirement Age: 50

Desired Asset Allocation:
  • 80% Stocks, 20% Bonds
  • 75% Domestic Stock, 25% International Stock
  • Domestic Stock: 70% Large Cap Blend, 30% Small Cap Value
  • International Stock: 70% Large Cap Blend, 30% Small Cap Value
Complete AA Breakdown:
  • Domestic Large Blend: 42% of total
  • Domestic Small Value: 18% of total
  • Domestic Bonds: 20% of total
  • International Large Blend: 14% of total
  • International Small Value: 6% of total

--------------------------------------------------------------------------------------------------------
Current Investments -- ~$730,000
--------------------------------------------------------------------------------------------------------

Vanguard Taxable -- ~$555,000 -- 76%
-----------------------------------------------------------
39.9% (VTSAX) Vanguard Total Stock Market Index Admiral Shares -- 0.05% ER
17.1% (VSIAX) Vanguard Small-Cap Value Index Fund Admiral Shares -- 0.09% ER
13.3% (VTIAX) Vanguard Total International Stock Market Index Admiral Shares -- 0.11% ER
5.7% (VFSVX) Vanguard FTSE All-World ex-US Small-Cap Index Fund Investor Shares -- 0.27% ER


Vanguard Traditional 401k -- ~$119,000 -- 16.3%
-----------------------------------------------------------
16.3% (VBMPX) Vanguard Total Bond Market Index Fund Institutional Plus Shares -- 0.03% ER


Vanguard Roth IRA -- ~$56,000 -- 7.7%
-----------------------------------------------------------
7.7% (VBTLX) Vanguard Total Bond Market Index Fund Admiral Shares -- 0.05% ER
Last edited by jotun on Wed Nov 29, 2017 5:04 pm, edited 1 time in total.
livesoft
Posts: 86075
Joined: Thu Mar 01, 2007 7:00 pm

Re: Bond Placement and Tax Efficiency

Post by livesoft »

At your age, I would put some equities in the Roth and change my asset allocation to have less bonds overall.
Wiki This signature message sponsored by sscritic: Learn to fish.
User avatar
triceratop
Posts: 5838
Joined: Tue Aug 04, 2015 8:20 pm
Location: la la land

Re: Bond Placement and Tax Efficiency

Post by triceratop »

^ What he said. I would expect substantial growth in purchasing power from a fund like VFSVX as compared to VBTLX. As much as I like taxes, it is hardly the end of the story or even the primary concern.

Of course, you probably don't want to sell your existing VFSVX holdings either, unless you just recently bought them.

edit: by the way, VSS doesn't get you to Intl SCV as in your asset allocation. That is a hard thing to achieve, frankly: a lot of people use Intl. Small + Intl Value as a proxy.
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."
User avatar
Topic Author
jotun
Posts: 63
Joined: Wed Sep 25, 2013 12:30 pm

Re: Bond Placement and Tax Efficiency

Post by jotun »

livesoft wrote: Wed Nov 29, 2017 5:02 pm At your age, I would put some equities in the Roth and change my asset allocation to have less bonds overall.
Thanks livesoft! Given my age and target retirement of 50, what would you advocate for bond AA?
livesoft
Posts: 86075
Joined: Thu Mar 01, 2007 7:00 pm

Re: Bond Placement and Tax Efficiency

Post by livesoft »

At the present time 16.3% to fill up your 401(k).

Of course, you could do many, many things. For instance, a short-term Treasury bond fund in taxable would not create much in the way of taxes for you. The possibilities are endless!
Wiki This signature message sponsored by sscritic: Learn to fish.
User avatar
Topic Author
jotun
Posts: 63
Joined: Wed Sep 25, 2013 12:30 pm

Re: Bond Placement and Tax Efficiency

Post by jotun »

triceratop wrote: Wed Nov 29, 2017 5:09 pm ^ What he said. I would expect substantial growth in purchasing power from a fund like VFSVX as compared to VBTLX. As much as I like taxes, it is hardly the end of the story or even the primary concern.

Of course, you probably don't want to sell your existing VFSVX holdings either, unless you just recently bought them.

edit: by the way, VSS doesn't get you to Intl SCV as in your asset allocation. That is a hard thing to achieve, frankly: a lot of people use Intl. Small + Intl Value as a proxy.
Thanks triceratop, especially given that your post spurred my thinking along these lines.

Questions:
  • What would you advise for bond AA given my current age/desired retirement age?
  • I just looked at the cost basis for my VSFVX holdings, and I only have about $6k in long-term capital gains, and a few hundred in short-term. Tax hit would be about $1k, which isn't much in the scheme of things, but still lame. Would you sell just to get things in the right spot now instead of later?
User avatar
triceratop
Posts: 5838
Joined: Tue Aug 04, 2015 8:20 pm
Location: la la land

Re: Bond Placement and Tax Efficiency

Post by triceratop »

jotun wrote: Wed Nov 29, 2017 5:25 pm
triceratop wrote: Wed Nov 29, 2017 5:09 pm ^ What he said. I would expect substantial growth in purchasing power from a fund like VFSVX as compared to VBTLX. As much as I like taxes, it is hardly the end of the story or even the primary concern.

Of course, you probably don't want to sell your existing VFSVX holdings either, unless you just recently bought them.

edit: by the way, VSS doesn't get you to Intl SCV as in your asset allocation. That is a hard thing to achieve, frankly: a lot of people use Intl. Small + Intl Value as a proxy.
Thanks triceratop, especially given that your post spurred my thinking along these lines.

Questions:
  • What would you advise for bond AA given my current age/desired retirement age?
  • I just looked at the cost basis for my VSFVX holdings, and I only have about $6k in long-term capital gains, and a few hundred in short-term. Tax hit would be about $1k, which isn't much in the scheme of things, but still lame. Would you sell just to get things in the right spot now instead of later?
I am not qualified to say what your bond AA should be. But you're going to need to tap your retirement assets for 35+ years, and I don't expect bonds to provide much real growth.

I would definitely not sell the VFSVX holding in the next 32 days, or in general any shares that are short term. Beyond that, let's see what your efficiency is...only 10bp worse than VXUS. I'm not sure I see the value in incurring that much in capital gains taxes. That $1k could be invested; there are calculations you can do to see how much is lost in future after-tax dollars by not investing that $1k in tax.
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."
User avatar
Topic Author
jotun
Posts: 63
Joined: Wed Sep 25, 2013 12:30 pm

Re: Bond Placement and Tax Efficiency

Post by jotun »

livesoft wrote: Wed Nov 29, 2017 5:23 pm At the present time 16.3% to fill up your 401(k).

Of course, you could do many, many things. For instance, a short-term Treasury bond fund in taxable would not create much in the way of taxes for you. The possibilities are endless!
Fair enough, thanks again for your thoughts!
User avatar
Topic Author
jotun
Posts: 63
Joined: Wed Sep 25, 2013 12:30 pm

Re: Bond Placement and Tax Efficiency

Post by jotun »

triceratop wrote: Wed Nov 29, 2017 5:29 pm I am not qualified to say what your bond AA should be. But you're going to need to tap your retirement assets for 35+ years, and I don't expect bonds to provide much real growth.

I would definitely not sell the VFSVX holding in the next 32 days, or in general any shares that are short term. Beyond that, let's see what your efficiency is...only 10bp worse than VXUS. I'm not sure I see the value in incurring that much in capital gains taxes. That $1k could be invested; there are calculations you can do to see how much is lost in future after-tax dollars by not investing that $1k in tax.
Re: bond AA, your thoughts make sense. It's one of the things that's concerned me about having my tax-advantaged space filled with bonds.

I agree that it's probably not worth eating the cap gains tax. Back-of-the-napkin calculations seem to indicate that I will make more money leaving it in the taxable account, despite the additional tax.

EDIT: Found out the answer myself using your sheet, sorry for the dumb question! One more question: given that I already have VFSVX in the taxable (and will keep it there), it looks like the next least-efficient fund is VTIAX/VXUS. I'm guessing that (or Intl Value/VTRIX per your earlier post) would be the next best candidates to put in the Roth IRA?
User avatar
Topic Author
jotun
Posts: 63
Joined: Wed Sep 25, 2013 12:30 pm

Re: Bond Placement and Tax Efficiency

Post by jotun »

Another question (hopefully final): I don't understand why I should park all my bonds in my 401k alone. Why not add some equities in my 401k as well as my Roth IRA so that both of them have larger future purchasing power? As in, split my 20% (or less) bond allocation across both my 401k and my Roth IRA, holding some equities in them as well? My apologies if this is covered somewhere else, as I just read this Bogleheads wiki post.
User avatar
triceratop
Posts: 5838
Joined: Tue Aug 04, 2015 8:20 pm
Location: la la land

Re: Bond Placement and Tax Efficiency

Post by triceratop »

jotun wrote: Thu Nov 30, 2017 4:12 pm Another question (hopefully final): I don't understand why I should park all my bonds in my 401k alone. Why not add some equities in my 401k as well as my Roth IRA so that both of them have larger future purchasing power? As in, split my 20% (or less) bond allocation across both my 401k and my Roth IRA, holding some equities in them as well? My apologies if this is covered somewhere else, as I just read this Bogleheads wiki post.
If equities grow more than bonds you would prefer to keep a greater portion of the returns after-tax. Your 401(k) is pre-tax earnings. Your Roth is post-tax.

(It's actually all a lie, and we should consider the portion of our 401k that is after-tax to be what we are rebalancing with, as grabiner does here and explained here:
You can adjust for the different tax treatment of assets in different accounts.
If you have $60,000 in bonds in a 401(k), and $40,000 in stocks in a
Roth IRA, your effective allocation is not 40% stock. If you will be in a 33%
tax bracket at retirement, the IRS and state treasury effectively own 33% of
your 401(k) but none of your Roth IRA, and thus your portfolio is effectively
50% in stock.
)
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."
User avatar
Topic Author
jotun
Posts: 63
Joined: Wed Sep 25, 2013 12:30 pm

Re: Bond Placement and Tax Efficiency

Post by jotun »

triceratop wrote: Thu Nov 30, 2017 4:29 pm If equities grow more than bonds you would prefer to keep a greater portion of the returns after-tax. Your 401(k) is pre-tax earnings. Your Roth is post-tax.

(It's actually all a lie, and we should consider the portion of our 401k that is after-tax to be what we are rebalancing with, as grabiner does here and explained here:
You can adjust for the different tax treatment of assets in different accounts.
If you have $60,000 in bonds in a 401(k), and $40,000 in stocks in a
Roth IRA, your effective allocation is not 40% stock. If you will be in a 33%
tax bracket at retirement, the IRS and state treasury effectively own 33% of
your 401(k) but none of your Roth IRA, and thus your portfolio is effectively
50% in stock.
Wow, I hadn't thought about it this way before, and feel dumb now. Thanks again for the links and for your help!
User avatar
triceratop
Posts: 5838
Joined: Tue Aug 04, 2015 8:20 pm
Location: la la land

Re: Bond Placement and Tax Efficiency

Post by triceratop »

jotun wrote: Thu Nov 30, 2017 5:04 pm
triceratop wrote: Thu Nov 30, 2017 4:29 pm If equities grow more than bonds you would prefer to keep a greater portion of the returns after-tax. Your 401(k) is pre-tax earnings. Your Roth is post-tax.

(It's actually all a lie, and we should consider the portion of our 401k that is after-tax to be what we are rebalancing with, as grabiner does here and explained here:
You can adjust for the different tax treatment of assets in different accounts.
If you have $60,000 in bonds in a 401(k), and $40,000 in stocks in a
Roth IRA, your effective allocation is not 40% stock. If you will be in a 33%
tax bracket at retirement, the IRS and state treasury effectively own 33% of
your 401(k) but none of your Roth IRA, and thus your portfolio is effectively
50% in stock.
Wow, I hadn't thought about it this way before, and feel dumb now. Thanks again for the links and for your help!
The problem is we don't know at what tax rate we will withdraw from the 401(k).
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."
User avatar
Topic Author
jotun
Posts: 63
Joined: Wed Sep 25, 2013 12:30 pm

Re: Bond Placement and Tax Efficiency

Post by jotun »

triceratop wrote: Thu Nov 30, 2017 5:19 pm The problem is we don't know at what tax rate we will withdraw from the 401(k).
In my case, I have no idea what my marginal tax rate will be when I withdraw from my 401k. With my current trajectory, I may not start withdrawing from my 401k until 40+ years from now. But I know for a fact that I won't be in the <=15% brackets (if they still exist). So either way it'll likely be a higher rate than capital gains. I hope I'm thinking about this correctly.
User avatar
triceratop
Posts: 5838
Joined: Tue Aug 04, 2015 8:20 pm
Location: la la land

Re: Bond Placement and Tax Efficiency

Post by triceratop »

jotun wrote: Thu Nov 30, 2017 5:44 pm
triceratop wrote: Thu Nov 30, 2017 5:19 pm The problem is we don't know at what tax rate we will withdraw from the 401(k).
In my case, I have no idea what my marginal tax rate will be when I withdraw from my 401k. With my current trajectory, I may not start withdrawing from my 401k until 40+ years from now. But I know for a fact that I won't be in the <=15% brackets (if they still exist). So either way it'll likely be a higher rate than capital gains. I hope I'm thinking about this correctly.
That's right. By the way, this isn't just about bonds. It is also true that you don't know how International vs. US stocks will perform over the next 40 years so your after-tax domestic/Intl split may be "off" (if that's something you care about)
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."
User avatar
dratkinson
Posts: 6116
Joined: Thu Jul 26, 2007 6:23 pm
Location: Centennial CO

Re: Bond Placement and Tax Efficiency

Post by dratkinson »

Another vote to skew your tax-advantaged space to equities for greater long term growth. Why? More tax-sheltered growth is better than less. Let your retired self worry about the problem of going into retirement with more money.

To make up any TA bond shortfall, can add a national municipal bond fund in taxable (appropriate in your 28% fed, 0% state tax brackets).


Disclosure. I went this route while in the 15% fed tax bracket, and found VWLTX (LT national muni bond fund) to produce more after-tax income than TBM. However, it is considered to be more risky than TBM. But since I was skewing my TA toward more risk, a little extra risk from bonds didn't worry me too much. And since I was not planning to sell for many years, the potential for greater price fluctuations were less of a concern when compared to its higher dividends.


In your tax bracket(s), VWITX (IT national muni fund) should produce more after-tax income than TBM*, is less risky, and a forum recommendation.

* I haven't checked the SEC yields of TBM and VWITX, nor computed VWITX's TEY (taxable-equivalent yield). You'll need to do this as a student exercise to confirm that it's better for you.

To expand your bonds-in-taxable search, compare the munis TEYs (IT and LT) against all of your bond fund candidates.
d.r.a., not dr.a. | I'm a novice investor; you are forewarned.
User avatar
Topic Author
jotun
Posts: 63
Joined: Wed Sep 25, 2013 12:30 pm

Re: Bond Placement and Tax Efficiency

Post by jotun »

triceratop wrote: Thu Nov 30, 2017 5:47 pm That's right. By the way, this isn't just about bonds. It is also true that you don't know how International vs. US stocks will perform over the next 40 years so your after-tax domestic/Intl split may be "off" (if that's something you care about)
Right, that makes sense. I'm not sure if I care just yet, unless I should care one way or another. :happy
User avatar
Topic Author
jotun
Posts: 63
Joined: Wed Sep 25, 2013 12:30 pm

Re: Bond Placement and Tax Efficiency

Post by jotun »

dratkinson wrote: Thu Nov 30, 2017 7:03 pm Another vote to skew your tax-advantaged space to equities for greater long term growth. Why? More tax-sheltered growth is better than less. Let your retired self worry about the problem of going into retirement with more money.

To make up any TA bond shortfall, can add a national municipal bond fund in taxable (appropriate in your 28% fed, 0% state tax brackets).


Disclosure. I went this route while in the 15% fed tax bracket, and found VWLTX (LT national muni bond fund) to produce more after-tax income than TBM. However, it is considered to be more risky than TBM. But since I was skewing my TA toward more risk, a little extra risk from bonds didn't worry me too much. And since I was not planning to sell for many years, the potential for greater price fluctuations were less of a concern when compared to its higher dividends.


In your tax bracket(s), VWITX (IT national muni fund) should produce more after-tax income than TBM*, is less risky, and a forum recommendation.

* I haven't checked the SEC yields of TBM and VWITX, nor computed VWITX's TEY (taxable-equivalent yield). You'll need to do this as a student exercise to confirm that it's better for you.

To expand your bonds-in-taxable search, compare the munis TEYs (IT and LT) against all of your bond fund candidates.
Thanks for your thoughts and experience, dratkinson. I'll look into the muni funds. It seems there are a good number of taxable bond options (including VWLTX/VWITX), so I'll have to sort through them and figure things out.

Do/did you personally hold most of your bonds in 401k/Roth IRA in addition to the bonds in taxable?
ai_3_us
Posts: 162
Joined: Mon Jan 09, 2017 6:53 pm

Re: Bond Placement and Tax Efficiency

Post by ai_3_us »

I am in a similar situation to the OP but 5 years younger. I currently have my Roth filled entirely with VGSLX since I would like some REITs and they are the least tax efficient. I have access to a 403(b) through TIAA-CREF and a WA State 457(b). The only bond fund in the 457(b) is a WA State bond fund which I have heard is bad, so I am invested only in a total market fund there. In my 403(b) I have purchased only TREA shares. Between the TREA shares and VGSLX I am at my desired real estate allocation, so in 2018 I plan to buy into a TIAA fixed annuity fund. The rest of my bonds (currently 10% AA) are held in taxable. In 2018 and 2019 I will max out my Roth instead of a traditional IRA since I will be in the 15% tax bracket.

Should I be concerned about not having equities in my Roth? Should I ditch the REITs for the possible equity growth until I am older and need to increase my bond AA? Should I consider purchasing more TREA shares in exchange for selling my REIT holdings? From what I understand, TREA and REITs should be considered a different section of my AA.
User avatar
dratkinson
Posts: 6116
Joined: Thu Jul 26, 2007 6:23 pm
Location: Centennial CO

Re: Bond Placement and Tax Efficiency

Post by dratkinson »

BH Bond Placement and Tax Efficiency
jotun wrote: Thu Nov 30, 2017 10:41 pm ...

Thanks for your thoughts and experience, dratkinson. I'll look into the muni funds. It seems there are a good number of taxable bond options (including VWLTX/VWITX), so I'll have to sort through them and figure things out.

Do/did you personally hold most of your bonds in 401k/Roth IRA in addition to the bonds in taxable?
Everything you read in the forum, in the Wiki, and in the recommended books---much of it mutually contradictory---is an appropriate suggestion for someone. You're going to have to figure out which advice applies to you and which does not.

So in making your changes, I suggest you start by following the forum’s recommended safe advice. Then live with those safe changes for a few years while you continue your investor education. See how the safe changes fit with your "need, willingness, and ability to accept risk"*.

* The "need, willingness, and ability to accept risk" has often been discussed. Search Wiki and forum for discussion topics.

If what you learn*, from your continuing investor education, and about your personal risk tolerance from living with the safe changes, allows you to accept more risk, then tweak your AA to add a little more. Stop tweaking when you run up against your risk tolerance limits.

* This is your required due diligence---to learn more about investing and yourself---before moving to more risky investments.

Idea. Find the Wiki topic on recommended “books” (search term). Read Swedroe’s bond book. Then read a second bond book (I read the one by Thau.). Where recommended authors agree, that is the safe main route. Where they disagree, those are optional routes. Just starting out, suggest you stick to the safer main road to Dublin… until you’ve completed your due diligence and know it’s safe for you to take an optional route.



Disclosure. I retired with no former access to 401k/TSP. I had a small tIRA, safe pension, and LBYM. I converted my tIRA to a rIRA after retirement to turn off RMDs and to get tax-free growth.

After discovering the forum and receiving my review, I changed to follow the forum's safe advice: tax-efficient equities in taxable, and the safest bonds (IT treasuries and TIPS) in tax-advantaged space. But after ~5yrs, the safe (no growth, low yield) bonds in my rIRA were driving me to tears. (The Roth conversion was to get tax-free growth; I want growth!) Something had to change.

I now hold all my bonds in taxable and I "shoot for the moon" (equities only) in my small rIRA. If memory serves, the "shoot for the moon in TA space" concept is documented by one Wiki sentence.

My overall AA is age appropriate (forum advice), which makes my taxable account (muni) bond heavy.

Ten years after my forum review and with continuing investor education/experience...

I've learned that I CAN tolerate...
--all equities in my rIRA (I want growth and have "need, willingness, and ability to accept risk"),
--a small IT national muni fund allocation as EF tier (better TEY than bank savings, CDs, saving bonds),
--a large/growing 50/50 allocation (forum advice) to LT national muni/IT single-state muni funds* as my major bond holdings (both better TEY than TBM). (*Additional due diligence requirement to use.)

I've learned that I CAN NOT tolerate...
--low growth investments in my rIRA (due diligence: tried it and safe bonds bored me to tears),
--safe ST and limited-term national muni funds (IMO the low yields are not worth the bother),
--or the AMT exposure and additional risk of HY muni funds (want to avoid AMT tax, don't need extra risk).
d.r.a., not dr.a. | I'm a novice investor; you are forewarned.
Post Reply