"Tax-Efficient Allocation" Fallacy?

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DavidREng
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Joined: Thu Oct 13, 2016 10:24 pm

"Tax-Efficient Allocation" Fallacy?

Post by DavidREng » Tue Sep 10, 2019 2:22 pm

I've read so much about the conventional wisdom of placing non-tax efficient asset classes (bonds, reits) into tax-advantaged accounts, and tax-efficient vehicles (low-turnover US index funds and international equities) into taxable accounts. However, it would seem to me that while a bond in a taxable account is taxed at one's marginal income tax rate, the impact is the least given the slower growth. On the other hand, while the tax rate on a total stock market index fund is lower, the significantly larger rate of compounding makes it worth the greater tax protection. While we don't know what tax rates nor market returns will be in the future, the answer to what to put where isn't necessarily so obvious. For what its worth, I live in a state income tax-free state at 37% federal marginal rate.

For example:

Let's say I have $100,000 in Stocks and $100,000 in bonds and let them grow at 8% and 4% (respectively) for the next 18 years. I have room for $100,000 in my Roth bucket and the rest in taxable. Which one do I put in Roth?

1. Stocks into taxable yields a pre-tax value of ~$400,000, making that $340,000 after 20% LTCG. Bonds into Roth yields ~$202,600.
** Total amount is ~$542,600 **

2. Stocks into Roth ends at $400,000 and bonds into taxable provides $156,000 (4% taxed at 37% resulting in 2.52% annual return)
** Total amount is $556,000 **

You could make a variety of assumptions to make whatever point you want, but it seems that the gist is that there is no simple, uniform answer.

Where am I going wrong?!

dbr
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Re: "Tax-Efficient Allocation" Fallacy?

Post by dbr » Tue Sep 10, 2019 2:32 pm

DavidREng wrote:
Tue Sep 10, 2019 2:22 pm
I've read so much about the conventional wisdom of placing non-tax efficient asset classes (bonds, reits) into tax-advantaged accounts, and tax-efficient vehicles (low-turnover US index funds and international equities) into taxable accounts. However, it would seem to me that while a bond in a taxable account is taxed at one's marginal income tax rate, the impact is the least given the slower growth. On the other hand, while the tax rate on a total stock market index fund is lower, the significantly larger rate of compounding makes it worth the greater tax protection. While we don't know what tax rates nor market returns will be in the future, the answer to what to put where isn't necessarily so obvious. For what its worth, I live in a state income tax-free state at 37% federal marginal rate.

For example:

Let's say I have $100,000 in Stocks and $100,000 in bonds and let them grow at 8% and 4% (respectively) for the next 18 years. I have room for $100,000 in my Roth bucket and the rest in taxable. Which one do I put in Roth?

1. Stocks into taxable yields a pre-tax value of ~$400,000, making that $340,000 after 20% LTCG. Bonds into Roth yields ~$202,600.
** Total amount is ~$542,600 **

2. Stocks into Roth ends at $400,000 and bonds into taxable provides $156,000 (4% taxed at 37% resulting in 2.52% annual return)
** Total amount is $556,000 **

You could make a variety of assumptions to make whatever point you want, but it seems that the gist is that there is no simple, uniform answer.

Where am I going wrong?!
I agree. It is not simple to add up the accounting for taxes over decades of future years for arbitrary holdings generating unspecified amounts of income for whatever the individual tax situation is over all that time. Also you left out traditional 401k and IRA accounts, I bonds, and tax exempt bonds and the effect of state taxes in all their variation, including the possibility of moving from one state to another.

frcabot
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Re: "Tax-Efficient Allocation" Fallacy?

Post by frcabot » Tue Sep 10, 2019 2:37 pm

I agree. I actually think it’s preferable to have more equities in Roth IRA account (esp when young) as the real advantage of a Roth is the tax-FREE growth. A higher tax-free return over 40 years is going to be a lot more valuable than paying tax on a few more conservative bond dividends. I wouldn’t stress too much about the tax allocation piece unless you’re in a very high tax bracket. Even then, you can simply use munis for the taxable portion of your bond allocation.

dbr
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Re: "Tax-Efficient Allocation" Fallacy?

Post by dbr » Tue Sep 10, 2019 2:40 pm

frcabot wrote:
Tue Sep 10, 2019 2:37 pm
I agree. I actually think it’s preferable to have more equities in Roth IRA account (esp when young) as the real advantage of a Roth is the tax-FREE growth. A higher tax-free return over 40 years is going to be a lot more valuable than paying tax on a few more conservative bond dividends. I wouldn’t stress too much about the tax allocation piece unless you’re in a very high tax bracket. Even then, you can simply use munis for the taxable portion of your bond allocation.
It is probably pretty routine here to agree with this. One should review the Wiki article and see what one thinks of it: https://www.bogleheads.org/wiki/Tax-eff ... _placement

There could be much to discuss there.

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Wiggums
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Re: "Tax-Efficient Allocation" Fallacy?

Post by Wiggums » Tue Sep 10, 2019 2:42 pm

dbr wrote:
Tue Sep 10, 2019 2:40 pm
frcabot wrote:
Tue Sep 10, 2019 2:37 pm
I agree. I actually think it’s preferable to have more equities in Roth IRA account (esp when young) as the real advantage of a Roth is the tax-FREE growth. A higher tax-free return over 40 years is going to be a lot more valuable than paying tax on a few more conservative bond dividends. I wouldn’t stress too much about the tax allocation piece unless you’re in a very high tax bracket. Even then, you can simply use munis for the taxable portion of your bond allocation.
It is probably pretty routine here to agree with this. One should review the Wiki article and see what one thinks of it: https://www.bogleheads.org/wiki/Tax-eff ... _placement

There could be much to discuss there.
+1

sharx
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Re: "Tax-Efficient Allocation" Fallacy?

Post by sharx » Tue Sep 10, 2019 3:42 pm

I've been researching this the past few days and have largely to the same conclusion as the OP.

One thing I'm not sure about in the example is whether the two scenarios truly have the same AA ratio. Arguably a dollar in taxable is less valuable than a dollar in a Roth.

withrye
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Re: "Tax-Efficient Allocation" Fallacy?

Post by withrye » Tue Sep 10, 2019 3:44 pm

sharx wrote:
Tue Sep 10, 2019 3:42 pm
I've been researching this the past few days and have largely to the same conclusion as the OP.

One thing I'm not sure about in the example is whether the two scenarios truly have the same AA ratio. Arguably a dollar in taxable is less valuable than a dollar in a Roth.
Now you have the pleasure of entering the tax-adjusted asset allocation rabbit hole :)

RubyTuesday
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Re: "Tax-Efficient Allocation" Fallacy?

Post by RubyTuesday » Tue Sep 10, 2019 3:46 pm

If you maintain the same tax-adjusted asset allocation it’s mostly a wash.

Many forget to tax adjust.

Many threads on this topic.
RT

retiredjg
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Re: "Tax-Efficient Allocation" Fallacy?

Post by retiredjg » Tue Sep 10, 2019 4:05 pm

DavidREng wrote:
Tue Sep 10, 2019 2:22 pm
Where am I going wrong?!
Where you are doing wrong is not having any tax-deferred accounts. It can be hard to find a winner when you are choosing only between taxable and Roth, especially in a state that does not have a high tax rate.

cherijoh
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Location: Charlotte NC

Re: "Tax-Efficient Allocation" Fallacy?

Post by cherijoh » Tue Sep 10, 2019 4:20 pm

DavidREng wrote:
Tue Sep 10, 2019 2:22 pm
I've read so much about the conventional wisdom of placing non-tax efficient asset classes (bonds, reits) into tax-advantaged accounts, and tax-efficient vehicles (low-turnover US index funds and international equities) into taxable accounts. However, it would seem to me that while a bond in a taxable account is taxed at one's marginal income tax rate, the impact is the least given the slower growth. On the other hand, while the tax rate on a total stock market index fund is lower, the significantly larger rate of compounding makes it worth the greater tax protection. While we don't know what tax rates nor market returns will be in the future, the answer to what to put where isn't necessarily so obvious. For what its worth, I live in a state income tax-free state at 37% federal marginal rate.

For example:

Let's say I have $100,000 in Stocks and $100,000 in bonds and let them grow at 8% and 4% (respectively) for the next 18 years. I have room for $100,000 in my Roth bucket and the rest in taxable. Which one do I put in Roth?

1. Stocks into taxable yields a pre-tax value of ~$400,000, making that $340,000 after 20% LTCG. Bonds into Roth yields ~$202,600.
** Total amount is ~$542,600 **

2. Stocks into Roth ends at $400,000 and bonds into taxable provides $156,000 (4% taxed at 37% resulting in 2.52% annual return)
** Total amount is $556,000 **

You could make a variety of assumptions to make whatever point you want, but it seems that the gist is that there is no simple, uniform answer.

Where am I going wrong?!
Most people don't have the binary choice between taxable and Roth.

My order of placement is:
  • stocks in Roth (1st), taxable (2nd), and traditional (3rd)
  • Bonds in Traditional (1st), taxable (2nd), Roth (3rd)
I have a large enough traditional account that all my bonds are in traditional but I have stocks in all three types of accounts.

livesoft
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Re: "Tax-Efficient Allocation" Fallacy?

Post by livesoft » Tue Sep 10, 2019 4:22 pm

DavidREng wrote:
Tue Sep 10, 2019 2:22 pm
For what its worth, I live in a state income tax-free state at 37% federal marginal rate.
...
Where am I going wrong?!
You should be using tax-exempt muni bonds in taxable. Was that in your analysis? I cannot tell.

Another error is probably that you skimmed information about tax-efficient allocation.
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grabiner
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Re: "Tax-Efficient Allocation" Fallacy?

Post by grabiner » Tue Sep 10, 2019 8:50 pm

DavidREng wrote:
Tue Sep 10, 2019 2:22 pm
Let's say I have $100,000 in Stocks and $100,000 in bonds and let them grow at 8% and 4% (respectively) for the next 18 years. I have room for $100,000 in my Roth bucket and the rest in taxable. Which one do I put in Roth?

1. Stocks into taxable yields a pre-tax value of ~$400,000, making that $340,000 after 20% LTCG. Bonds into Roth yields ~$202,600.
** Total amount is ~$542,600 **

2. Stocks into Roth ends at $400,000 and bonds into taxable provides $156,000 (4% taxed at 37% resulting in 2.52% annual return)
** Total amount is $556,000 **

You could make a variety of assumptions to make whatever point you want, but it seems that the gist is that there is no simple, uniform answer.
There are several issues here.

The proper tax rates for you are 23.8% and 40.8%, including the Net Investment Income tax.

Stocks in a taxable account have a higher tax cost than the capital-gains tax rate, because you pay tax on the dividends every year. The reinvested dividends reduce your capital gain, but you pay tax again on the growth, increasing the tax cost.

If you are in the top tax bracket, you should be holding munis, not taxable bonds. Munis with the same risk as taxable bonds yielding 4% should yield about 3%, which reduces the tax cost.

And holding an equal dollar amount of stocks in the Roth account rather than the taxable account involves more risk, as the IRS will share your taxable gains or losses. If you adjust for this (putting X dollars in taxable or Y dollars in Roth so that the risk level is the same), this decreases the advantage of stocks in an IRA. If you use a traditional IRA rather than a Roth IRA, you eliminate much of this effect, as the tax costs of stocks in a traditional IRA and a taxable account are similar.

Finally, the tax cost of bonds depends on the yield of the bonds. In the top tax bracket, if you hold Admiral shares of Vanguard Intermediate-Term Tax-Exempt with a 1.43% yield, the tax cost is about 0.48% (that is, taxable bonds yielding 1.91% would have about the same risk). And that greatly reduces the tax cost of bonds in taxable. Therefore, in the top tax bracket, I recommend holding munis in a taxable account and stocks in a tax-deferred account. If bond yields rise, you can sell your munis for a capital loss and switch to stocks in taxable.

(edited to correct fund name)
Last edited by grabiner on Wed Sep 11, 2019 11:03 pm, edited 1 time in total.
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AHTFY
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Re: "Tax-Efficient Allocation" Fallacy?

Post by AHTFY » Tue Sep 10, 2019 9:57 pm

I'm in this very situation right now. After being 100% stocks for quite a while, I decided to add some bonds. (Not trying to time the market, but it makes sense with age and more savings.)

I want to bring up one other factor: rebalancing. If I put my bonds in my taxable account alongside some stocks (Vanguard Total World), if I have to rebalance I will have to sell and thereby trigger a tax gain or loss. If I rebalance in my non-taxable account, I don''t have to worry about that. Just for simplicity sake, it would be simpler for me to stay 100% stocks in taxable and a mix of stocks and bonds in my tax free account.

If it weren't for this, I would probably allocate my bonds to my taxable account so that I'm not 100% in stocks in available savings if the market crashes.

livesoft
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Re: "Tax-Efficient Allocation" Fallacy?

Post by livesoft » Wed Sep 11, 2019 2:14 am

AHTFY wrote:
Tue Sep 10, 2019 9:57 pm
I want to bring up one other factor: rebalancing. If I put my bonds in my taxable account alongside some stocks (Vanguard Total World), if I have to rebalance I will have to sell and thereby trigger a tax gain or loss. If I rebalance in my non-taxable account, I don''t have to worry about that. Just for simplicity sake, it would be simpler for me to stay 100% stocks in taxable and a mix of stocks and bonds in my tax free account.

If it weren't for this, I would probably allocate my bonds to my taxable account so that I'm not 100% in stocks in available savings if the market crashes.
You could take the quarterly distributions of your equity funds and use them buy munis in taxable. Since distributions are about 2% or so each year, this could help with rebalancing without having to sell shares in your taxable account.
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deikel
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Re: "Tax-Efficient Allocation" Fallacy?

Post by deikel » Wed Sep 11, 2019 3:08 pm

grabiner wrote:
Tue Sep 10, 2019 8:50 pm
If bond yields rise, you can sell your munis for a capital loss and switch to stocks in taxable.
Uhh, I like this one, never thought about this....
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