out of space - international or muni bond in taxable?

[newbogleheader02]

Hi,

I'm running out of space in tax advantaged accounts to meet my asset allocation targets and soon need to redirect funds in my taxable account. Seems like I can add either an international index (VTMGX) or a municipal bond fund. I was getting ready to add international fund to taxable, but maybe I should go with municipal bond fund to avoid taxes? I'm maxing all tax advantaged contributions and have funds left to contribute to taxable. Appreciate any insight. I'm not sure how to think about this decision.

Current asset allocation: 62% stock, 38% bond, 28% of stock as international
Desired asset allocation: 60% stock, 40% bond, 30% of stock as international
So close enough to target allocations, but all new tax account funds have been going to VTSAX which doesn't seem sustainable while maintaining targets.
Federal tax rate: 24%, State tax rate: 3.07% (PA)
Looking at early retirement in about 4 years at age 52 which may be a factor to include in decision making.

Current Taxable: 45% of total
43% VTSAX (total US stock index), ER 0.04%
2% SVSPX (S&P 500 index), ER 0.16%
New contributions to ???

Current Trad IRA: 16% of total
16% VBTLX (total bond index), ER 0.05%
Not making new contributions due to avoiding pro-rata rule. Maybe I should not worry about this and contribute to get more bonds in tax deferred?

Current HSA: 1% of total
1% FTIHX (total international index), ER 0.06%
New contributions to FTIHX

Current Roth IRA: 12% of total
11% VTIAX (total international index), ER 0.05%
1% FTIHX (total international index), ER 0.06%
New contributions of after-tax 401k via in service rollover to FTIHX (2x per year allowed). Not eligible for regular Roth IRA contributions.

Current 401k: 26% of total
22% state street total bond index, ER 0.02%
4% state street total international index, ER 0.045%
New contributions going to state street total bond index

Though I'm still adding international funds to HSA and Roth IRA accounts and bonds to 401k, sizable contributions to taxable brokerage coupled with VTSAX returns is leading to need for soon redirecting available taxable funds to something other than VTSAX unless I want to change my asset allocation targets. Options:
1. Ignore pro-rate rule and add non-deductible contributions to traditional IRA which will help add space in tax deferred for bonds and/or international equity
2. Add international fund to taxable
3. Add municipal bond fund to taxable
4. Continue as is for now, see how market goes, and do nothing until there is further deviation from target asset allocation.

Thanks!

[retired@50]

Current Trad IRA: 16% of total
16% VBTLX (total bond index), ER 0.05%

2. Add international fund to taxable

Thanks!

Can you roll the current Trad IRA into your current 401k plan?

This would simplify things.

Adding international to taxable is generally okay, assuming you are interested in dealing with the foreign tax credit on your tax return.

Regards,

[newbogleheader02]

Can you roll the current Trad IRA into your current 401k plan?

This would simplify things.

Adding international to taxable is generally okay, assuming you are interested in dealing with the foreign tax credit on your tax return.

Regards,

Ah, rolling the traditional IRA into 401k only moves pretax money and removes or minimizes pro-rata impacts? In this scenario, part of my answer would be to free up tax deferred space by contributing to non-deductible IRA?

[breakfastinbed]

This is an interesting question that depends on two factors - what specific funds you are looking to invest in, and what tax bracket you will be in for retirement.

At your tax bracket, factoring in foreign tax credit for funds like FTIHX and VTSNX (just because I have their numbers on hand), the difference between taxable and tax-sheltered is miniscule - a matter of a few basis points.

The difference between total bond and an intermediate municipal fund is similarly miniscule as you are close to the break-even tax point where bonds outperform munis. If your tax bracket were to drop in retirement, total bond would likely better than a muni.

Overall the difference is quite small, but numbers-wise I think international in taxable wins out. You could also split the difference.

Note: all of the above assumes you do not pay NIIT, which would change things significantly.

[newbogleheader02]

This is an interesting question that depends on two factors - what specific funds you are looking to invest in, and what tax bracket you will be in for retirement.

At your tax bracket, factoring in foreign tax credit for funds like FTIHX and VTSNX (just because I have their numbers on hand), the difference between taxable and tax-sheltered is miniscule - a matter of a few basis points.

The difference between total bond and an intermediate municipal fund is similarly miniscule as you are close to the break-even tax point where bonds outperform munis. If your tax bracket were to drop in retirement, total bond would likely better than a muni.

Overall the difference is quite small, but numbers-wise I think international in taxable wins out. You could also split the difference.

Note: all of the above assumes you do not pay NIIT, which would change things significantly.

Hi. Thanks for the comments. However, either you are misunderstanding my question or I'm misunderstanding your reply.

The question is not whether to put total bond or municipal bond in taxable account or whether to put total international in taxable or tax deferred. The question is whether to add municipal bonds to the taxable account or to instead add international to the taxable account. One or the other seems to be needed in order to achieve desired bond and international asset allocations.

For the record, I expect to be in a lower tax bracket in retirement. Also, the international fund would be VTMGX (developed markets) and municipal bond would probably be either VPALX (PA muni) or VWIUX, VMLUX, or VTEAX. I'm not paying NIIT at this time.

EDIT: I suppose if bonds in taxable is better for my situation, it could be a question of using municipal bonds or taxable bonds. But in that case, international in taxable would seem better than total bond.

[rob]

I would add to International in taxable long before any bonds.

[Hacksawdave]

Since you picked age 52 to retire, then only the taxable account is game for withdrawals without penalty, save taking back Roth contributions. Have you calculated your expected expenses in retirement and have established your income sources to cover the expenses?

Answering yes you have the income to fund early retirement without having to draw down too much from the taxable account will decide if the last four years is to build municipals in the taxable account or go international in tax deferred.

My last three years prior to retirement were building more municipals. I had to stretch the timeframe a little as they laid me off in 2019, then Covid, and then having rates go to zero. I had to wait another three years to pick up what might be the last batch once rates peaked as they were too pricey for what I wanted. Last December the cost per basis point of distribution was one-third of the prior purchase cost.

[breakfastinbed]

This is an interesting question that depends on two factors - what specific funds you are looking to invest in, and what tax bracket you will be in for retirement.

At your tax bracket, factoring in foreign tax credit for funds like FTIHX and VTSNX (just because I have their numbers on hand), the difference between taxable and tax-sheltered is miniscule - a matter of a few basis points.

The difference between total bond and an intermediate municipal fund is similarly miniscule as you are close to the break-even tax point where bonds outperform munis. If your tax bracket were to drop in retirement, total bond would likely better than a muni.

Overall the difference is quite small, but numbers-wise I think international in taxable wins out. You could also split the difference.

Note: all of the above assumes you do not pay NIIT, which would change things significantly.

Hi. Thanks for the comments. However, either you are misunderstanding my question or I'm misunderstanding your reply.

The question is not whether to put total bond or municipal bond in taxable account or whether to put total international in taxable or tax deferred. The question is whether to add municipal bonds to the taxable account or to instead add international to the taxable account. One or the other seems to be needed in order to achieve desired bond and international asset allocations.

For the record, I expect to be in a lower tax bracket in retirement. Also, the international fund would be VTMGX (developed markets) and municipal bond would probably be either VPALX (PA muni) or VWIUX, VMLUX, or VTEAX. I'm not paying NIIT at this time.

EDIT: I suppose if bonds in taxable is better for my situation, it could be a question of using municipal bonds or taxable bonds. But in that case, international in taxable would seem better than total bond.

The point of my presenting three options is that there is a point where paying taxes on a total bond fund leads to a greater post-tax yield than investing in a municipal fund - this occurs at around 24-25% total income tax, and at your tax bracket you are likely not going to notice a difference in returns between total bond vs a low-cost municipal fund like VWIUX or VTEAX; if interest rates drop or your tax bracket decreases, however, you may in the future. So if you were to choose bonds in taxable, it may behoove you to consider total bond in lieu of municipal funds. In general, municipal bonds are probably not necessary unless your marginal tax rate equals/exceeds 32%.

If your question is whether you should add bonds (of any kind) or international to taxable, I have that the cost difference of putting VTMGX in taxable, with tax credit factored in, is about a ninth of the difference in pre-tax yield between BND and VTEAX. So international in taxable would be my recommendation.

[retired@50]

Can you roll the current Trad IRA into your current 401k plan?

This would simplify things.

Adding international to taxable is generally okay, assuming you are interested in dealing with the foreign tax credit on your tax return.

Regards,

Ah, rolling the traditional IRA into 401k only moves pretax money and removes or minimizes pro-rata impacts? In this scenario, part of my answer would be to free up tax deferred space by contributing to non-deductible IRA?

By combining the traditional IRA into your existing 401k, you'd open up the possibility of using a backdoor Roth strategy.

If you do this, you might be able to contribute the maximum to your tax-deferred 401k, and also contribute to a traditional non-deductible IRA, which you could convert to a Roth IRA. This is the essence of "backdoor Roth" which is often used by high earners.

Regards,

[retiredjg]

Muni bond funds work best for people in the higher tax brackets. At the 24% federal rate and with low state taxes, the muni fund will not be terribly helpful. You may not even break even.

For that reason, I'd move international to taxable and use the freed up space for bonds. The foreign tax credit is simple with tax software.

[retiredjg]

Added: needing more space for bonds is a reasonable reason to use non-deductible contributions to IRA. But you have correctly identified that will trigger pro-rating when you start taking money out of the IRA or doing Roth conversions. That is not difficult but it does go on forever.

I think you may eventually need to hold both international and bonds/fixed income in taxable. You don't have a great deal of wiggle room.

[newbogleheader02]

Since you picked age 52 to retire, then only the taxable account is game for withdrawals without penalty, save taking back Roth contributions. Have you calculated your expected expenses in retirement and have established your income sources to cover the expenses?

Answering yes you have the income to fund early retirement without having to draw down too much from the taxable account will decide if the last four years is to build municipals in the taxable account or go international in tax deferred.

My last three years prior to retirement were building more municipals. I had to stretch the timeframe a little as they laid me off in 2019, then Covid, and then having rates go to zero. I had to wait another three years to pick up what might be the last batch once rates peaked as they were too pricey for what I wanted. Last December the cost per basis point of distribution was one-third of the prior purchase cost.

Thanks. Yes, I have a good idea of expenses. What I like is automatically transferring funds for investment and then just using what is left to give a set total budget for spending. This has been working well for 6 months without need for additional funding. Planning to continue this for the next few years to further reinforce spending amounts.

Income planned to come from taxable account. However, I think I get into thinking about municipals because of the tax free aspect and reading more replies and posts about it, I think I'm just not at a place where that makes sense yet so exploring other options first.

Good luck in your retirement!

[newbogleheader02]

This is an interesting question that depends on two factors - what specific funds you are looking to invest in, and what tax bracket you will be in for retirement.

At your tax bracket, factoring in foreign tax credit for funds like FTIHX and VTSNX (just because I have their numbers on hand), the difference between taxable and tax-sheltered is miniscule - a matter of a few basis points.

The difference between total bond and an intermediate municipal fund is similarly miniscule as you are close to the break-even tax point where bonds outperform munis. If your tax bracket were to drop in retirement, total bond would likely better than a muni.

Overall the difference is quite small, but numbers-wise I think international in taxable wins out. You could also split the difference.

Note: all of the above assumes you do not pay NIIT, which would change things significantly.

Hi. Thanks for the comments. However, either you are misunderstanding my question or I'm misunderstanding your reply.

The question is not whether to put total bond or municipal bond in taxable account or whether to put total international in taxable or tax deferred. The question is whether to add municipal bonds to the taxable account or to instead add international to the taxable account. One or the other seems to be needed in order to achieve desired bond and international asset allocations.

For the record, I expect to be in a lower tax bracket in retirement. Also, the international fund would be VTMGX (developed markets) and municipal bond would probably be either VPALX (PA muni) or VWIUX, VMLUX, or VTEAX. I'm not paying NIIT at this time.

EDIT: I suppose if bonds in taxable is better for my situation, it could be a question of using municipal bonds or taxable bonds. But in that case, international in taxable would seem better than total bond.

The point of my presenting three options is that there is a point where paying taxes on a total bond fund leads to a greater post-tax yield than investing in a municipal fund - this occurs at around 24-25% total income tax, and at your tax bracket you are likely not going to notice a difference in returns between total bond vs a low-cost municipal fund like VWIUX or VTEAX; if interest rates drop or your tax bracket decreases, however, you may in the future. So if you were to choose bonds in taxable, it may behoove you to consider total bond in lieu of municipal funds. In general, municipal bonds are probably not necessary unless your marginal tax rate equals/exceeds 32%.

If your question is whether you should add bonds (of any kind) or international to taxable, I have that the cost difference of putting VTMGX in taxable, with tax credit factored in, is about a ninth of the difference in pre-tax yield between BND and VTEAX. So international in taxable would be my recommendation.

Thanks. I think you are correct, I'm likely not yet needing municipal bonds. I suppose I'm averse to paying more taxes so it makes it seem attractive...I need to at least sharpen the pencil and do the math on muni vs. regular bond options when time comes.

[newbogleheader02]

Can you roll the current Trad IRA into your current 401k plan?

This would simplify things.

Adding international to taxable is generally okay, assuming you are interested in dealing with the foreign tax credit on your tax return.

Regards,

Ah, rolling the traditional IRA into 401k only moves pretax money and removes or minimizes pro-rata impacts? In this scenario, part of my answer would be to free up tax deferred space by contributing to non-deductible IRA?

By combining the traditional IRA into your existing 401k, you'd open up the possibility of using a backdoor Roth strategy.

If you do this, you might be able to contribute the maximum to your tax-deferred 401k, and also contribute to a traditional non-deductible IRA, which you could convert to a Roth IRA. This is the essence of "backdoor Roth" which is often used by high earners.

Regards,

I had completely overlooked this option to free up more tax advantaged space while avoiding the pro-rata rule. Thank you!

[newbogleheader02]

Muni bond funds work best for people in the higher tax brackets. At the 24% federal rate and with low state taxes, the muni fund will not be terribly helpful. You may not even break even.

For that reason, I'd move international to taxable and use the freed up space for bonds. The foreign tax credit is simple with tax software.

Thank you. I believe you are correct though may consider these other options first.

Remaining options:
- roll IRA to 401k so I can do non-deductible IRA contributions to free up more tax advantaged space. This seems to make the most sense.
- consider ibonds or even ee bonds for extending tax advantaged space allowing more international in tax deferred and allowing additional accumulation of cash for early retirement spending without taxes (until withdrawn). The math probably doesn't support this, but I like the idea of no taxes on additional savings that could then be used when retired.
- do nothing, let asset allocation drift a bit. In a little over a year, will be year that I turn 50 and can allocate additional funds in tax advantaged space to adjust asset allocation. Though depending on market returns, this probably won't do enough.

[retiredjg]

Muni bond funds work best for people in the higher tax brackets. At the 24% federal rate and with low state taxes, the muni fund will not be terribly helpful. You may not even break even.

For that reason, I'd move international to taxable and use the freed up space for bonds. The foreign tax credit is simple with tax software.

Thank you. I believe you are correct though may consider these other options first.

Remaining options:
- roll IRA to 401k so I can do non-deductible IRA contributions to free up more tax advantaged space. This seems to make the most sense.
- consider ibonds or even ee bonds for extending tax advantaged space allowing more international in tax deferred and allowing additional accumulation of cash for early retirement spending without taxes (until withdrawn). The math probably doesn't support this, but I like the idea of no taxes on additional savings that could then be used when retired.
- do nothing, let asset allocation drift a bit. In a little over a year, will be year that I turn 50 and can allocate additional funds in tax advantaged space to adjust asset allocation. Though depending on market returns, this probably won't do enough.

As written, this plan does not eliminate pro-rating at some point in time because you only mentioned making the non-deductible contributions. But you may have just left something out?

This plan works well if you use the non-deductible IRA contributions as the first step to backdoor Roth. That gives you more space to put international into Roth, freeing up space in the 401k for more bonds. There will also be space in 401k for more bonds when you reach age 50.

I Bonds and EE bonds are generally a good choice.

There is also something to be said about not doing anything much at this point because you are essentially on target now anyway.

[Lastrun]

Added: needing more space for bonds is a reasonable reason to use non-deductible contributions to IRA. But you have correctly identified that will trigger pro-rating when you start taking money out of the IRA or doing Roth conversions. That is not difficult but it does go on forever.

I think you may eventually need to hold both international and bonds/fixed income in taxable. You don't have a great deal of wiggle room.

Thanks for this post. I am also 100% bonds in my IRAs, and (trust me on this) am done with the 401k world, and also with Treasury Direct. I thought, this may be an idea to capture some tax deferred space with additional bonds, but totally brain-f*rt*ed on the pro-rata rule if I later want to do conversions on the IRAs, which is a possibility.