Managing AA Targets between Taxable and Tax-Advantaged

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Horton
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Managing AA Targets between Taxable and Tax-Advantaged

Post by Horton » Fri Jun 27, 2014 4:37 pm

I have traditionally looked at all accounts (taxable and tax-advantaged) on a combined basis when establishing and monitoring my preferred asset allocation. Recently, I have begun to wonder if individuals should have separate asset allocations for taxable and tax-advantaged if they (a) have significant taxable investments and (b) intend to retire prior to age 59 ½.

To explain in further detail, I’ll use the following scenarios.

Scenario #1 – Manage Taxable and Tax-Advantaged Accounts According to One Combine Asset Allocation

If an individual intends to retire at, near, or after age 59 ½, then it doesn’t seem like there are any significant risks with this approach.

If, however, an individual intends to retire (i.e., take withdrawals to fund living expenses) much earlier than age 59 ½ and they follow recommended asset location (i.e., stocks in taxable and bonds in tax-advantaged), then it seems like they are taking on significant risk within their “taxable portfolio” and not enough risk with their “tax-advantaged portfolio” since the “tax-advantaged portfolio” cannot be accessed until age 59 ½.*

For instance, assume a 40 year old individual who intends to retire at age 45 with the following portfolio:

Taxable Account = $1,000,000 in stocks

Tax-Advantaged Account = $1,000,000 in bonds

Total Portfolio = $2,000,000 with 50/50 stock/bond split

In total, the individual’s asset allocation may be absolutely appropriate, but, when considering the fact that the individual will begin tapping taxable accounts in 5 years, the individual’s “taxable portfolio” is much too risky.

Further, since the individual cannot tap his “tax-advantaged portfolio” until he reaches 59 ½*, those investments are invested much too conservatively.

One might think that the simple solution would be periodic reallocation as withdrawals are made, but this ignores the fact that if the stock market declines significantly then the individual is at risk of running out of funds in the “taxable portfolio” prior to reaching age 59 ½ since he is invested 100% in stocks within the “taxable portfolio”.

Scenario #2 – Manage Taxable and Tax Advantaged Accounts According to Separate Asset Allocations

In this scenario, the individual could either maintain a 50/50 asset allocation in both the taxable and tax-advantaged portfolios or, alternatively, could maintain a more conservative (e.g., 40/60) allocation in the “taxable potfolio” and a more aggressive (e.g., 60/40) allocation in the tax-advantaged portfolio.
The biggest downside to this approach is the adverse tax consequence to holding bonds in taxable accounts. This could be mitigated by owning municipal bonds (due to the tax-exempt earnings) or potentially I-Bonds (due to their tax deferral feature), but the individual may prefer to own other types of fixed income (e.g, Treasuries, Corporate Bonds, etc.).

The upside seems to be that the “taxable portfolio” is invested according to the individual’s risk tolerance and there is a greater chance that the “taxable portfolio” will last until 59 ½.

For our 40 year old, his options may be somewhat limited given that it would not be prudent for him to sell $500,000 of his current portfolio to reach the desired 50/50 asset allocation given the immediate tax expense that would be incurred. However, it may be worthwhile for this individual to change his contribution strategy – for example, all future contributions to the “taxable portfolio” go to fixed income and all future contributions to the “tax-advantaged portfolio” go to equity.

What are your thoughts? Is there something obvious that I am missing? Is there a best approach?

* For purposes of the discussion, I have ignored 72t SEPP withdrawals as a fall-back option for Scenario #1. While this may be a viable option, it may not provide adequate cash flow in certain circumstances.

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Re: Managing AA Targets between Taxable and Tax-Advantaged

Post by grabiner » Fri Jun 27, 2014 9:43 pm

The reason that the split AA works is that you can reallocate. If your tax-advantaged portfolio is all stock, and you want to spend $100K while keeping your 60% stock allocation, you can sell $100K in stock in your taxable account, and move $40K from stock to bonds in your retirement account. Likewise, if the stock market drops, you can sell bonds to buy stocks in your retirement account.

Things can go wrong if a market drop leaves you without enough money for penalty-free withdrawals. Therefore, if you are intending to use a taxable account in stock for pre-retirement needs (such as a house down payment), you need to have twice as much in the taxable account as the amount you would need. If the stock market drops 50%, you will still have enough in the taxable account (and likely benefit from the ability to harvest your losses).

But if you are planning to retire early, this is less likely to be a problem. You will need a taxable account to be able to retire early, and will also be able to withdraw any Roth IRA contributions tax-free.
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Re: Managing AA Targets between Taxable and Tax-Advantaged

Post by retiredjg » Sat Jun 28, 2014 6:19 am

In addition, if you retire in or after the year in which you reach 55, money in a 401k/403b would be available. I realize this does not fit your scenario of retiring at 45, but it is something a lot of people don't know so I thought I'd mention it.

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Horton
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Re: Managing AA Targets between Taxable and Tax-Advantaged

Post by Horton » Sat Jun 28, 2014 3:23 pm

grabiner wrote:The reason that the split AA works is that you can reallocate. If your tax-advantaged portfolio is all stock, and you want to spend $100K while keeping your 60% stock allocation, you can sell $100K in stock in your taxable account, and move $40K from stock to bonds in your retirement account. Likewise, if the stock market drops, you can sell bonds to buy stocks in your retirement account.

Things can go wrong if a market drop leaves you without enough money for penalty-free withdrawals. Therefore, if you are intending to use a taxable account in stock for pre-retirement needs (such as a house down payment), you need to have twice as much in the taxable account as the amount you would need. If the stock market drops 50%, you will still have enough in the taxable account (and likely benefit from the ability to harvest your losses).

But if you are planning to retire early, this is less likely to be a problem. You will need a taxable account to be able to retire early, and will also be able to withdraw any Roth IRA contributions tax-free.
I understand the point about reallocating, and even commented on it directly in the original post, but if an individual is planning to retire 10 or more years prior to age 59 1/2 it seems like they may be exposing themselves to significant risk of depleting taxable funds prior to age 59 1/2. Yes, they may withdraw Roth contributions and even resort to SEPP, but what if that isn't enough?

The retort may be - then you aren't ready to retire yet! And, that may very we'll be true if invested 100% in equities. But, would the answer be different if the taxable portfolio was invested differently?

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Re: Managing AA Targets between Taxable and Tax-Advantaged

Post by Peter Foley » Sat Jun 28, 2014 5:35 pm

I believe there is another scenario where it makes some sense to manage AA targets among accounts. Minnesota has a relatively low threshold for the estate tax. Because spouses are essentially exempt, it does not come into play until the second spouse dies.

If assets are sufficient to trigger the tax, each spouse could have an account with children designated as beneficiaries rather than the other spouse. That account could be managed with a longer time horizon (higher stock allocation) than other accounts in the portfolio. First spouse dies, second spouse inherits X% of the assets and the children inherit y%.

This may make sense to do for federal estate taxes as well. However, at that level of assets a trust and a tax lawyer are no doubt worth the fees.

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Re: Managing AA Targets between Taxable and Tax-Advantaged

Post by DonCamillo » Sat Jun 28, 2014 6:52 pm

I am looking at a combined allocation from the opposite end of the spectrum, retiring late instead of early (after 70). In my case, it is not withdrawals from taxable accounts before retirement, but required minimum distributions that can upset the allocation applecart.

My solution is to have some of my tax deferred assets and some of my taxable assets in the same funds. For example, I can move money from a Vanguard index fund in an IRA to a taxable account in the same fund without changing allocation at all. I keep enough in both tax-deferred and taxable to qualify for Admiral rates in both.

Thus a three fund scenario can be a nine fund scenario; U.S. equity index, international equity index, and total bond fund duplicated in IRA, Roth, and taxable accounts. I can overweight fixed income in the tax free and tax deferred, and overweight equity in the taxable to minimize taxes. Actually, because I live in a state with a high income tax, I substitute a muni bond fund for the total bond in the taxable account. But it has the same vendor, so a transfer is easy.
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Re: Managing AA Targets between Taxable and Tax-Advantaged

Post by Kevin M » Sat Jun 28, 2014 7:31 pm

I would continue to manage all accounts as a single portfolio for AA purposes, but would modify asset location if concerned about depleting taxable assets too quickly in the event of a long, large stock market decline. Especially at current low rates, holding more fixed income in taxable is not a big deal; some even argue that it's preferable to hold fixed income in taxable and stocks in tax advantaged at current rates.

You already mentioned SEPP (72t), which really minimizes the risk you are concerned about. I personally think I'd prefer to hold more fixed income in taxable to avoid the complexities of 72t.

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Re: Managing AA Targets between Taxable and Tax-Advantaged

Post by Ticktock » Sat Jun 28, 2014 8:07 pm

Dallasguy
I think you scenario 2 is right. And I think you need to consider the benefits of pushing IRA withdrawals to 70 yrs old vs 59.5 ( other than in current tax bracket Roth conversions)

I am planning a retire early scenario. 1/3 assets in IRA at 65/35 and will migrate them to 60 /40 or 50/50 as I approach 70. 2/3 assets in after tax 55/45 might go 50/50 but that's a lot of muni. I am currently still working and part of the after tax is in hedge and private equity but that will end in about 2 more years.

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Re: Managing AA Targets between Taxable and Tax-Advantaged

Post by JimInIllinois » Sat Jun 28, 2014 8:31 pm

I would ask how contingent your early retirement is on the performance of the stock market over the next few years. If you are dead set on retirement in five years then you may want a taxable liability-matching portfolio locked in now. On the other hand, if an additional five years of market exposure would significantly enhance your chances of long-term success and you would be willing to work a few more years while waiting for a recovery then you could go 100% stocks in taxable and an aggressive overall asset allocation until the day before you quit your job.

If you could afford to retire today then you don't need to take risk on the taxable side. If you could not retire today then you probably don't want to give up five years of portfolio growth and should keep playing until you win the game.

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Re: Managing AA Targets between Taxable and Tax-Advantaged

Post by Horton » Sun Jun 29, 2014 11:23 am

JimInIllinois wrote:I would ask how contingent your early retirement is on the performance of the stock market over the next few years. If you are dead set on retirement in five years then you may want a taxable liability-matching portfolio locked in now. On the other hand, if an additional five years of market exposure would significantly enhance your chances of long-term success and you would be willing to work a few more years while waiting for a recovery then you could go 100% stocks in taxable and an aggressive overall asset allocation until the day before you quit your job.

If you could afford to retire today then you don't need to take risk on the taxable side. If you could not retire today then you probably don't want to give up five years of portfolio growth and should keep playing until you win the game.
Your comment actually hits on something else that I have been thinking about.

I am actually younger than 40 but have designed my contribution strategy to potentially allow me to retire early (God wiling!). I am currently 100% equities in taxable, but have begun to consider (a) whether I should eventually hold fixed income in taxable, (b) when is the right point to make the switch...and (c) what are the right fixed income investments to hold in taxable (munis and I-Bonds, I suppose?).

For example, if I stay 100% equities in taxable, then my projected retirement date may be somewhere between let's say age 40 and age 55 based on market performance. Whereas, if I begin adding fixed income, then perhaps that allows me to narrow the window to sometime between ages 45 and 50. With 100% equity, I have the upside potential of being able to create a liability-matching portfolio (LMP) as early as age 40. However, I also have the downside potential of not being able to create an LMP until age 55.

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Re: Managing AA Targets between Taxable and Tax-Advantaged

Post by livesoft » Sun Jun 29, 2014 11:40 am

I am early retired. Our taxable account represents about 45% of our portfolio and is allocated 100% to equities. I don't see any need to put any fixed income in taxable. Already the taxable account pays out more than 2% in dividends each year which can be used for spending or whatever.

I suppose if I ever became worried about it, then I would invest some of the taxable account into a short-term bond fund, but by nature I am not a worrier.
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Re: Managing AA Targets between Taxable and Tax-Advantaged

Post by feh » Mon Jun 30, 2014 11:53 am

DallasGuy wrote: One might think that the simple solution would be periodic reallocation as withdrawals are made, but this ignores the fact that if the stock market declines significantly then the individual is at risk of running out of funds in the “taxable portfolio” prior to reaching age 59 ½ since he is invested 100% in stocks within the “taxable portfolio”.
I agree with you that this is a risk. As I will be an early retiree, I'm addressing it by keeping 4 years of living expenses in cash-like investments, to avoid selling during a market downturn.

Our taxable accounts (not counting the cash buffer) are 100% equities and roughly half of our total portfolio.

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