Journal article on stocks in retirement accounts / bonds in taxable

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JustSomeGuy155
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Journal article on stocks in retirement accounts / bonds in taxable

Post by JustSomeGuy155 » Mon Jul 23, 2018 12:15 am

On another thread I opened, I got a suggestion to hold all of my bonds in a taxable account. I was curious so I created a spreadsheet to compare holding bonds in taxable vs. 401k vs. roth ASSUMING the investor could fill all tax-advantaged space. To my surprise, bonds in taxable came out ahead for almost all of the reasonable tax brackets, interest and stock growth rates I tested. For higher tax rates, using municipal bonds made the effect even more dramatic. I found this odd given the common advice to always hold bonds in retirement accounts, so I started googling and found an article which does a test similar to what I tested in my spreadsheet:

Link to journal article

I'm interested if anyone has a critique of the article, given the common advice on this board of holding bonds in retirement accounts

Also exciting, if economic conditions changed and it was no longer advantageous to hold bonds in taxable, reversing the position would have low tax-cost:
If in the future a financial advisor believes that the expected return on bonds has become significantly closer to the expected return on stocks, what is the cost to undo the recommended strategy of Stocks In-Bonds Out? The answer is that the tax cost is minimal. Selling any stocks or stock-holding funds held inside a TDA or TEA and buying bond funds inside the retirement account with the proceeds triggers no tax. Further, selling bonds held outside the retirement account typically triggers little gain because the basis is close to the selling price
Hope others find this as interesting as I did!

AlohaJoe
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Re: Journal article on stocks in retirement accounts / bonds in taxable

Post by AlohaJoe » Mon Jul 23, 2018 2:30 am

JustSomeGuy155 wrote:
Mon Jul 23, 2018 12:15 am
I'm interested if anyone has a critique of the article, given the common advice on this board of holding bonds in retirement accounts
The article seems mostly fine to me. As you've discovered with common advice, it isn't always correct, especially when it is offered with no empirical explanations and has any interaction with taxes (which are both personal and change over time). Type "bonds go in taxable" in the search at the top right box and find 49,700 results on bogleheads.org about the argument.....

Keep in mind that the paper you linked to found that in a scenario where someone is paying 0% LTCG tax and 15% interest tax (which means almost everyone, at least under current law) the difference between the "right" and the "wrong" way is minuscule: 0.14% a year. And that was assuming 4% returns for bonds.

Right now, especially given the (known) low bond rates and (widely expected) low stock returns, getting it wrong probably won't matter.

That said, the author seems to have completely missed the point of Reichenstein's 2007 article: you can't just ignore risk when you are doing this. The author of the article has ignored risk and only looked at return. Reichenstein's point is that you have to look at both and when you look at risk as well as return then the conventional wisdom is once again correct.

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JustSomeGuy155
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Re: Journal article on stocks in retirement accounts / bonds in taxable

Post by JustSomeGuy155 » Mon Jul 23, 2018 7:18 am

AlohaJoe wrote:
Mon Jul 23, 2018 2:30 am
Keep in mind that the paper you linked to found that in a scenario where someone is paying 0% LTCG tax and 15% interest tax (which means almost everyone, at least under current law) the difference between the "right" and the "wrong" way is minuscule: 0.14% a year. And that was assuming 4% returns for bonds.
Noted -- when I plug those tax numbers into my spreadsheet I do seem to be able to get bonds in retirement accounts to come out ahead for some reasonable bond/equity returns. But as a NYC resident those tax rates seem unattainable :D
AlohaJoe wrote:
Mon Jul 23, 2018 2:30 am
That said, the author seems to have completely missed the point of Reichenstein's 2007 article: you can't just ignore risk when you are doing this. The author of the article has ignored risk and only looked at return. Reichenstein's point is that you have to look at both and when you look at risk as well as return then the conventional wisdom is once again correct.
Can you explain this more? Do you mean that by keeping higher risk/return stocks in tax-advantaged accounts, you'd be changing the allocation over time to be more stock heavy? From my testing, it seems to me that assuming:
1. you have the income to maintain your desired bond allocation while filling tax-advantaged space with stocks
2. you have some LTCG taxes

It would almost always make sense to keep bonds in taxable. Though I suppose assumption #1 is likely uncommon for those in the lower income brackets.

Additionally, from the insight in the article, there is low-tax cost to reversing position, so there seems to be little downside to holding bonds in taxable until assumptions #1 and #2 are untrue for an investor

larryswedroe
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Re: Journal article on stocks in retirement accounts / bonds in taxable

Post by larryswedroe » Mon Jul 23, 2018 7:44 am

To be helpful here
The seminal paper on this issue is Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing,” by Robert M. Dammon, Chester S. Spatt, Harold H. Zhang, which appeared in the June 2004 issue of the Journal of Finance. And they showed the math that leads to the optimal decision being holding equities in taxable.

The following is from the chapter on the subject in The Only Guide You'll Ever Need for the Right Financial Plan

BTW, in addition to the math showed by the three authors there are six reasons why the preference should be as stated
• Equities receive capital gains treatment while fixed income investments are taxed at ordinary income tax rates. And the returns from most alternative investments are generally considered either ordinary income or short-term capital gains, making them less tax efficient than equities.
• Securities in taxable accounts receive a step-up in basis for the heirs at death, eliminating capital gains taxes, though not the estate tax. The higher expected return of equities takes the most advantage of the potential step-up, creating the preference for holding them in taxable accounts. On the downside, securities with unrealized losses in taxable accounts receive a step-down in basis at death — a good reason to harvest losses when available.
• Capital gains taxes are due only when realized. Investors have some ability to time the realization of gains. In addition, the advent of core and multi-style funds, tax-managed funds, and ETFs has greatly improved the tax efficiency of equity investing.
• When there are losses in taxable accounts, the losses can be harvested for tax purposes. The more volatile the asset, the more valuable the option to harvest losses. Equities are more volatile than fixed income assets.
• Assets held in taxable accounts can be donated to charities. By donating the appreciated shares (the preference should be to donate the shares with the largest long-term capital gain), capital gains taxes can be avoided. Because equities have higher expected returns than fixed income assets, this option is more valuable for equities.
• Taxes on dividends of foreign stock holdings are often withheld at the source. Investors can, however, claim a foreign tax credit (FTC) that can then be used as a credit against U.S. taxes. This credit is lost if the asset is held in a tax-advantaged account. We estimate that the loss of the FTC leads to a reduction of returns of about 9 percent of the amount of the dividend. This figure can change over time and across funds due to changes in withholding rates, tax treaties, and asset allocation within a fund. Remember, if the investment in international assets is a “fund of funds” structure, no portion of the FTC can be passed on to the investor by the fund of funds. However, if more than half of the fund is invested in individual foreign securities and the remainder structured as a fund of funds, the fund will qualify for a FTC.

BTW, my new book, Your Complete Guide to a Safe and Secure Retirement will have chapter and appendix (showing the math) on the subject. It will be published in January 2019. Here's the TOC

Introduction-The Four Horesemen of Retirement Planning; Threats to Successful Retirement
Chapter 1: Retirement Planning Beyond the Financials
Chapter 2: The Discovery Process
Chapter 3: Asset Allocation
Chapter 4: The Investment Policy Statement and the Care and Maintenance of the Portfolio
Chapter 5: Monte Carlo Simulations
Chapter 6: Investment Strategy I: Implementing the Investment Plan
Chapter 7: Investment Strategy Part II: Reducing the Risk of Black Swans
Chapter 8: IRA and Retirement/Profit Sharing Plans
Chapter 9: Health Savings Accounts
Chapter 10: The Asset Location Decision
Chapter 11: Spend Down Strategies
Chapter 12: Social Security
Chapter 13: Medicare
Chapter 14: Longevity Risk: The Role of Annuities
Chapter 15: The Role of Insurance: The Management of Risk
Chapter 16: Reverse Mortgages
Chapter 17: Women’s Unique Retirement Issues
Chapter 18: Estate Planning
Chapter 19: Preparing Your Heirs
Chapter 20: The Threat of Financial Elder Abuse
Conclusion
Appendix A: Sample Family Profile
Appendix B: Sample Family Mission Statement
Appendix C: The Math of Asset Location
Appendix D: Should Investors Prefer Dividend-Paying Stocks?
Appendix E: Should You Hire a Financial Advisor
Appendix F: Implementation: Recommended Mutual Funds and ETFs 
Appendix G: Types of Irrevocable Trusts
Appendix H: Recommended Reading

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celia
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Re: Journal article on stocks in retirement accounts / bonds in taxable

Post by celia » Mon Jul 23, 2018 9:40 am

The problem I have with that article is that they don't distinguish between tax-deferred and post-tax (Roth) retirement accounts. To me, they are vastly different. I think that is one reason we don't use the term "tax-advantaged" accounts very much in this forum. I even think of tax-deferred as "tax-DISadvantaged" since you get hit with a tax bill down the road that you often didn't plan for. Every dollar withdrawn is taxed as ordinary income, too.

I still think that our wiki page on Tax-efficient Fund Placement is the way to go, although it sounds complicated, due to trying to address every kind of mutual fund account. In addition, we often don't have enough room in each space (Roth, taxable, tax-deferred) to hold each asset class we want.

See my tag line below.
A dollar in Roth is worth more than a dollar in a taxable account. A dollar in taxable is worth more than a dollar in a tax-deferred account.

johnra
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Re: Journal article on stocks in retirement accounts / bonds in taxable

Post by johnra » Mon Jul 23, 2018 10:30 am

I think you need bonds in BOTH tax-deferred and taxable accounts. The reason is that in a stock downturn, when you need cash, you want to be able to take from either side depending upon what the situation calls for and the particulars of the year. While bonds in a taxable account generates taxable income, cashing in the bonds won't generate much tax. On the other hand, bonds in a tax-deferred account generate deferred income, but when you transfer out is taxable. Thus, you want to be positioned in both depending on what is needed.

Spirit Rider
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Re: Journal article on stocks in retirement accounts / bonds in taxable

Post by Spirit Rider » Mon Jul 23, 2018 11:00 am

AlohaJoe wrote:
Mon Jul 23, 2018 2:30 am
Keep in mind that the paper you linked to found that in a scenario where someone is paying 0% LTCG tax and 15% interest tax (which means almost everyone, at least under current law)
That may be true when you include all taxpayers, but then again the vast majority of taxpayers probably have no taxable investment accounts at all. Recent information is that only 30% of Americans have total savings > $1K and only 15% > $10K, with the majority of those probably in savings accounts and/or CDs.

While some retired Bogleheads might be in the 0% capital gains tax bracket, 10% and now 12% ordinary income tax brackets. However, I would venture a guess that the majority of Bogleheads are subject to a >= 15% capital gains tax rate and a >= 22% ordinary income tax rate.

larryswedroe
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Re: Journal article on stocks in retirement accounts / bonds in taxable

Post by larryswedroe » Mon Jul 23, 2018 11:40 am

Celia
The math is the same for either type of TA account, roth or traditional

mega317
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Re: Journal article on stocks in retirement accounts / bonds in taxable

Post by mega317 » Mon Jul 23, 2018 12:50 pm

johnra wrote:
Mon Jul 23, 2018 10:30 am
I think you need bonds in BOTH tax-deferred and taxable accounts. The reason is that in a stock downturn, when you need cash, you want to be able to take from either side depending upon what the situation calls for and the particulars of the year. While bonds in a taxable account generates taxable income, cashing in the bonds won't generate much tax. On the other hand, bonds in a tax-deferred account generate deferred income, but when you transfer out is taxable. Thus, you want to be positioned in both depending on what is needed.
Some of your post doesn't make sense to me.
1. Holding your bonds in tax-deferred doesn't limit where you get cash from. You can sell stocks in taxable and exchange bonds for stocks in tax-deferred.
2. Yes when you withdraw bonds from tax-deferred it is taxable, but so is a withdrawal from stocks which will have been expected to appreciate more and thus a larger tax impact.

Spirit Rider
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Re: Journal article on stocks in retirement accounts / bonds in taxable

Post by Spirit Rider » Mon Jul 23, 2018 1:43 pm

mega317 wrote:
Mon Jul 23, 2018 12:50 pm
johnra wrote:
Mon Jul 23, 2018 10:30 am
I think you need bonds in BOTH tax-deferred and taxable accounts. The reason is that in a stock downturn, when you need cash, you want to be able to take from either side depending upon what the situation calls for and the particulars of the year. While bonds in a taxable account generates taxable income, cashing in the bonds won't generate much tax. On the other hand, bonds in a tax-deferred account generate deferred income, but when you transfer out is taxable. Thus, you want to be positioned in both depending on what is needed.
Some of your post doesn't make sense to me.
1. Holding your bonds in tax-deferred doesn't limit where you get cash from. You can sell stocks in taxable and exchange bonds for stocks in tax-deferred.
2. Yes when you withdraw bonds from tax-deferred it is taxable, but so is a withdrawal from stocks which will have been expected to appreciate more and thus a larger tax impact.
This is exactly why you should have adequate emergency/contingency funds. So you don't have to sell marketable securities in a severe downturn.

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Re: Journal article on stocks in retirement accounts / bonds in taxable

Post by grabiner » Mon Jul 23, 2018 10:02 pm

The article avoids the common problem in which stocks look more attractive in a Roth IRA by treating $25,000 in a traditional IRA as equivalent to $18,750 in a Roth IRA in a 25% bracket. With the adjustment, the traditional and Roth IRA will have equal value if invested he same way, as you will lose 25% of the traditional IRA when you withdraw it. (If you don't make this adjustment, putting stock in the Roth IRA gives you higher expected return, but also higher risk, so there is no net advantage.)

However, the article gets the tax-adjusted value of a taxable account wrong, treating it as equal to a Roth IRA. If you have $18,750 in a taxable account in bonds, and $18,750 in a Roth IRA (or $25,000 in a traditional IRA) in stocks, you have more risk than if you held the funds the other way around, as the IRS will share in your losses in the taxable account but not in the Roth IRA.

Reproducing the authors' assumptions (8% stock returns which are 2% qualified dividends and 6% unrealized gains, 4% bond returns, 20-year time horizon, 25% tax but 15% on qualified dividends and long-term gains) with $18,750 in taxable and $18,750 in the traditional IRA (which makes the risk levels close) makes the 20-year values $65545+33865=99410 with stocks in the IRA, and $30813+75193=106006 with bonds in the IRA. Thus, at these bond yields, bonds in the IRA come out ahead.

In the second scenario (15% tax bracket in retirement), the IRS's share of the risk in the taxable account is very small, but the IRS's share of the risk in the traditional IRA is 15%, not 25%. Thus a more reasonable comparison would be $25,000 in the IRA and $21,250 in the taxable account, Now putting stocks in the IRA makes the returns $99045+38380=137425, and putting bonds in the IRA makes the returns $46561+99865=146426. Again, bonds in the IRA come out ahead. (The advantage is actually a bit less, because the IRS will share some of the risk if stocks are in a taxable account; a market decline will reduce dividend yields in future years.)
Wiki David Grabiner

AlohaJoe
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Re: Journal article on stocks in retirement accounts / bonds in taxable

Post by AlohaJoe » Mon Jul 23, 2018 11:57 pm

JustSomeGuy155 wrote:
Mon Jul 23, 2018 7:18 am
Can you explain this more? Do you mean that by keeping higher risk/return stocks in tax-advantaged accounts, you'd be changing the allocation over time to be more stock heavy?
If you have $100 in a 401(k), you don't actually have $100. You have (approximate numbers just to show an example) $75 and the government has $25. But is also means that the government is taking on some of the risk, as well. Likewise, in a taxable account you don't have $100. You have $85 and the government has $15; and the government bears some of the risk.

Reichenstein's argument is that you need to compare the after-tax returns and the after-tax risk of all four things (stocks in taxable, stocks in tax-deferred, bonds in taxable, bonds in tax-deferred) and that just looking at final portfolio values doesn't tell you enough. After all, if we just look at final portfolio values then we'd go with 100% stocks all the time. So we know that looking at final portfolio values isn't the right way to compare portfolios and make decisions.

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