Debunking Bonds in Taxable

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Cartographer
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Debunking Bonds in Taxable

Post by Cartographer » Mon Oct 08, 2018 3:02 pm

There doesn’t appear to be a universal consensus on how to split stocks and bonds across Traditional/Roth/Taxable accounts. The usual recommendation seems to be bonds go in tax-advantaged since their interest is taxed unfavorably, but there are plenty on the other side, both on these forums and elsewhere.

For example, WCI had a post a couple years ago arguing for bonds in Taxable: https://www.whitecoatinvestor.com/asset ... n-taxable/

The intuitive argument is that since tax-advantaged space is good, I want to maximize this by putting higher growing assets into it. Supposedly, under some parameter settings (such as low interest rate environments) this benefit will outweigh the cost of decreased tax-efficiency of bonds in Taxable. Then WCI included an example demonstrating this claim. He calculated a hypothetical example showing that bonds in Taxable resulted in a portfolio of $1.20M, whereas bonds in Roth resulted in $1.06M. Apparently a clear win for bonds in Taxable.

First off, I reject the intuitive argument. After all, higher returns are good, but that doesn't mean I should make investment choices that maximize expected returns. Otherwise, no one here would holds bonds at all. Similarly, having more money in Roth at the end of the day is better than having that money in Taxable, but that doesn't mean I should make allocation choices to maximize the expected size of my Roth.

Second, it appears the WCI example is flawed. In particular, the WCI forgot to tax-adjust his asset allocation to actually do a fair comparison between the two examples. The topic of bonds in Taxable has come up numerous times on the forum, and the WCI post mentioned frequently, but I didn't see anyone point out this error. And the flaw is pretty critical to the example.

In more detail, in WCI's example, he considered $100k in Roth and Taxable, and then either had all bonds in Roth and all stocks in Taxable, or vice versa. Unfortunately the $100k in taxable is partially owned by the government by way of taxes. WCI correctly subtracted the taxes owed, but didn’t take into account that the taxes reduced the volatility of the taxable account. Thus, his bonds in Roth example was actually a fair bit more conservative that bonds in Taxable. So he wasn’t comparing apples to apples.

The wiki on tax-adjusting says to reduce the value of the Taxable account by 25%, presumably corresponding to 15% capital gains owed at sale, plus the compounded effect of taxes on dividends over the years. I personally think there is a conceptually better way to tax adjust, but that will be the topic of another post. For this, I’ll use the recommended 25%.

Therefore, the bonds in Taxable scenario can really be thought of as $100k stocks and $75k bonds, whereas bonds in Roth is $100k bonds and $75k stocks. Hardly equivalent asset allocations. If I were to adjust the bonds in Roth example to match the allocation of the bonds in Taxable, I would need to convert $25k of the Roth bonds into stocks. Re-doing the numbers under these assumptions, I arrive at $1.25M for bonds in Roth, somewhat higher than bonds in Taxable for an equivalent level of risk. So even using WCI's numbers (which relied on low interest rates, which may no longer be possible), it looks like bonds still go in tax-advantaged accounts.

Funnily enough, I actually got onto the whole topic of tax-adjusting asset allocation from the WCI article itself. In the comments section, someone brought up Traditional accounts, which weren’t discussed in the post. In response, WCI argued that you could tax-adjusted the Traditional to make it equivalent to Roth. Somehow, it appears WCI forgot to tax-adjust his taxable account...


I also have a much more nuanced analysis that I think makes the case for bonds in tax-advantaged even more compelling. I’d be happy to share it if anyone’s interested, but it’s pretty long (even longer than this post). For my first post on the subject, I didn’t want to bore people too much!

Side note: there are of course good reasons to keep bonds in Taxable, such as liquidity. This post is ignoring aspects like this, and it simply just focusing on risk and return.
Last edited by Cartographer on Mon Oct 08, 2018 4:07 pm, edited 1 time in total.

michaeljc70
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Re: Debunking Bonds in Taxable

Post by michaeljc70 » Mon Oct 08, 2018 3:11 pm

One scenario I can envision where bonds in taxable is beneficial is:

-You retire early (before 59 1/2)
-The market is in a downturn so you don't want to sell stocks from taxable accounts
-You can't access bonds without special withdrawals from IRAs (like 72t)

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eye.surgeon
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Re: Debunking Bonds in Taxable

Post by eye.surgeon » Mon Oct 08, 2018 3:12 pm

The boglehead wiki here makes the following case for bonds in taxable:

The advantages for holding bonds in a taxable account include:

1. Bonds have a lower expected return than stocks, and hence sometimes a lower tax cost.
2. Switching placement when necessary does not incur a large capital gains tax. If you hold stocks in a taxable account instead, large built-up unrealized capital gains makes it very difficult to switch even if switching would otherwise be beneficial.
3. Nominal treasury bonds, TIPS, and in-state muni bonds are not subject to the state income tax.
4. The effective tax rate on muni bonds is usually much lower than the highest marginal tax rate on ordinary income.
5. Interest from muni bonds is not included in Adjusted Gross Income (AGI), which determines eligibility for many income tax deductions and credits, whereas dividends and capital gains are included in AGI.


So it's not just WCI advocating it.

Bottom line, the answer to the question of Bonds in Taxable is not yes or no. it depends. It's more than risk/return analysis as you pointed out.
Last edited by eye.surgeon on Mon Oct 08, 2018 3:31 pm, edited 7 times in total.
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Re: Debunking Bonds in Taxable

Post by Call_Me_Op » Mon Oct 08, 2018 3:17 pm

Because of the various considerations, I hold some bonds (and bond equivalents like CDs) in taxable and some in tax-advantaged.
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Re: Debunking Bonds in Taxable

Post by livesoft » Mon Oct 08, 2018 3:21 pm

I wouldn't worry about an old article by WCI at all. He walked that opinion back years ago. I think he gets more eyeballs to the original because it is controversial and maybe more page reads means more income to him.
Bottom line, the answer to the question of Bonds in Taxable is not yes or no. it depends. It's more than risk/return analysis as you pointed out.
This is very close to current advice from WCI.

Example: viewtopic.php?p=4141743#p4141743
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Re: Debunking Bonds in Taxable

Post by willthrill81 » Mon Oct 08, 2018 3:35 pm

If 'the' answer is so incredibly difficult for so many incredibly intelligent people to nail down, I can't help but wonder whether it's because it generally isn't likely to make a big difference either way.

Specifically, I think that everyone should run the numbers for themselves to see what is likely to make the most sense in their unique situation.
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Cartographer
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Re: Debunking Bonds in Taxable

Post by Cartographer » Mon Oct 08, 2018 3:40 pm

livesoft wrote:
Mon Oct 08, 2018 3:21 pm
I wouldn't worry about an old article by WCI at all. He walked that opinion back years ago. I think he gets more eyeballs to the original because it is controversial and maybe more page reads means more income to him.
Bottom line, the answer to the question of Bonds in Taxable is not yes or no. it depends. It's more than risk/return analysis as you pointed out.
This is very close to current advice from WCI.

Example: viewtopic.php?p=4141743#p4141743
The WCI article is just the one that I see keep coming up and the one with numbers, so it was the one I focused on. But there are many on this forum who post similar "more money in Roth is better so stocks go in Roth" arguments, even much more recently. And it also appears on the wiki for tax-efficient fund placement:

"Due to higher returns, equities have the potential to expand tax-advantaged space, leading to higher tax savings later on despite higher tax bills in the present. This is particularly true at the presently low bond yields, when the tax penalty from bonds in taxable is not as high as it has been in the past"

I think this line of reasoning is entirely incorrect, as the higher tax savings of stocks in tax-advantaged space comes a the cost of higher risk. If all I cared about was maximizing the end value of my account, I wouldn't hold any bonds at all.

And of course, there are multiple reasons to hold bonds in Taxable. But line of argument seems to be all about maximizing returns and ignoring these kinds of considerations anyway.

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Re: Debunking Bonds in Taxable

Post by willthrill81 » Mon Oct 08, 2018 3:49 pm

There is a solution to this dilemma: don't use taxable accounts. :beer
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Re: Debunking Bonds in Taxable

Post by dwickenh » Mon Oct 08, 2018 3:55 pm

willthrill81 wrote:
Mon Oct 08, 2018 3:49 pm
There is a solution to this dilemma: don't use taxable accounts. :beer
Always use a taxable account, along with your Roth and TIRA.

The three together are magic for controlling income for taxes and Health Insurance Subsidies.

Dan
The market is the most efficient mechanism anywhere in the world for transferring wealth from impatient people to patient people.” | — Warren Buffett

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Re: Debunking Bonds in Taxable

Post by retiredjg » Mon Oct 08, 2018 3:59 pm

Cartographer wrote:
Mon Oct 08, 2018 3:02 pm
For example, WCI had a post a couple years ago arguing for bonds in Roth: https://www.whitecoatinvestor.com/asset ... n-taxable/
Maybe this was a "mis-speak" on your part, but WCI argued for bonds in taxable, not bonds in Roth.

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Re: Debunking Bonds in Taxable

Post by Cartographer » Mon Oct 08, 2018 4:07 pm

retiredjg wrote:
Mon Oct 08, 2018 3:59 pm
Cartographer wrote:
Mon Oct 08, 2018 3:02 pm
For example, WCI had a post a couple years ago arguing for bonds in Roth: https://www.whitecoatinvestor.com/asset ... n-taxable/
Maybe this was a "mis-speak" on your part, but WCI argued for bonds in taxable, not bonds in Roth.
Yup, meant bonds in Taxable

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Re: Debunking Bonds in Taxable

Post by international001 » Mon Oct 08, 2018 4:15 pm

So it seems that WCI assumptions is that you invest in bonds for one account, in stocks in the other, no rebalancing, and stocks on tax-sheltered win. I think this is a no brainer. Over long term, the benefits of tax-free compounding will always win

Now, there is people saying that you should rebalance among taxable and tax sheltered, so the *overall* asset allocation remains constant. In this case, you would have to weight in how much the rebalancing is costing you (perhaps nothing if you are always able to do it with new money!). If the cost is small, having stocks in tax sheltered would seem better

Of course, *overall* allocation may be used if you are assuming that taxable is only for retirement, what may not be the case. If it is, you should be saving more than the ~$60k/year than you can save on tax sheltered

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Re: Debunking Bonds in Taxable

Post by willthrill81 » Mon Oct 08, 2018 4:25 pm

dwickenh wrote:
Mon Oct 08, 2018 3:55 pm
willthrill81 wrote:
Mon Oct 08, 2018 3:49 pm
There is a solution to this dilemma: don't use taxable accounts. :beer
Always use a taxable account, along with your Roth and TIRA.

The three together are magic for controlling income for taxes and Health Insurance Subsidies.

Dan
I have no need for a taxable account as we have over $75k of tax-advantaged space every year.
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Re: Debunking Bonds in Taxable

Post by dwickenh » Mon Oct 08, 2018 4:27 pm

willthrill81 wrote:
Mon Oct 08, 2018 4:25 pm
dwickenh wrote:
Mon Oct 08, 2018 3:55 pm
willthrill81 wrote:
Mon Oct 08, 2018 3:49 pm
There is a solution to this dilemma: don't use taxable accounts. :beer
Always use a taxable account, along with your Roth and TIRA.

The three together are magic for controlling income for taxes and Health Insurance Subsidies.

Dan
I have no need for a taxable account as we have over $75k of tax-advantaged space every year.
Then the solution for you is to not use taxable accounts, though not for everyone.
The market is the most efficient mechanism anywhere in the world for transferring wealth from impatient people to patient people.” | — Warren Buffett

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Re: Debunking Bonds in Taxable

Post by willthrill81 » Mon Oct 08, 2018 4:30 pm

dwickenh wrote:
Mon Oct 08, 2018 4:27 pm
willthrill81 wrote:
Mon Oct 08, 2018 4:25 pm
dwickenh wrote:
Mon Oct 08, 2018 3:55 pm
willthrill81 wrote:
Mon Oct 08, 2018 3:49 pm
There is a solution to this dilemma: don't use taxable accounts. :beer
Always use a taxable account, along with your Roth and TIRA.

The three together are magic for controlling income for taxes and Health Insurance Subsidies.

Dan
I have no need for a taxable account as we have over $75k of tax-advantaged space every year.
Then the solution for you is to not use taxable accounts, though not for everyone.
I know. I was being facetious.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

Cartographer
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Re: Debunking Bonds in Taxable

Post by Cartographer » Mon Oct 08, 2018 4:31 pm

international001 wrote:
Mon Oct 08, 2018 4:15 pm
So it seems that WCI assumptions is that you invest in bonds for one account, in stocks in the other, no rebalancing, and stocks on tax-sheltered win. I think this is a no brainer. Over long term, the benefits of tax-free compounding will always win

Now, there is people saying that you should rebalance among taxable and tax sheltered, so the *overall* asset allocation remains constant. In this case, you would have to weight in how much the rebalancing is costing you (perhaps nothing if you are always able to do it with new money!). If the cost is small, having stocks in tax sheltered would seem better

Of course, *overall* allocation may be used if you are assuming that taxable is only for retirement, what may not be the case. If it is, you should be saving more than the ~$60k/year than you can save on tax sheltered
Yes, rebalancing is another issue with the WCI calculation that I didn't get into. Without rebalancing, using the assumptions given, stocks lose more to taxation that bonds, simply because stocks are allowed to grow so much relative to bonds. The crossover point happens at about 25 years for WCI's numbers, a hair shy of the 30 years used in the example.

Even if we ignore rebalancing costs: if you rebalance on much shorter time-scales (say at most a couple years), and if you properly adjust for the increased risk of holding stocks in taxable, then stocks in taxable will be the right answer (again, if we only consider risk/return and ignore many other good reasons to hold bonds in taxable).

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Re: Debunking Bonds in Taxable

Post by Gort » Mon Oct 08, 2018 4:38 pm

After we come to a consesnus on this topic, perhaps we could discuss the "How much international should I hold?" topic. :oops:

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Re: Debunking Bonds in Taxable

Post by willthrill81 » Mon Oct 08, 2018 4:39 pm

Gort wrote:
Mon Oct 08, 2018 4:38 pm
After we come to a consesnus on this topic, perhaps we could discuss the "How much international should I hold?" topic. :oops:
Not that! Anything but that!!! :oops:
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Re: Debunking Bonds in Taxable

Post by dwickenh » Mon Oct 08, 2018 4:42 pm

willthrill81 wrote:
Mon Oct 08, 2018 4:30 pm
dwickenh wrote:
Mon Oct 08, 2018 4:27 pm
willthrill81 wrote:
Mon Oct 08, 2018 4:25 pm
dwickenh wrote:
Mon Oct 08, 2018 3:55 pm
willthrill81 wrote:
Mon Oct 08, 2018 3:49 pm
There is a solution to this dilemma: don't use taxable accounts. :beer
Always use a taxable account, along with your Roth and TIRA.

The three together are magic for controlling income for taxes and Health Insurance Subsidies.

Dan
I have no need for a taxable account as we have over $75k of tax-advantaged space every year.
Then the solution for you is to not use taxable accounts, though not for everyone.
I know. I was being facetious.
I should have known that :oops:
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Re: Debunking Bonds in Taxable

Post by retiredjg » Mon Oct 08, 2018 4:51 pm

international001 wrote:
Mon Oct 08, 2018 4:15 pm
So it seems that WCI assumptions is that you invest in bonds for one account, in stocks in the other, no rebalancing, and stocks on tax-sheltered win.
I'm not sure how you came to this conclusion. I'm pretty sure that this is not what WCI thinks. :happy

I think this is a no brainer. Over long term, the benefits of tax-free compounding will always win
Not in this case. The earnings from stocks/stock funds in a tax-advantaged account are taxed at a higher rate than the earnings from the same investment in a taxable account. You end up with less money if you pay higher tax rates.

This does not mean you should not put stocks in a tax-advantaged account - tax-deferral is a good tool and you need to fill your tax-deferred accounts with whatever you are investing in. Once that is done, stocks are preferred in taxable.

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Re: Debunking Bonds in Taxable

Post by elgob » Mon Oct 08, 2018 4:51 pm

For a detailed analysis of this issue, see
The Asset Location Decision Revisited, a 2013 article in the Journal of Financial Planning
https://www.onefpa.org/journal/Pages/No ... sited.aspx
It concludes:
This study has revealed that the traditional approach to calculating an individual’s asset allocation does not adjust the TDA’s market value for the embedded tax liability. Furthermore, it does not recognize that the government takes some of the return and bears some risk of assets held in taxable account. Therefore, the same asset, whether stock or bond, is effectively a different asset when held in a TDA or taxable account.

Results from this analysis indicate that the usual asset location advice is for an individual investor to locate stocks in taxable accounts and bonds in retirement accounts (TDAs and TEAs) to the extent possible, while attaining the optimal asset allocation. Even with today’s historically low interest rates, this usual asset location advice prevails for most investors. However, exceptionally low yields can reverse the usual asset location advice, especially for individuals with above-average risk aversion. Finally, the usual asset location advice prevails for investors who select a risk-free asset for the fixed-income portion of their portfolios.

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Re: Debunking Bonds in Taxable

Post by columbia » Mon Oct 08, 2018 4:58 pm

Imagine if you have stocks and bonds in al of your accounts. Also imagine that you $50K in treasury fund in your taxable account (along with equities in that account), after a 10 year year bull market. Also imagine that you now need $50k for an expense.

Would you rather sell that treasury fund or VTSAX at the top of the bull market? From a tax standpoint, I know which one I’d rather sell on 10/8/2018.
Last edited by columbia on Mon Oct 08, 2018 4:59 pm, edited 1 time in total.

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Re: Debunking Bonds in Taxable

Post by cookymonster » Mon Oct 08, 2018 4:59 pm

I ran the numbers using WCI's methodology, and the final totals in each scenario were within 2% of each other.

I see myself continuing to put bonds in traditional retirement accounts because I don't really want to mess with municipal bonds. If my taxes go up dramatically maybe I'll reconsider.

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Re: Debunking Bonds in Taxable

Post by livesoft » Mon Oct 08, 2018 5:09 pm

columbia wrote:
Mon Oct 08, 2018 4:58 pm
Imagine if you have stocks and bonds in al of your accounts. Also imagine that you $50K in treasury fund in your taxable account (along with equities in that account), after a 10 year year bull market. Also imagine that you now need $50k for an expense.

Would you rather sell that treasury fund or VTSAX at the top of the bull market? From a tax standpoint, I know which one I’d rather sell on 10/8/2018.
I am always happy to sell VTSAX because I have no bonds to sell in taxable. I don't pay taxes on the sale because I offset any gains with previous carry over losses from tax-loss harvesting. Put that in your analysis, too, please.
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Re: Debunking Bonds in Taxable

Post by lukestuckenhymer » Mon Oct 08, 2018 5:13 pm

Call_Me_Op wrote:
Mon Oct 08, 2018 3:17 pm
Because of the various considerations, I hold some bonds (and bond equivalents like CDs) in taxable and some in tax-advantaged.
Do we consider CDs a "bond equivalent"? A CD to me is a cash equivalent. Bonds can lose principal, cash and CDs can't.

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Re: Debunking Bonds in Taxable

Post by international001 » Mon Oct 08, 2018 6:38 pm

So it seems that WCI assumptions is that you invest in bonds for one account, in stocks in the other, no rebalancing, and stocks on tax-sheltered win.
I'm not sure how you came to this conclusion. I'm pretty sure that this is not what WCI thinks. :happy
It's exactly his example.. using $100k for each of the accounts
I think this is a no brainer. Over long term, the benefits of tax-free compounding will always win
Not in this case. The earnings from stocks/stock funds in a tax-advantaged account are taxed at a higher rate than the earnings from the same investment in a taxable account. You end up with less money if you pay higher tax rates.

This does not mean you should not put stocks in a tax-advantaged account - tax-deferral is a good tool and you need to fill your tax-deferred accounts with whatever you are investing in. Once that is done, stocks are preferred in taxable.
[/quote]

No. If you compound for enough time, you want investment with higher return to be tax deferred, so you don't have to pay taxes every year and lower the *exponential* rate of return. Just make numbers on a spreadsheet if you don't see it

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Re: Debunking Bonds in Taxable

Post by sambb » Mon Oct 08, 2018 7:18 pm

confounders:
'munis have a higher tax equivalent yield than bonds in taxable
No one knows what capital gains tax rates will be
lots of other things

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Re: Debunking Bonds in Taxable

Post by willthrill81 » Mon Oct 08, 2018 9:12 pm

lukestuckenhymer wrote:
Mon Oct 08, 2018 5:13 pm
Call_Me_Op wrote:
Mon Oct 08, 2018 3:17 pm
Because of the various considerations, I hold some bonds (and bond equivalents like CDs) in taxable and some in tax-advantaged.
Do we consider CDs a "bond equivalent"? A CD to me is a cash equivalent. Bonds can lose principal, cash and CDs can't.
CDs are another form of fixed income. And yes, many use CDs in partial or complete lieu of bonds. A CD isn't equivalent to cash, however, because there is always some kind of early withdrawal penalty. And in real dollars, CDs can absolutely lose money.
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Re: Debunking Bonds in Taxable

Post by Cartographer » Mon Oct 08, 2018 9:33 pm

international001 wrote:
Mon Oct 08, 2018 6:38 pm
So it seems that WCI assumptions is that you invest in bonds for one account, in stocks in the other, no rebalancing, and stocks on tax-sheltered win.
I'm not sure how you came to this conclusion. I'm pretty sure that this is not what WCI thinks. :happy
It's exactly his example.. using $100k for each of the accounts
I think this is a no brainer. Over long term, the benefits of tax-free compounding will always win
Not in this case. The earnings from stocks/stock funds in a tax-advantaged account are taxed at a higher rate than the earnings from the same investment in a taxable account. You end up with less money if you pay higher tax rates.

This does not mean you should not put stocks in a tax-advantaged account - tax-deferral is a good tool and you need to fill your tax-deferred accounts with whatever you are investing in. Once that is done, stocks are preferred in taxable.
No. If you compound for enough time, you want investment with higher return to be tax deferred, so you don't have to pay taxes every year and lower the *exponential* rate of return. Just make numbers on a spreadsheet if you don't see it
[/quote]

What you want is the investment that loses the most to taxes over the rebalancing period to be in tax-advantaged. If you never rebalance or rebalance over extremely long intervals (e.g. 30 years), stocks will lose the most, and hence belong in tax-advantaged. However, if you rebalance over just several years, then bonds lose the most to taxes and belong in tax-advantaged accounts

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Re: Debunking Bonds in Taxable

Post by xb7 » Tue Oct 09, 2018 1:59 am

As others have suggested, different investors have different financial circumstances, some of which IMO are good situations in which to have some bonds on the taxable side. One factor is whether you're already retired (perhaps pre-RMD retirement) and living off of current income & capital gains --- perhaps you want to have some steady bond income as part of that.

Another is something that others have mentioned --- forced sales to rebalance. If you have nothing but bonds in your (non-Roth) IRA/401(k) when you get to age 70-1/2 and have to start taking RMDs, then at a time in your life when your glide path might typically put you more in bonds and less in stocks overall, you'll be forced to sell off bonds in your IRA. Which in turn might reasonably require stock fund sales on the taxable side to maintain a desired balance.
As best as I can figure out, it's not so good to defer bond income in an IRA if it just means that you sort of paint yourself into a tax corner in this way.

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Re: Debunking Bonds in Taxable

Post by SpideyIndexer » Wed Oct 10, 2018 3:51 pm

international001 wrote:
Mon Oct 08, 2018 4:15 pm
So it seems that WCI assumptions is that you invest in bonds for one account, in stocks in the other, no rebalancing, and stocks on tax-sheltered win. I think this is a no brainer. Over long term, the benefits of tax-free compounding will always win

Now, there is people saying that you should rebalance among taxable and tax sheltered, so the *overall* asset allocation remains constant. In this case, you would have to weight in how much the rebalancing is costing you (perhaps nothing if you are always able to do it with new money!). If the cost is small, having stocks in tax sheltered would seem better

Of course, *overall* allocation may be used if you are assuming that taxable is only for retirement, what may not be the case. If it is, you should be saving more than the ~$60k/year than you can save on tax sheltered
No, I think it is a brainer. If your TD account is all stocks, quite possibly it will grow really big over time time, forcing (taxable) RMDs to get too large. Not only that, but since RMDs cannot be used to fund a Roth conversion, so one may be not have the option to make Roth conversions except in a very high tax bracket. My opinion is that there is a broad optimum range of AA for taxable and for TD, which needs to be part of one's overall investment strategy. It may change over time and depends on the size of one's taxable, TD and Roth space along with needs in retirement.

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Re: Debunking Bonds in Taxable

Post by vineviz » Wed Oct 10, 2018 7:16 pm

lukestuckenhymer wrote:
Mon Oct 08, 2018 5:13 pm
Call_Me_Op wrote:
Mon Oct 08, 2018 3:17 pm
Because of the various considerations, I hold some bonds (and bond equivalents like CDs) in taxable and some in tax-advantaged.
Do we consider CDs a "bond equivalent"? A CD to me is a cash equivalent. Bonds can lose principal, cash and CDs can't.
Some people confuse CDs with bonds, yes, but they are a cash instrument.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Debunking Bonds in Taxable

Post by retiredjg » Wed Oct 10, 2018 7:53 pm

A CD can be whatever you want it to be...except maybe a stock. :happy

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Re: Debunking Bonds in Taxable

Post by stlutz » Wed Oct 10, 2018 8:40 pm

The other problem is that tax laws change. It hasn't always been the case that long-term capital gains and dividends got favorable treatment. It's very possible that the same could happen in the future. The problem with optimizing is that you're optimizing for right now, which might be different from what is optimal in the future.

Furthermore, the bonds-in-tax-advantaged approach was obvious when Treasury bonds yielded 6 or 7%. That changed when rates dropped to 2% or less. Note that the wiki says that "low yielding" bonds belong in taxable. What will bonds yield in 5 years? I have no idea.

Because I can't predict future interest rates or tax policy I hold the same stock/bond mix in all of my accounts. I'll never have the "best" arrangement but I won't have the worst either when things change in an unexpected way.

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Re: Debunking Bonds in Taxable

Post by SpideyIndexer » Thu Oct 11, 2018 1:53 pm

Stlutz raises good points. One needs to consider future returns of stock and bonds along with future taxation thereof in order to optimize asset placement. Lots of things that may vary. So I hedge between the two camps: taxable is more stock heavy and TD more bond heavy but not 100/0 or 0/100 in either. Roth is the most stock heavy.

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Re: Debunking Bonds in Taxable

Post by watchnerd » Fri Oct 12, 2018 12:37 am

stlutz wrote:
Wed Oct 10, 2018 8:40 pm

Because I can't predict future interest rates or tax policy I hold the same stock/bond mix in all of my accounts. I'll never have the "best" arrangement but I won't have the worst either when things change in an unexpected way.
This is what I do, with the modification that the bond mix changes from 100% Treasuries to 50% Treasuries, 50% Munis in my taxable.
Tax Sheltered: 35% US Stock | 35% ex-US Stock | 30% TTM || Taxable: 35% US Stock | 35% ex-US Stock | 15% TTM | 15% Munis

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Re: Debunking Bonds in Taxable

Post by international001 » Fri Oct 19, 2018 8:46 am

SpideyIndexer wrote:
Wed Oct 10, 2018 3:51 pm
international001 wrote:
Mon Oct 08, 2018 4:15 pm
So it seems that WCI assumptions is that you invest in bonds for one account, in stocks in the other, no rebalancing, and stocks on tax-sheltered win. I think this is a no brainer. Over long term, the benefits of tax-free compounding will always win

Now, there is people saying that you should rebalance among taxable and tax sheltered, so the *overall* asset allocation remains constant. In this case, you would have to weight in how much the rebalancing is costing you (perhaps nothing if you are always able to do it with new money!). If the cost is small, having stocks in tax sheltered would seem better

Of course, *overall* allocation may be used if you are assuming that taxable is only for retirement, what may not be the case. If it is, you should be saving more than the ~$60k/year than you can save on tax sheltered
No, I think it is a brainer. If your TD account is all stocks, quite possibly it will grow really big over time time, forcing (taxable) RMDs to get too large. Not only that, but since RMDs cannot be used to fund a Roth conversion, so one may be not have the option to make Roth conversions except in a very high tax bracket. My opinion is that there is a broad optimum range of AA for taxable and for TD, which needs to be part of one's overall investment strategy. It may change over time and depends on the size of one's taxable, TD and Roth space along with needs in retirement.

Ok.. I was not thinking about this considerations. My case was just maximizing $ at 65 and assume you would spend it all. What case are you thinking? 1. Doing a rollover from 401k to traditional IRA
2. And then doing a conversion of this X from traditional IRA to Roth IRA.

For RMD you cannot even do 1
If you plan to leave a big chunk to your inheritors, you may account for this considerations. RMD are taxed are your marginal tax brackets, and you may want to avoid that. This is under the assumption that you want to invest on 401k instead of going full-loaded on Roth IRA

But I think my point still holds: if the long term is long enough, better stocks on tax deferred. Whatever % of the tax you have to pay later, it will be less than the benefit of a higher compounding effect

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Re: Debunking Bonds in Taxable

Post by aristotelian » Fri Oct 19, 2018 10:11 am

international001 wrote:
Fri Oct 19, 2018 8:46 am
But I think my point still holds: if the long term is long enough, better stocks on tax deferred. Whatever % of the tax you have to pay later, it will be less than the benefit of a higher compounding effect
I would say the opposite. The longer your horizon, the more you expect stocks to grow. You do not want that growth to be taxed at your marginal rate. It would always be better to have that growth in Roth (tax free) or taxed at long term capital gains rate (which is always lower than your marginal income tax rate) in taxable. The last place you would want stocks growing is in a tax deferred account. You can get the same compounding effect in Roth or brokerage, but subject to lower tax on withdrawal.

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Re: Debunking Bonds in Taxable

Post by Cartographer » Fri Oct 19, 2018 10:18 am

international001 wrote:
Fri Oct 19, 2018 8:46 am
But I think my point still holds: if the long term is long enough, better stocks on tax deferred. Whatever % of the tax you have to pay later, it will be less than the benefit of a higher compounding effect
If your goal is just to maximize the expected amount of money you have at the end of the day, then stocks in tax-advantaged usually wins since you don't have to pay capital gains on the growth. BUT, if your goal is just to maximize the expected amount of money you have at the end of the day, then you wouldn't hold bonds at all and just have stocks in ALL your accounts. The reason to hold bonds in the first place is to manage risk, and the risk is increased by putting stocks in tax-advantaged space.

Think of it this way: tax-advantaged space is very valuable, and putting stocks in tax-advanted means you are putting this valuable space at risk.

To accurately compare asset location choices, you cannot compare a higher risk, higher return portfolio (stocks in tax-advantaged) to a lower risk, lower return portfolio (stocks in taxable). You have to either control for risk or return. Tax adjusting is meant to control for risk. Once you do the calculations with proper tax adjusting to keep risk constant, you will usually find that stocks actually belong in taxable.

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Re: Debunking Bonds in Taxable

Post by international001 » Mon Oct 22, 2018 10:28 am

Tx.. good points

So let's say you want to rebalance between taxable and not taxable so the percentage of bonds is constant across them. Perhaps you can weight differently (multiply taxable by 1/0.85, tax-sheltered by 1/0.70 -assuming your marginal tax 30% -, to consider the actual money you would have at retirement)

Then I guess it doesn't matter much which one compounds faster because the faster compounding has to get trimmed and the extra get invested in the lowest component. Anybody has any calculators or has used his/her own numbers?

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Re: Debunking Bonds in Taxable

Post by grabiner » Mon Oct 22, 2018 8:34 pm

international001 wrote:
Mon Oct 22, 2018 10:28 am
Tx.. good points

So let's say you want to rebalance between taxable and not taxable so the percentage of bonds is constant across them. Perhaps you can weight differently (multiply taxable by 1/0.85, tax-sheltered by 1/0.70 -assuming your marginal tax 30% -, to consider the actual money you would have at retirement)

Then I guess it doesn't matter much which one compounds faster because the faster compounding has to get trimmed and the extra get invested in the lowest component. Anybody has any calculators or has used his/her own numbers?
This is what I do; the wiki discusses this as Tax-adjusted asset allocation.

I use a spreadsheet to compute my current allocation, so the tax adjustment is just one additional line. Since I expect to retire in a 31% combined federal and state tax bracket (25% federal, 8% MD deducted from federal, assuming that the tax rates go back up in 2026), I count $10,000 in my employer plan as $6900 of spendable value, while $10,000 in my Roth IRA is $10,000 of spendable value. After the tax adjustment, I then break down the $10,000 or $6900 further according to the allocation of the fund; if the $6900 were in an S&P 500 index, that would be $3450 of large-cap growth and $3450 of large-cap value.
Wiki David Grabiner

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Re: Debunking Bonds in Taxable

Post by jalbert » Mon Oct 22, 2018 10:12 pm

grabiner wrote:
Mon Oct 22, 2018 8:34 pm
international001 wrote:
Mon Oct 22, 2018 10:28 am
Tx.. good points

So let's say you want to rebalance between taxable and not taxable so the percentage of bonds is constant across them. Perhaps you can weight differently (multiply taxable by 1/0.85, tax-sheltered by 1/0.70 -assuming your marginal tax 30% -, to consider the actual money you would have at retirement)

Then I guess it doesn't matter much which one compounds faster because the faster compounding has to get trimmed and the extra get invested in the lowest component. Anybody has any calculators or has used his/her own numbers?
This is what I do; the wiki discusses this as Tax-adjusted asset allocation.

I use a spreadsheet to compute my current allocation, so the tax adjustment is just one additional line. Since I expect to retire in a 31% combined federal and state tax bracket (25% federal, 8% MD deducted from federal, assuming that the tax rates go back up in 2026), I count $10,000 in my employer plan as $6900 of spendable value, while $10,000 in my Roth IRA is $10,000 of spendable value. After the tax adjustment, I then break down the $10,000 or $6900 further according to the allocation of the fund; if the $6900 were in an S&P 500 index, that would be $3450 of large-cap growth and $3450 of large-cap value.
If your bracket is 31%, the tax drag on withdrawals will likely be significantly less than 31%.
Risk is not a guarantor of return.

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Re: Debunking Bonds in Taxable

Post by JimInIllinois » Mon Oct 22, 2018 10:49 pm

michaeljc70 wrote:
Mon Oct 08, 2018 3:11 pm
One scenario I can envision where bonds in taxable is beneficial is:

-You retire early (before 59 1/2)
-The market is in a downturn so you don't want to sell stocks from taxable accounts
-You can't access bonds without special withdrawals from IRAs (like 72t)
Why would you not want to sell stocks from taxable accounts during a downturn? Lower stock prices reduce your capital gains, and you could even harvest losses. You can simultaneously repurchase similar assets in your tax-deferred/tax-free accounts to keep your asset allocation where you want it. I guess I could see your point if you were in danger of running out of taxable assets before age 59 1/2, but then you should always have a year or so of living expenses as accessible cash to ride out a downturn.

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Re: Debunking Bonds in Taxable

Post by international001 » Tue Oct 23, 2018 8:45 am

jalbert wrote:
Mon Oct 22, 2018 10:12 pm

If your bracket is 31%, the tax drag on withdrawals will likely be significantly less than 31%.
I was thinking the same. You have to consider not only the last dollar of your pre-tax 401k but also the first dollar of your pre-tax 401k (after you count SS, taxable distributions and any other income)

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Re: Debunking Bonds in Taxable

Post by michaeljc70 » Tue Oct 23, 2018 9:28 am

JimInIllinois wrote:
Mon Oct 22, 2018 10:49 pm
michaeljc70 wrote:
Mon Oct 08, 2018 3:11 pm
One scenario I can envision where bonds in taxable is beneficial is:

-You retire early (before 59 1/2)
-The market is in a downturn so you don't want to sell stocks from taxable accounts
-You can't access bonds without special withdrawals from IRAs (like 72t)
Why would you not want to sell stocks from taxable accounts during a downturn? Lower stock prices reduce your capital gains, and you could even harvest losses. You can simultaneously repurchase similar assets in your tax-deferred/tax-free accounts to keep your asset allocation where you want it. I guess I could see your point if you were in danger of running out of taxable assets before age 59 1/2, but then you should always have a year or so of living expenses as accessible cash to ride out a downturn.
Most people prefer buying low and selling high.

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Re: Debunking Bonds in Taxable

Post by Cartographer » Tue Oct 23, 2018 12:42 pm

international001 wrote:
Tue Oct 23, 2018 8:45 am
jalbert wrote:
Mon Oct 22, 2018 10:12 pm

If your bracket is 31%, the tax drag on withdrawals will likely be significantly less than 31%.
I was thinking the same. You have to consider not only the last dollar of your pre-tax 401k but also the first dollar of your pre-tax 401k (after you count SS, taxable distributions and any other income)
The risk is really in the margins though. If my investments return an extra dollar, that dollar will get taxed at the marginal rate. Therefore, the variation in portfolio outcomes is scaled down by the marginal rate, not the effective rate. So if you are trying to determine the optimal asset location, you should use marginal.

On the other hand, if you are just trying to estimate your after-tax net worth, you would use the effective tax rate.

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Re: Debunking Bonds in Taxable

Post by jalbert » Tue Oct 23, 2018 8:54 pm

The risk is really in the margins though. If my investments return an extra dollar, that dollar will get taxed at the marginal rate. Therefore, the variation in portfolio outcomes is scaled down by the marginal rate, not the effective rate. So if you are trying to determine the optimal asset location, you should use marginal.
I would have to disagree. The purpose of setting an asset allocation amongst various asset classes is to manage the risk of a market downturn eroding substantial value from the existing portfolio. If the market drops 50%, existing assets invested in the market are worth 50% less.
Risk is not a guarantor of return.

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Re: Debunking Bonds in Taxable

Post by grabiner » Tue Oct 23, 2018 9:20 pm

jalbert wrote:
Mon Oct 22, 2018 10:12 pm
grabiner wrote:
Mon Oct 22, 2018 8:34 pm

This is what I do; the wiki discusses this as Tax-adjusted asset allocation.

I use a spreadsheet to compute my current allocation, so the tax adjustment is just one additional line. Since I expect to retire in a 31% combined federal and state tax bracket (25% federal, 8% MD deducted from federal, assuming that the tax rates go back up in 2026), I count $10,000 in my employer plan as $6900 of spendable value, while $10,000 in my Roth IRA is $10,000 of spendable value. After the tax adjustment, I then break down the $10,000 or $6900 further according to the allocation of the fund; if the $6900 were in an S&P 500 index, that would be $3450 of large-cap growth and $3450 of large-cap value.
If your bracket is 31%, the tax drag on withdrawals will likely be significantly less than 31%.
This is correct for determining the value of the portfolio for spending purposes; $1M in an employer plan will lead to more than $690,000 of spending value because some of it will be taxed at 21% (15% federal) rather than 31% (25% federal).

But the marginal tax rate is 31%, and that is what is relevant for asset allocation. If I lose $10,000 in my employer plan, I will pay $3100 less in tax on the withdrawal, which is just as bad as losing $6900 in my Roth IRA. Therefore, holding $20,000 in my employer plan in bonds and $13,800 in my Roth IRA in stocks is equivalent to holding the same funds the other way around; either one costs me $6900 if the stock market loses half its value.
Wiki David Grabiner

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Re: Debunking Bonds in Taxable

Post by jalbert » Tue Oct 23, 2018 9:44 pm

Suppose for the sake of simplicity, the return on the investments were zero after losing $10K in a tax-deferred account in a market drop. After the loss of $10K, suppose you draw the account down to a zero balance through a sequence of withdrawals over time determined by your spending needs.

Had you not lost the $10K then you would now have a balance of $10K instead of zero. Had you not lost the $10K, those dollars would have been the last $10K you withdrew from the account, not the first $10K. I’m fairly certain that most retirees would no longer be in a 31% bracket after their tax-deferred retirement savings had dwindled to $10K, but I suppose it would be possible with a large, taxable pension or other taxable income source.
Risk is not a guarantor of return.

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Re: Debunking Bonds in Taxable

Post by hoops777 » Tue Oct 23, 2018 10:03 pm

vineviz wrote:
Wed Oct 10, 2018 7:16 pm
lukestuckenhymer wrote:
Mon Oct 08, 2018 5:13 pm
Call_Me_Op wrote:
Mon Oct 08, 2018 3:17 pm
Because of the various considerations, I hold some bonds (and bond equivalents like CDs) in taxable and some in tax-advantaged.
Do we consider CDs a "bond equivalent"? A CD to me is a cash equivalent. Bonds can lose principal, cash and CDs can't.
Some people confuse CDs with bonds, yes, but they are a cash instrument.
A CD is a CD.It is not cash and it is not a bond.However,it can be an excellent investment.Thank you. :D
K.I.S.S........so easy to say so difficult to do.

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