High tax, short horizon, forthcoming home purchase, what to do?

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
Post Reply
Topic Author
Dioremius
Posts: 5
Joined: Tue Jun 11, 2019 4:16 pm

High tax, short horizon, forthcoming home purchase, what to do?

Post by Dioremius » Tue Jun 11, 2019 5:01 pm

I have a 7-digit windfall coming in over the next few years, and I will use most of it to buy a home in 2-5 years. Trying to figure out how to productively park it.

My effective marginal tax rate for ordinary/STCG income is very high: 43.8% federal + 10% state+local (considering NIIT, AMT and phaseouts). Very little tax-advantaged space.

The Bogleheads forum and wiki (e.g., managing a windfall, tax-efficient fund placement) have been extremely helpful in assessing the situation. It seems that my circumstances, above, makes things especially tricky.

I've considered the following options:
  1. Short-term treasury ETF (e.g., VGSH/SCHO). Matches my time horizon, but my after-tax yield is about %1.30, well less than inflation. (Similarly for short-term TIPs ETF, or individual bonds.)
  2. Intermediate/long-term muni fund in my state. After-tax yield is 2.2%, but effective duration is about 7 years. So high interest+call rate risk, under-diversified, and a bit of credit risk. (Going for national munis like VTEB would decrease after-tax yield to %1.87; national short-term like VMLUX, to just %1.54.)
  3. Domestic equity (e.g., VTI/SCHB). Good in diversification, tax efficiency and expected returns, but poor match for my 2-5 investment horizon. Especially with the widespead sentiments about an overstretched economic cycle (yeah, market timing, shoot me now).
  4. Residential REITs. I would love to get exposure to residential real-estate now, to roughly match the future liability. Put otherwise, given my major real-estate purchase in the future, I'm effectively short real-estate now and would like to remedy that. But REITs are notoriously tax-inefficient. They're also over-exposed to interest rate risk, which I'd already have plenty of with above bonds.

    The little tax-advantaged space I have is already filled up with residential REITs. No good ETF here: they all have high expense ratios, wrong composition and/or low liquidity. So I went over the stock holdings of the REZ Residential REIT ETF, filtered out the weird stuff like mobile homes, and bought the top dozen stocks weighted by market cap. I was hoping that home construction ETFs, like ITB and XHB, would be a good proxy for residential real estate, but the correlation seems low.
  5. I could look for idiosyncratic non-brokered investments, such as local real estate (perhaps in a qualified opportunity zone!). But I have neither the experience nor the time to judge and manage such investments.
I'm already maximizing 401(k), I-series bonds, 529 and backdoor Roth, and donating some long-term appreciated property, but these barely makes a dent in the windfall income. Other assets are put aside for retirement, so here I really am focusing only on the short/intermediate term.

So... What to do?

I'm currently parked in mostly short-term treasuries, and while I got lucky with the recent drop in fed rates, I wouldn't want to get negative after-tax real yield over several years.

User avatar
grabiner
Advisory Board
Posts: 24384
Joined: Tue Feb 20, 2007 11:58 pm
Location: Columbia, MD

Re: High tax, short horizon, forthcoming home purchase, what to do?

Post by grabiner » Tue Jun 11, 2019 8:53 pm

If the in-state intermediate muni fund has too long a duration for you, you can put some of the money in a shorter-term muni fund such as Vanguard Limited-Term Tax-Exempt or Short-Term Tax-Exempt. If you split evenly between two funds, more than half your money would be exempt from state tax.

But you also say that you would use "most of it" to buy a home. This makes it reasonable to take the duration risk of the in-state fund; if you are using 80% of the money in two years, and 20% of the money in 17 years as part of your retirement fund, then your overall appropriate duration is 5 years. If rates rise, you will lose a bit of the money but still have as much as you need.
Wiki David Grabiner

User avatar
Tyler Aspect
Posts: 1170
Joined: Mon Mar 20, 2017 10:27 pm
Location: California
Contact:

Re: High tax, short horizon, forthcoming home purchase, what to do?

Post by Tyler Aspect » Wed Jun 12, 2019 1:06 am

Surely with your income that commands the top federal tax bracket you should be able to purchase a home. Maybe you already has a home and you are looking to purchase another one with the incoming money.

The intermediate term yields are low currently. It is certainly the case that short term yields also do not look impressive. It is just the nature of saving up for a down-payment that one is stuck with low return for a certain time.

For the super wealthy folks why not just dump the money according to your asset allocation, be it a mix of stock and bond ETFs. At what ever time that you can outright buy a house without needing mortgage then sell securities to make it happen. I call this "house sniping".
Past result does not predict future performance. Mentioned investments may lose money. Contents are presented "AS IS" and any implied suitability for a particular purpose are disclaimed.

Topic Author
Dioremius
Posts: 5
Joined: Tue Jun 11, 2019 4:16 pm

Re: High tax, short horizon, forthcoming home purchase, what to do?

Post by Dioremius » Wed Jun 12, 2019 1:27 pm

Tyler, the funny thing is, I'm not "really" in the top federal tax bracket, and I'm not wealthy enough to buy a home yet (it's expensive where I live). My normal income, without the transient windfall, would put me in the 24% bracket. But there's the AMT curse when you have "too much" long-term capital gain. Every extra dollar of short-term capital or ordinary income from investment can then be subject to:

28% Alternative Minimum Tax
7% due to 25% phaseout on the exemption from the 28% AMT (in the relevant range)
3.8% Net Investment Tax Income
5% due to pushing long-term capital gain from the 15% bracket to the 20% bracket
= 43.8% marginal tax rate

Add >10% of state tax and its own phase-outs, and even keeping up with inflation becomes difficult.
Last edited by Dioremius on Thu Jun 13, 2019 1:33 am, edited 1 time in total.

retiredjg
Posts: 36342
Joined: Thu Jan 10, 2008 12:56 pm

Re: High tax, short horizon, forthcoming home purchase, what to do?

Post by retiredjg » Wed Jun 12, 2019 1:36 pm

Do whatever Grabiner says. He is likely local expert who has put the most time into this research.

Do not use stocks of any kind if you want the money to be available at a certain time. Do not use residential REITS either.

I seriously doubt your limited tax-advantaged space should be filled with residential REITS, but that is a different question. :happy

Topic Author
Dioremius
Posts: 5
Joined: Tue Jun 11, 2019 4:16 pm

Re: High tax, short horizon, forthcoming home purchase, what to do?

Post by Dioremius » Wed Jun 12, 2019 9:36 pm

Grabiner, thanks, that's a great point: the fraction of income that I'll keep for retirement in munis, whose duration is too short, does justify a longer bond duration elsewhere.

Still, it feels grossly undiversified to go all-in on munis and their risks (e.g., looming pensions, and the current fashion in messing around with tax law). I want some diversification to hedge against that, and the only other pertinent classes I can think of are equity and short-term treasuries.

So I'm now thinking of this asset allocation:

Image

Does this look reasonable?

User avatar
grabiner
Advisory Board
Posts: 24384
Joined: Tue Feb 20, 2007 11:58 pm
Location: Columbia, MD

Re: High tax, short horizon, forthcoming home purchase, what to do?

Post by grabiner » Wed Jun 12, 2019 10:25 pm

Dioremius wrote:
Wed Jun 12, 2019 9:36 pm
Grabiner, thanks, that's a great point: the fraction of income that I'll keep for retirement in munis, whose duration is too short, does justify a longer bond duration elsewhere.

Still, it feels grossly undiversified to go all-in on munis and their risks (e.g., looming pensions, and the current fashion in messing around with tax law). I want some diversification to hedge against that, and the only other pertinent classes I can think of are equity and short-term treasuries.
You are in a high state tax bracket, which makes Treasuries a reasonable deal. Also, since Treasuries have less risk, they have lower yields, which reduces the federal tax burden. You could make the same duration decision with Treasuries that you do with nominal bonds.

For a medium-term need, I would prefer TIPS to nominal Treasuries. If inflation is unexpectedly high, the price of the home you want to buy will increase, and TIPS will increase in value with it; nominal bonds will lose value if inflation drives up interest rates.

So you might look at a 50/50 split between CA munis and TIPS.

My usual recommendation for intermediate-term duration in CA is 50% CA Long-Term Tax-Exempt and 50% Limited-Term Tax-Exempt; this reduces the CA-specific risk, and leaves more than half your income exempt from CA tax. However, if you are concerned about the risk of having so much of your portfolio in munis, which is certainly a reasonable concern, then TIPS are an alternative.
Wiki David Grabiner

Topic Author
Dioremius
Posts: 5
Joined: Tue Jun 11, 2019 4:16 pm

Re: High tax, short horizon, forthcoming home purchase, what to do?

Post by Dioremius » Thu Jun 13, 2019 1:03 am

Thanks, Grabiner! Your suggestions are extremely helpful.

You're right, short-term national munis look like the best way for me to reduce duration and single-state muni exposure. Checking the yields again: my after-tax yield would be 1.52 (with VMLUX), compared to 1.18% for short-term treasures (VGSH). Worth the risk.

Also, on the treasuries side, TIPs are a very appealing idea, for both of the reason you gave. And indeed, historically, the correlation with munis is lower for short-term TIPs (VTIP) than for short-term treasuries (VGSH).

So I'll use a 1:1 mix of the above two in lieu of short-term treasuries:

Image

(I updated the yields to today's SEC yield data, so they're a bit lower than above.)

I'm still allocating 10% equity on the home-purchase side, despite the short horizon, since I think that stock markets are correlated with home prices around here, and also because it's a bit of diversification from the bonds.

I'm also keeping some ultrashort treasuries at hand (for tax payments and emergency fund), which are excluded from the above for simplicity, but they do bring down my average duration a bit.

Post Reply