Fund allocation based on Return/Risk?

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retirap
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Joined: Mon Jan 06, 2020 1:44 am

Fund allocation based on Return/Risk?

Post by retirap » Mon Jan 13, 2020 3:29 pm

Hi, I've got some idea of allocating funds accordingly based on its tax-efficiency, however, is there any study on choosing funds based on its return/risk?

E.g, suppose I have an 80/20 AA, comparing the following 2 scenarios:
1. put 20% bonds in taxable accounts, then 20% of assets in the tax-advantaged accounts will have no tax and will compounding faster, but the risk could be also higher.
2. put 20% bonds in the tax-advantaged accounts, let taxable accounts take that higher return/risk investments.
So which one do you think is better? or any numbers to support it?

Thanks!

financeperchance
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Re: Fund allocation based on Return/Risk?

Post by financeperchance » Mon Jan 13, 2020 3:38 pm

Almost always #2 is better. See, e.g., https://search.proquest.com/openview/8f ... r&cbl=4849

Topic Author
retirap
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Re: Fund allocation based on Return/Risk?

Post by retirap » Tue Jan 14, 2020 6:04 am

financeperchance wrote:
Mon Jan 13, 2020 3:38 pm
Almost always #2 is better. See, e.g., https://search.proquest.com/openview/8f ... r&cbl=4849
Thanks very much for the resource, do you have a full doc? or maybe more detailed numbers?

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grabiner
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Re: Fund allocation based on Return/Risk?

Post by grabiner » Tue Jan 14, 2020 10:12 pm

retirap wrote:
Mon Jan 13, 2020 3:29 pm
Hi, I've got some idea of allocating funds accordingly based on its tax-efficiency, however, is there any study on choosing funds based on its return/risk?

E.g, suppose I have an 80/20 AA, comparing the following 2 scenarios:
1. put 20% bonds in taxable accounts, then 20% of assets in the tax-advantaged accounts will have no tax and will compounding faster, but the risk could be also higher.
2. put 20% bonds in the tax-advantaged accounts, let taxable accounts take that higher return/risk investments.
So which one do you think is better? or any numbers to support it?
If the tax-advantaged account is traditional, the IRS will take about the same share of stock gains from either account; if you withdraw at a 22% tax rate, the IRS takes 22% of your traditional IRA gains, and 15% of capital gains plus about 0.3% a year of dividends in a taxable account. It is usually better to hold bonds in the tax-deferred account, as these lose less to tax in an IRA than in a taxable account; however, it depends on bond yields, your tax rate, and the options in your 401(k).

If the tax-advantaged account is a Roth, #2 has a higher expected return, but also more risk; if the stock market crashes, the IRS shares your losses in a taxable account, but you take all the losses in a Roth. You can adjust for this; see Tax-adjusted asset allocation on the wiki. Once you adjust for this, the advantage of stocks in a Roth goes away; $7800 of stocks in a Roth and $10,000 of stocks in a traditional IRA will have the same after-tax value if invested the same way.
Wiki David Grabiner

Topic Author
retirap
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Re: Fund allocation based on Return/Risk?

Post by retirap » Wed Jan 15, 2020 12:38 am

Thanks for the comments!
grabiner wrote:
Tue Jan 14, 2020 10:12 pm
If the tax-advantaged account is traditional, the IRS will take about the same share of stock gains from either account; if you withdraw at a 22% tax rate, the IRS takes 22% of your traditional IRA gains, and 15% of capital gains plus about 0.3% a year of dividends in a taxable account. It is usually better to hold bonds in the tax-deferred account, as these lose less to tax in an IRA than in a taxable account; however, it depends on bond yields, your tax rate, and the options in your 401(k).
1. When u say traditional, u mean traditional 401k or Roth, which are both tax-deferred?
2. "the IRS will take about the same share of stock gains from either account" I am a little bit confused on this one.
Suppose I have X amount of money in traditional 401k, after one year, it becomes X + a, then I exchange for another fund, this operation won't incur any tax, it this right? looking at ur next statement, so u will only be taxed when withdrawing?
3. "it is usually better to hold bonds in the tax-deferred account, as these lose less to tax in an IRA than in a taxable account"
What if I hold bond in the format of the bond index fund in a taxable account? then the gain will be counted as capital gain and be taxed only at 15%?
4. Is there a big difference between money market funds and bond index funds? the only diff is that the latter one might has higher return/risk?
grabiner wrote:
Tue Jan 14, 2020 10:12 pm
If the tax-advantaged account is a Roth, #2 has a higher expected return, but also more risk; if the stock market crashes, the IRS shares your losses in a taxable account, but you take all the losses in a Roth. You can adjust for this; see Tax-adjusted asset allocation on the wiki. Once you adjust for this, the advantage of stocks in a Roth goes away; $7800 of stocks in a Roth and $10,000 of stocks in a traditional IRA will have the same after-tax value if invested the same way.
5. So you mean the loss from Roth will be counted less as taxable loss compared to a loss in a traditional account?
6. "$7800 of stocks in a Roth and $10,000 of stocks in a traditional IRA will have the same after-tax value", this is based on the assumption that the tax rate is 22%. a) is it possible that the income will be lower when we are older? b) and we can use withdrawal in terms of the loan to avoid tax?

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grabiner
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Re: Fund allocation based on Return/Risk?

Post by grabiner » Thu Jan 16, 2020 12:14 am

retirap wrote:
Wed Jan 15, 2020 12:38 am
Thanks for the comments!
grabiner wrote:
Tue Jan 14, 2020 10:12 pm
If the tax-advantaged account is traditional, the IRS will take about the same share of stock gains from either account; if you withdraw at a 22% tax rate, the IRS takes 22% of your traditional IRA gains, and 15% of capital gains plus about 0.3% a year of dividends in a taxable account. It is usually better to hold bonds in the tax-deferred account, as these lose less to tax in an IRA than in a taxable account; however, it depends on bond yields, your tax rate, and the options in your 401(k).
1. When u say traditional, u mean traditional 401k or Roth, which are both tax-deferred?
I mean traditional as distinct from Roth. Tradition 401(k)s and IRAs have the same tax treatment; all withdrawals from either one are taxed at your full rate. Roth 401(k)s and IRAs allow tax-free withdrawals if you meet the rules.
2. "the IRS will take about the same share of stock gains from either account" I am a little bit confused on this one.
Suppose I have X amount of money in traditional 401k, after one year, it becomes X + a, then I exchange for another fund, this operation won't incur any tax, it this right? looking at ur next statement, so u will only be taxed when withdrawing?
This is correct, but it misses the point. If you hold stocks in a taxable account, it should be done with the intention of not selling the stocks until you spend the money, because of the capital-gains tax. While you can exchange freely in a 401(k) or IRA, you will eventually spend that money as well, and the IRS will take 22% of all your gains in that account (and 22% of the amount you contributed, unless it was a non-deductible IRA).
3. "it is usually better to hold bonds in the tax-deferred account, as these lose less to tax in an IRA than in a taxable account"
What if I hold bond in the format of the bond index fund in a taxable account? then the gain will be counted as capital gain and be taxed only at 15%?
Dividends from a bond index fund are taxed as ordinary income, at your full tax rate. (If the fund happens to distribute any capital gains, those will be taxed at 15%, but capital gains on bond funds are usually very small.)
4. Is there a big difference between money market funds and bond index funds? the only diff is that the latter one might has higher return/risk?
This is correct. There isn't much tax difference, but money-market fund prices should remain stable, while bond prices can fluctuate as interest rates change or bonds are upgraded and downgraded. The risk of bond funds is low enough that it is usually worth using bond funds (or other fixed-income investments, such as CDs) rather than money-market funds for money you aren't planning to spend in the next year.
grabiner wrote:
Tue Jan 14, 2020 10:12 pm
If the tax-advantaged account is a Roth, #2 has a higher expected return, but also more risk; if the stock market crashes, the IRS shares your losses in a taxable account, but you take all the losses in a Roth. You can adjust for this; see Tax-adjusted asset allocation on the wiki. Once you adjust for this, the advantage of stocks in a Roth goes away; $7800 of stocks in a Roth and $10,000 of stocks in a traditional IRA will have the same after-tax value if invested the same way.
5. So you mean the loss from Roth will be counted less as taxable loss compared to a loss in a traditional account?
The same dollar loss in a Roth costs you more, just as the same dollar gain in a Roth gains you more. In a traditional retirement account, the IRS takes a fixed percentage the account, so a $10,000 loss costs you only $7800 of spendable cash in a 22% bracket. In a taxable account, a $10,000 loss will result in $10,000 in deductible capital losses or $10,000 less in capital gains, and the smaller balance will result in a lower dividend tax in the future if you do not sell immediately.
6. "$7800 of stocks in a Roth and $10,000 of stocks in a traditional IRA will have the same after-tax value", this is based on the assumption that the tax rate is 22%. a) is it possible that the income will be lower when we are older? b) and we can use withdrawal in terms of the loan to avoid tax?
If your tax rate is lower, you can do the same calculation with a different ratio than 78%. If you will withdraw your traditional IRA at a 12% marginal tax rate, then $8800 in a Roth and $10,000 in a traditional IRA will have the same returns if invested the same way. But this still eliminates the advantage of stocks in the Roth.

You cannot take a loan in retirement to avoid paying taxes on IRA or 401(k) withdrawals. (Nor can you leave the money there indefinitely to avoid paying taxes; you must start withdrawals at age 72, and if you die, your non-spouse heirs must withdraw the money within 10 years and pay tax at their rate.)

You can take a loan from your 401(k) while you are still working, to avoid withdrawing the money with a taxable distribution. However, you will have to pay the money back, and after you have paid it back, you will eventually withdraw it and pay taxes on it. If you do not pay the loan back when you leave your job, it is then treated as if you had withdrawn all the money, so you pay tax on it, and a 10% penalty if you are under 59-1/2.
Wiki David Grabiner

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