where to put bonds

[jsa307]

question for the forum:
all new deposits to my 401k automatically go to a target date fund. i also have a taxable account for retirement. i keep the taxable account all equities, and convert pieces of the target fund to bonds as necessary to balance my taxable equities and achieve my desired ratio. i believed i was following boglehead advice by keeping bonds in tax deferred space when possible, thus avoiding taxes on the interest they produce. a friend recently told me that i should do the opposite, as the greatest long term gains (and thus capital gains) will be in equities, so the benefit would be greater to use tax deferred space for equities (or in this case, a target fund) rather than waste a portion of it on bonds ..... who is correct??

[Triple digit golfer]

question for the forum:
all new deposits to my 401k automatically go to a target date fund. i also have a taxable account for retirement. i keep the taxable account all equities, and convert pieces of the target fund to bonds as necessary to balance my taxable equities and achieve my desired ratio. i believed i was following boglehead advice by keeping bonds in tax deferred space when possible, thus avoiding taxes on the interest they produce. a friend recently told me that i should do the opposite, as the greatest long term gains (and thus capital gains) will be in equities, so the benefit would be greater to use tax deferred space for equities (or in this case, a target fund) rather than waste a portion of it on bonds ..... who is correct??

Your friend is misguided.

Tax-deferred space is taxed at ordinary income rates (generally higher) upon withdrawal and taxable space is taxed at capital gains rates (generally lower) upon withdrawal, so I put my equities in taxable and bonds in tax-deferred.

[retiredjg]

Yes. Your friend is misguided.

It is true that stocks have a higher expectation of return. The important difference is how the earnings are taxed.

The earnings of stocks in tax-deferred accounts are taxed as ordinary income. But if the stocks are in taxable, the long term capital gains and qualified dividends are taxed at a lower rate than if the stocks are in tax-deferred space.

This does not mean you should put all your stocks in taxable. What it means is that when your portfolio spills into taxable (because tax deferred space is filled) it should be stocks that spill over and bonds that stay in tax-deferred space.

[wetgear]

question for the forum:
all new deposits to my 401k automatically go to a target date fund. i also have a taxable account for retirement. i keep the taxable account all equities, and convert pieces of the target fund to bonds as necessary to balance my taxable equities and achieve my desired ratio. i believed i was following boglehead advice by keeping bonds in tax deferred space when possible, thus avoiding taxes on the interest they produce. a friend recently told me that i should do the opposite, as the greatest long term gains (and thus capital gains) will be in equities, so the benefit would be greater to use tax deferred space for equities (or in this case, a target fund) rather than waste a portion of it on bonds ..... who is correct??

This might help.

https://www.bogleheads.org/wiki/Tax-eff ... _placement

[ReallyLikeToSave]

Your friend may be generalizing incorrectly. If you read the guidance link posted above you will see that the set of Tax Advantaged accounts (401k, IRA, Roth, HSA etc) are further subdivided from tax-deferred (401k) through to tax-'free' (Roth). Roth therefore is considered better suited to high growth investments.

In summary - bonds in tax advantaged space, within those spaces the guidance gets more nuanced to your situation - but generally 401k for bonds and higher growth investments in Roth.

There are plenty of caveats such as poor bond options in your 401k, the accounts you have available and your approach to using those accounts, or a lack of tax-advantaged space you have remaining in which case you may choose to put some Bonds in there vs taxable.

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ReallyLikeToSave

[dbr]

And, of course, there is the fallback that when necessary for high tax individuals one may own tax exempt bonds.

Another exception is I bonds that bring their own tax deferral of earnings with them but have to be invested with after tax money and can't be held in a tax deferred account.

A smaller nuance is that Treasuries, including TIPS, are state tax exempt.

[miket29]

a friend recently told me that i should do the opposite, as the greatest long term gains (and thus capital gains) will be in equities, so the benefit would be greater to use tax deferred space for equities

ask your friend why you would want to tax the equity gains at ordinary income rates instead of long-term capital gains rates

That said, there can be reasons for holding at least some equities in tax deferred. As you approach retirement you may want to change your asset allocation to a higher percentage of bonds and you can make changes tax-free in tax deferred accounts.

[jsa307]

thanks for all the replies ... if it's as simple (in most cases) as LTG rates being lower than deferred ordinary income rates, why would anyone use tax deferred space for equities?

[dukeblue219]

thanks for all the replies ... if it's as simple (in most cases) as LTG rates being lower than deferred ordinary income rates, why would anyone use tax deferred space for equities?

Because most people don't fill up their tax-deferred space.

[jsa307]

so ... if someone is going to be contributing enough to max out tax deferred accounts + make additional taxable equities purchases ... contributions to tax deferred accounts should only be made to the extent that bond space is needed??

[Exchme]

Note that when you start putting different assets in differently taxed accounts, you are subtly shifting your effective asset allocation. Since tax deferred accounts (IRA, 401k) can be thought of as a portion belonging to the government and a portion to you, putting bonds preferentially in tax deferred foists an extra large share of bonds into the government basket, leaving more stocks in your basket. Just like any time you hold more stocks and fewer bonds, that is higher return on average, but with higher risk of loss. For any given "tax efficient" placement, you can mimic the results with an equal allocation in all accounts portfolio, just one with a higher share of stocks.

The effective allocation of a "tax efficient" portfolio also changes as your tax bracket, relative size of tax deferred to other accounts changes and how full it is of bonds changes, so you never really know your risk. For instance, my 80/20 portfolio with tax efficient placement gives the same results averaged over our lifetime as holding 87.3/12.7 in each account. Not only is that a surprising difference, but the effective allocation changes continuously as the IRA first fills with bonds prior to RMDs and then is slowly drawn down by RMDs and will change again when one of us passes and the survivor has to file as single. I started doing this and now am sort of stuck as I don't want to take the capital gains taxes to put it back, but I wouldn't have done it in the first place if I had understood it better. I recommend just keeping everything the same, it's simpler and you know your risk.

[Triple digit golfer]

so ... if someone is going to be contributing enough to max out tax deferred accounts + make additional taxable equities purchases ... contributions to tax deferred accounts should only be made to the extent that bond space is needed??

No.

Here's the easiest way I could put it. Fill up tax advantaged (pre-tax such as traditional 401k or after-tax such as Roth IRA) space first, no matter what.

Place your bonds in tax-deferred (pre-tax, such as 401k) space, if available.

Place your equities in any account type.

[retiredjg]

thanks for all the replies ... if it's as simple (in most cases) as LTG rates being lower than deferred ordinary income rates, why would anyone use tax deferred space for equities?

Because there is a great benefit to tax-deferral. If you would pay tax at 32% now but can pay tax at 12% or 22% later on the same money, you end up with more money by deferring the tax until later when you are in a lower tax bracket.

[retiredjg]

so ... if someone is going to be contributing enough to max out tax deferred accounts + make additional taxable equities purchases ... contributions to tax deferred accounts should only be made to the extent that bond space is needed??

No. Fill up all your tax-advantaged accounts before putting any retirement money into taxable. When money does go into taxable, it should be tax-efficient stock index funds first. If necessary, hold bonds in taxable to achieve your stock to bond ratio. If your income is high, there is a good chance the bonds in taxable should be tax-exempt.

[iceport]

thanks for all the replies ... if it's as simple (in most cases) as LTG rates being lower than deferred ordinary income rates, why would anyone use tax deferred space for equities?

Because there is a great benefit to tax-deferral. If you would pay tax at 32% now but can pay tax at 12% or 22% later on the same money, you end up with more money by deferring the tax until later when you are in a lower tax bracket.

That's not quite how I'd describe the benefit of tax deferral. That explanation relies on a lower tax rate in retirement. A huge benefit of the tax deferral actually happens even if taxes stay exactly the same in retirement.

It's called tax-free growth. Yes, pretty much the same tax-free growth provided by Roth accounts.

Assuming exactly the same tax rate in retirement as while working (a theoretical possibility I suspect never happens in real life), the tax-deferred account will yield exactly the same outcome as a Roth account.

This wiki article runs through the math: https://www.bogleheads.org/wiki/Traditi ... lculations

In the likely scenario in which taxes are actually lower in retirement, then you get *even-better-than-tax-free* growth in the tax "deferred" account! (That's even better than a Roth.)

~~~~~~~~~~~~~~~~~~~~~~~~~~

Back on the OP's original question, I'd just chime in with a somewhat contrarian comment. When I started investing more responsibly and with more understanding roughly 18 years ago (in other words, when I became a Boglehead), I followed the general guidance given in this thread so far. The thing is, I already had an decent sized taxable account compared to tax-advantaged accounts. Now, my taxable account is 50% of the portfolio — and that's even after the haircut we took on equities last year. And I've got small enough tax-deferred space that my bond holdings spill over substantially into my Roth space. And as it turned out, with bond yields so meager until recently, I probably didn't save much in taxes. (That has now changed.) Looking back, it was probably the wrong choice to place only equities in the taxable account.

Over long periods of time, if the equity risk premium actually pays off, the equities in taxable accounts really will do what is expected — and that could mean a ballooning taxable account compared to the size of the others. I think the equities in taxable advice works out better when the taxable account is relatively small compared to the others, when it's literally holding only tax-advantaged "spillover."

When it starts out as the main account, folks like me can end up with huge taxable accounts and precious little Roth space.

OP, I think the advice given here is sound, particularly now that bond yields have risen so much. All I'm saying is that your friend is not completely wrong; there actually *can be* a downside to putting only equities in taxable. It's still probably the better approach, but it doesn't come without a trade-off.

[secondopinion]

Back on the OP's original question, I'd just chime in with a somewhat contrarian comment. When I started investing more responsibly and with more understanding roughly 18 years ago (in other words, when I became a Boglehead), I followed the general guidance given in this thread so far. The thing is, I already had an decent sized taxable account compared to tax-advantaged accounts. Now, my taxable account is 50% of the portfolio — and that's even after the haircut we took on equities last year. And I've got small enough tax-deferred space that my bond holdings spill over substantially into my Roth space. And as it turned out, with bond yields so meager until recently, I probably didn't save much in taxes. (That has now changed.) Looking back, it was probably the wrong choice to place only equities in the taxable account.

Over long periods of time, if the equity risk premium actually pays off, the equities in taxable accounts really will do what is expected — and that could mean a ballooning taxable account compared to the size of the others. I think the equities in taxable advice works out better when the taxable account is relatively small compared to the others, when it's literally holding only tax-advantaged "spillover."

When it starts out as the main account, folks like me can end up with huge taxable accounts and precious little Roth space.

OP, I think the advice given here is sound, particularly now that bond yields have risen so much. All I'm saying is that your friend is not completely wrong; there actually *can be* a downside to putting only equities in taxable. It's still probably the better approach, but it doesn't come without a trade-off.

Agreed. Also, the tax-free accounts can be made to swap gears (stocks earlier, bonds later). This is because capital gains on bonds is not much but is so for stocks; by the time one needs to control the "income" output, then hopefully the tax-free accounts will be much larger while the taxable will not be generating a bunch of income.

I do not know; I have not ran the numbers.

[arcticpineapplecorp.]

Remember that in taxable the only part of sale that's taxable is the gain (not your principal like it is in tax deferred).

Say you invest $10k in taxable and $10k in tax deferred.

Years later both investments are each worth $20k.

If you take out the $20k in tax deferred, the entire $20k is taxed at your ordinary income rate while only $10k of the $20k in taxable is taxed at cap gains rate (because $10k of that $20k in taxable was principal and principal is not taxed, just gain).

Make sense?

So you want to put higher yielding stuff in taxable and bonds in tax deferred. If you do the inverse ALL your principal and gains are taxed upon withdrawal from tax deferred, whereas at least you withdraw your principal tax free from taxable and only the gain is taxable.

Also since bonds pay more interest/dividends than stock, you don't want bonds in taxable since you're paying more tax due to higher income received. Get the higher income payments at least in the tax deferred where you can defer them and pay tax on your schedule (when money is withdrawn from tax deferred). You want to reduce dividends in taxable so you can better control your taxes there.

be sure to share this thread with your friend. perhaps he will change his mind.