Bonds - Which Account Should They Go In?

[scubadog]

Please forgive the potentially dumb question, but:

I am moving from a nearly 100% stock portfolio to one with a 20% bond allocation to try and avoid some of the deeper bounces of the economy, especially as I near in on 2ish years till FIRE.

But reallocating I'm now asking myself "where exactly should these bonds go?" As in, which account? Basically this is a question about which accounts should have maximum growth and which ones should have minimal/stable growth (I think?).

In case it helps clarify, here are some anonymity washed figures to illustrate my situation:
I have a 401a with about 130,000 in it which I plan to roll to my traditional IRA, to then be rolled into my roth according to the pipeline.
I have a traditional IRA with 6,000 in it
I have a Roth with 40,000 in it
I have a brokerage with 20,000 in it

My thinking was: "its better to have the bonds in my brokerage, with any overflow need in allocation into my roth, because my brokerage isnt tax sheltered and I can harvest losses. I might miss out on harvesting gains, but can and should maximize growth in my tax sheltered accounts since those gains are minimally taxed when they go through the pipeline anyway."

If I'm being unclear please ask questions and I'll clarify! Again, bigger picture here is "what accounts should bond allocations go in and what accounts should growth be allocated into?"

[skuzuker28]

My thinking is you want them in a traditional retirement account (TIRA or employer-sponsored plan).  Bonds and bond funds throw off ordinary income, though not much in our current low-yield environment.  Everything in a traditional IRA gets treated as ordinary income at distribution, so you get the same tax treatment on the income eventually.

Roth would be my last choice, those I think should be your equity accounts as you would expect them to fave the most growth and the favorable tax treatment at distribution is how you avoid tax on those gains.

[Radagast]

In taxable space series I savings bonds are a great choice, with crazy high yields relative to other bonds right now and are as safe as you can get. They are also tax deferred until you cash them out after achieving a lower income - a screaming deal. The down side is it may take several years to buy them in a useful amount. My choice for (moderately) risky bonds in taxable space is VWALX, which are different enough from other bonds and stocks that I think they could be a useful addition to a portfolio.

Otherwise I agree with the poster above that a traditional tax deferred IRA or 401k is best if they have a fairly high yield. Save Roth space for assets with potentially high growth, which bonds certainly do not have. Though if you are after pure safety and don’t care about opportunity costs then interest rates are so low on safe bonds right now that you would hardly be taxed on interest anyhow, even in a brokerage account.

[robartsd]

My bond holdings follow skuzuker28's thinking - tax deferred retirement accounts. I'm currently holding VBTLX in a Traditional IRA.

[scubadog]

Thanks for the thoughtful responses and recommendations! I think your answers though imply taking tax hits I am trying to avoid on conversions? I could be wrong about that of course.

I'm actually planning to use the roth conversion ladder (roth pipeline) as outlined here:
https://www.madfientist.com/how-to-access-retirement-funds-early/
And my confusion is due to the discussion of capital gains and losses as outlined here:
https://www.gocurrycracker.com/never-pay-taxes-again/
The confusion just basically stems to: "Given x income, what is optimal? Because x income will change pre and post retirement, which changes what happens to my brokerage taxation."

Basically pre retirement my brokerage gains are taxed at my income bracket
https://taxfoundation.org/2019-tax-brackets/
So if I know I'm taking a tax hit in my brokerage gains, why have growth there? Also, why have growth in my roth when I can only withdraw my principle pre traditional retirement age?

So taking a big step back here's my tentative plan, which I'm seeking help on, as clearly I don't know what I'm talking about:
1. Knowing I still incur gains taxes at my pre retirement income tax bracket, I allocate 100% bonds in my brokerage since I know I'm taking tax hits there anyway.
2. Day 1 of retirement roll 401k into trad. IRA. Now I have only a trad. IRA, Roth, and Brokerage. My income is now 0, so I am in the lowest tax bracket. I thus switch my brokerage to 100% stocks and put my bonds in my trad. IRA in preparation of holding those stocks in my brokerage for more than a year so I get the 0% long term capital gains tax bracket, so long as I dont make more than 40k per year in my brokerage (which I seriously doubt I would). We're assuming here that I stay in the lowest income tax bracket through retirement for easier calculations.
2. Let's say I have 10k yearly living expenses. I roll over the 10k I will need in 5 years, every year, from my trad. IRA to my roth taking the lowest penalty being in the lowest bracket, and live off of the principle 40k I put into my roth since I can withdraw that penalty free... or after the first year I can pull from my brokerage instead of my roth since my brokerage will count as long term gains in the lowest bracket at that point anyway - either way I'm set for the first 5 years and then, rollovers sufficient, the rest is gravy.

So if I'm thinking about all of this correctly, my bonds should be in my brokerage pre retirement and trad. IRA post retirement, right? Or am I missing something here? I suppose I'm missing out on harvesting gains and losses in my brokerage with 100% bonds in my brokerage pre retirement.. 

[Radagast]

Nope. Taxes on capital gains do not occur until you sell, and stocks are minimally taxed on nonqualified dividends until then. So you want to hold stocks in brokerage accounts to pay little to no taxes now and little to no taxes when you later sell when you have lower income. The tiny taxation really helps with compound growth potential. For bonds, interest is generally a significant portion of growth and in the long term the only meaningful source of growth. You pay annual tax on bond interest at your current marginal tax rate, which greatly diminishes bond growth (little that there can be of it right now).

Taxable space is best reserved for stocks and savings bonds.

[terran]

Take a look at https://www.bogleheads.org/wiki/Tax-efficient_fund_placement

A couple of things you might be confused about:
1) You aren't (necessarily) taxed on gains while you're still working. You're only taxed on gains when you realize those gains (sell the investment at a gain). Most of the increase in value from investing in stocks will be gains, which you can defer until you're no longer working.
2) You will pay tax on dividends while working, but most dividends are qualified dividends, which are taxed at the same (lower) rate as long term capital gains.
3) You'll pay tax on interest income from bonds/CDs/bank accounts while working. This is taxed at the same rate (higher) as regular income. Most of the increase in value from investing in bonds is interest, which you can't defer, so you'll pay that at your current higher bracket.

[scubadog]

I seeeee. Would this change if we're talking about index bond funds, since they're treated like mutual funds?

Because what the two of you said definitely makes sense, but I realize I only hold index bond funds which I think are treated differently right?

Also especially thanks for the link terran, I'm reading it now and it's extremely illuminating... forgive the question if its answered in the link and I just didn't see it, this is turf I'm not too familiar with.

[terran]

No, index bond funds still pay out interest, and don't increase in value much (little opportunity for lower tax rate capital gains) so they're best held in tax advantaged accounts.

To your point, though, other than Vanguard, stock index funds are actually less tax efficient than straight stocks. This is because they're sometimes forced to realize capital gains when people want their money back out of the mutual fund and these gains are then distributed to the remaining owners. It's not a big difference, but it does negate some of the advantage of deferring capital gains until you have lower income. You can get around this by investing in Exchange Traded Funds (ETFs) instead of index funds because they're somehow able to flush the gains out of the fund without distributing it to current owners. As I mentioned, another option is to invest in Vanguard mutual funds. This is because Vanguard has a patent that lets them treat their mutual funds as a share class of their ETFs, which lets them flush capital gains from the mutual funds in the same way as all companies flush them from ETFs. Long story short, form maximal tax efficiency with your stock investing, stick with Vanguard mutual funds, or ETFs from other companies.

[scubadog]

Finances_With_Purpose: I plan to get my monthly/annual living expenses from Roth and brokerage withdrawals, so essentially the 4% dividends off of that growth I anticipate it making. Eventually all of my funds will be in either of these two accounts, so I dont anticipate complications like not being able to withdraw growth. I also dont anticipate holding any individual bonds, just bond mutual funds most likely, and still the majority of my growth and dividends I'll live off of will come from the stocks anyway. And yes - that was my chin scratcher - but it sounds like from the advice so far I have some moving around to do and that will include 100% stocks in my brokerage to take advantage of write-offs (more on that below).

Terran: Thanks for your clarity... I read through the link you posted and from what you've said (as well as the other posters) I wanted to pitch a new structure to you and the others as a kind of "check" to make sure I've understood everything. Also to clarify, my contrived numbers below assume no growth just so everyone can see where funds move over time.

Total fake portfolio value: 190,000

Day 1 of retirement:
401k: 100,000 - with an overall portfolio bond allocation of 20% in, say, VBTLX or VWALX, all of that 20% holdings, or lie in this account
Trad. IRA: 10,000 - stock ETFs or vanguard index allocations
Roth: 50,000 - stock ETFs or vanguard index allocations with highest growth funds located here
Brokerage: 30,000 - foreign index funds, small cap, mid cap, US stocks in ETFs or vanguard indexes

Year 5 of retirement, having rolled my 401k into my trad. IRA and then converted IRA to roth one year at a time at lowest tax bracket:
Roth: 160,000 - VBTLX or VWALX, growth stocks, basically all of portfolio except what's not in brokerage.
Brokerage: 30,000 - foreign index funds, small cap, mid cap, US stocks in ETFs or vanguard indexes

Withdrawals will come from my Roth principle pre retirement and my brokerage, knowing that my gains are only realized at execution and will be at the 0% bracket in retirement since they will be long term gains at that time.

Additionally, for what its worth, I've been taking careful notes on the nuances not included in my example, and every response so far I've considered and incorporated - like what you said Terran on mutual funds outside of vanguard being a little less efficient due to forced distributions and it might be better to stick with vanguard's patented mutual funds and ETFs in and outside vanguard (I have my eye on QQQ for example). And robartsd, skuzuker28, Radagast, for the bond fund suggestions and best locations (though Radagast, I still need to look further into series I savings bonds in my taxable, that's confusing turf for me having never been exposed yet). Thank you all so much for the help so far!

[terran]

Yes, you seem to have understood the concepts of where to invest various asset types for tax efficiency. I suppose we should add that investments like REITs should be put in tax advantaged accounts, even though you didn't mention them (I don't invest in REITs, but some do).

This is beyond the scope of this discussion, and you might have meant your example to only illustrate tax efficient investing, not be realistic, but I'd be concerned that $190,000 wouldn't be enough to retire on, and that $20k/$190k = 10.5% bonds would be too low at the start of retirement. Here's an excellent resource for figuring out how much you should hold in bonds at various points during retirement and how much you should plan on withdrawing (which will suggest how much you need saved based on expected expenses): https://earlyretirementnow.com/safe-withdrawal-rate-series/

I don't know that there's a one-size-fits-all answer to this question.  For instance, are you going to get your cash from bonds?  Or from stock dividends?  Etc.  It depends upon those things.  You can also only bank losses from stocks outside of your tax-deferred account. 

I don't think this matters since you can withdraw from one place and adjust your asset allocation in another. Say you want to withdraw from bonds first. Does it matter that you have the bonds in tax advantaged accounts, but want to withdraw from taxable? You can sell stocks in taxable and spend that money and simultaneously sell bonds in tax advantaged and buy stocks. The net effect is that you have the money you need to spend, the same amount of stocks as you had before and fewer bonds without having had to hold tax inefficient bonds in taxable.

[scubadog]

Thanks terran! Yeah I don't have any REITs but thank you.

Thankfully those were only modeled numbers I made up to make it obvious where things were moving in the example. My real number is around 300k. I'm leaning into about 20% bonds even now, pre retirement, and only see that number going up post retirement. If modeled after the 4% rule (which I see the link you posted disputes, and I would have to agree with the evidence provided in the link) given my average living expenses are 1k per month and anticipated to reduce when I move abroad immediately upon retiring, where I anticipate about 800 or less per month (I have only exceeded 1k about 3 times in the last 30 months, so I think its a good figure) I think I'll be alright. That would put me in the article's more conservative estimate - at about 2.6%. I have some personal case studies to suggest that 800 estimate is also accurate - not just pulling that figure out of nowhere.
I plan to pad things as necessary too - be agile in retirement, right in line with the site you sent. I don't anticipate making 0 income in retirement, just would like it if I could freely have stretches of 0 income without worry, and if things were really going poorly the first few years I would just return to the workforce and build my egg back to where it needs to be.

But thank you for the concern - had I not thought about this, you would have been illuminating an unknown unknown that would have a major impact on my plans!

[terran]

Sounds good, have fun! We're planning to spend the first part of our retirement abroad too, albeit at a much higher net worth as we'll be slowly traveling around, don't want to limit ourselves to only low cost locations, want to be able to afford to come back stateside at some point, and have some family obligations.

[robartsd]

My thought is that you want no more than 20% in bonds until your stash is at least 50% of your target, but about 40% bonds when you FIRE. Not sure if it would be better to glide path over the last half of accumulation or just transfer 20% of your stash to bonds just before FIRE.

[terran]

My thought is that you want no more than 20% in bonds until your stash is at least 50% of your target, but about 40% bonds when you FIRE. Not sure if it would be better to glide path over the last half of accumulation or just transfer 20% of your stash to bonds just before FIRE.

I agree, and I struggle with this as well. If the goal is to maximize balance and minimize time to FIRE on average then I think it's to increase bonds immediately before retirement (no, or very steep glidepath). The risk here is that the market crashes just before retirement and you have to keep working. If the goal is to retire on a specific date then I think a more gradual glidepath makes sense. The risk here is that you end up working longer than you would have if higher market returns were doing more of the work for you. Could be an interesting discussion to start another thread for.