Author Topic: Which is best from a tax perspective?  (Read 6361 times)

secondcor521

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Which is best from a tax perspective?
« on: September 24, 2014, 09:50:35 PM »
Which of the following options would create the lowest tax bill?

1.  $X in VBTLX in a taxable account and $X in VTSAX in a traditional IRA.
2.  $X in VTSAX in a taxable account and $X in VBLTX in a traditional IRA.
3.  $X in VWIUX in a taxable account and $X in VTSAX in a traditional IRA.
4.  $X in VTSAX in a taxable account and $X in VWIUX in a traditional IRA.

Assume "$X" is some amount of money that is enough to avoid any Vanguard account maintenance fees and to meet the fund minimums.  Assume the money is invested for 10 years, and the owner is in the 25% marginal federal and 8% marginal state tax rate.  Assume one buy at the beginning and no other transactions.  Assume dividends are not reinvested.

I believe I know the answer but I'm double checking.

Thanks.

P.S. - Yes, rising interest rates and don't buy bonds.  Yes, expense ratios matter.  Yes, they're different investments.  Yes, two of the options are essentially the same from a tax perspective.  I know all that.  My question is strictly about the income tax aspect.  (But post it anyway if you must; I'll read and appreciate all the comments.)

Ybserp

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Re: Which is best from a tax perspective?
« Reply #1 on: September 26, 2014, 09:39:58 AM »
If you are trying to minimize current year income taxes then #3 is by far the best. (I'm not sure why you even considered doing #4 though. VWIUX  is Vanguard Intermediate-Term Tax-Exempt Fund Admiral Shares right? Why are you considering putting a kind of investment which earns you less money because of it's tax-exempt nature into a tax-deferred account?)

Cheddar Stacker

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Re: Which is best from a tax perspective?
« Reply #2 on: September 26, 2014, 11:02:31 AM »
#3. Don't put tax free earnings into a T.IRA, ever. You have to pay taxes on those earnings then when you draw them out. It wouldn't make any sense.

I would rank them like this in order of tax efficiency:

3
2
1
4

Tax free muni's in the taxable account is best, then equities, then taxable bonds. But #4 is just a terrible idea so it's ranked last.

secondcor521

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Re: Which is best from a tax perspective?
« Reply #3 on: September 27, 2014, 12:13:19 PM »
Thanks for the replies.

Here's the back story:

I'm 45 years old and have reached FI and am in OMY mode.  I am 100% in stocks.  I think I should move some money into bonds.  I think my plan is to first decide between VBTLX, VSIGX, VBILX, and VWIUX, and then decide whether to have my bond ownership be in my traditional IRA or a taxable account.  Basically I have a bunch of VTSAX in my traditional IRA that I could move into bonds, or I have some cash on the sidelines that I could use to invest in a taxable account.  (The cash is in a savings account earning squat, and I'd like to get it invested.)

As far as bond funds go, I want to be in a broad-based, low-cost US bond fund.  For whatever reason I like corporate bonds better than federal government bonds.  I think I like the intermediate (5-10 year) duration.  Yes, VWIUX is a muni-bond fund...I added that one to my list because my Dad suggested it, and he's a pretty smart guy and a very good investor.  I think his thought process is that I can save on federal taxes with it, but that was originally when I was considering a taxable investment rather than a traditional IRA investment.

The alternatives were created by taking the two most likely bond fund investments, and then the two ways I could invest (traditional IRA / taxable).  To me, #2 and #4 are the same tax-wise, and yes, #4 is stupid.

So any additional thoughts would be welcome.  Thanks!

Ybserp

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Re: Which is best from a tax perspective?
« Reply #4 on: October 01, 2014, 07:17:39 AM »
So what have you decided to do?

secondcor521

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Re: Which is best from a tax perspective?
« Reply #5 on: October 01, 2014, 09:17:55 AM »
I decided to ask Vanguard for their recommendation.  They recommended choice #2, and I'm pretty sure that's what I'm going to do.

Their basic thought process on the investment was that VBTLX gave me the broadest exposure to the bond market - the other choices (I actually was also considering VSIGX and VBILX in addition to VWIUX) lacked corporate, short and long term, and US government bonds, respectively.  Which is what I specifically wanted - I want broad bond exposure but don't want to make bets on govt vs corporate, short vs. long, etc.

They then recommended I put the investment inside my traditional IRA because they said that is the most tax-efficient way to allocate things.  It seems to me it probably wouldn't matter since I plan to be in a low bracket, and currently I think that qualified dividends are treated essentially the same as capital gains tax-wise.  But I think that VBTLX would throw off a higher percentage of its gains in the form of dividends, which while I'm working I'd have to pay high taxes on, whereas VTSAX I could avoid realizing gains and paying taxes while I'm working.  So I think that's the right call also.

They also recommended that I move even further towards bonds than I really want to.  I was thinking 80/20 at the most conservative, and they recommended 65/35.  They also recommended international exposure.  I understand both of these recommendations, and I'm mulling them over but I'm not sure if I'll do either.

Cheddar Stacker

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Re: Which is best from a tax perspective?
« Reply #6 on: October 01, 2014, 09:35:31 AM »
Bonds will actually kick off interest, not dividends (generally) which are considered ordinary income and get no special tax treatment. That's why they put them in the IRA. Just don't put tax exempt bonds in the IRA, so if you have one fund that has a heavier weight towards tax free bonds, get that out of the IRA.

I'd stick to your guns with the 80/20, or maybe drop as low as 75/25. I'm sure you've read all the threads discussing how a higher bond allocation has a higher risk/lower success rate for the early retiree, but if not you should check them out or run your numbers through one of the simulators for more assurance.

Congrats on getting to FI. I hope you get out before OMY. You might be picking a great time to get some money into bonds. I'd start hoarding some cash as well since you're so close. Good luck!

secondcor521

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Re: Which is best from a tax perspective?
« Reply #7 on: October 01, 2014, 10:03:55 PM »
Interest, right.  Duh.

I'm actually not sure if I'll go lower than 90/10...I think I'm going to move ~5% every couple of months until it feels right.

Yes, I'm familiar with the early retiree aspect of stocks and SWR.  I mentioned that as a possible factor and the Vanguard rep didn't think it made a difference.  Another thing that helps me stay higher in stocks is that I can always work longer if I need/want to.  There's not really anything driving my 2/5/2016 date other than that's when my juicy stock options will vest, and I should have enough plus a buffer by that point.

I have some cash as well; I think I'll aim to maintain about 15 months in cash, since that's what my plan calls for.  Right now I'm a little above that I think...

Cheddar Stacker

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Re: Which is best from a tax perspective?
« Reply #8 on: October 02, 2014, 07:43:12 AM »
When I get to the point you're at (which should be around your age coincidently) I plan to keep a lot more cash. Maybe up to 3 years of expenses in a CD Ladder or some type of short term bonds if interest rates are good enough. 15 months seems a bit tight to me, and I'm pretty aggressive, but I hope it works out well for you.

Since you're getting close to the end, have you read Dr. Doom's drawdown series at livingafi? In my opinion this should be required reading before pulling the trigger.

secondcor521

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Re: Which is best from a tax perspective?
« Reply #9 on: October 02, 2014, 09:37:58 PM »
Well, if I end up at 80/20 and use 4%, that would be 20 years in stocks and 5 years in bonds, and then the 15 months would be on top of that.

My rough plan using ASCII art (numbers are very rough):

Code: [Select]
                                             
                              taxable (2 yrs)
                                 ^
                                 |     transfer as needed
                                 V
Traditional IRA -> Roth IRA -> savings -> checking -> spend
(20+ yrs)          (~7 yrs)    (15 mo)     (1 mo)

Numbers in parentheses above represent rough sizes in terms of monthly or yearly expenses.
Traditional IRA will contain the 20% VBTLX.
Balance of traditional IRA and Roth IRA and taxable represent the 80% in VTSAX.
I'll do a conversion from traditional to Roth in December each year.
I'll do a withdrawal from Roth to savings in January each year.
I'll set up monthly transfers from savings to checking that will become my monthly allowance.
There are a number of other pieces of the puzzle, large and small, that I've left out for simplicity.

I have slowly been putting together a plan in a separate Word doc that is currently 4 pages long and covers goals, transition plan, income, spending, investing, living, and contingency plans.  Under transition plan there's a section on research I plan to do, and I'll add Dr. Doom's series to the list.

My basic bond question here belies the fact that I've actually done a lot of research and reading over the years.  I've forgotten most of it over the past five years or so as I've just had my head down hammering away at kids' college funding, debt/mortgage payoff, maxing 401k, maxing Roth, income increases, etc.  I hit basic FI about a year ago and so I looked up and started looking seriously at where I am rather than just from a theoretical point of view and sort of letting the reality sink in.

One thing that is not readily apparent is that for Mustachians who are saving 50% of their income, you can hit FI and then blow past it pretty quickly.  The analogous imagery in my mind is of those submarines that surface with full up on the bow plane - breaching the surface is quite quick and, um, emphatic:

     https://www.youtube.com/watch?v=JrU0bYq7KPQ#t=27

This is especially true if you happen to hit FI in the midst of a market upswing, as I was lucky enough to have happen to me.
« Last Edit: October 02, 2014, 09:40:22 PM by secondcor521 »

Cheddar Stacker

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Re: Which is best from a tax perspective?
« Reply #10 on: October 02, 2014, 10:08:03 PM »
Seems like a very solid, well thought out plan. Kudos. If you ever want to share that word doc I'd be interested in checking it out.

One tiny note: if you are looking to keep taxes low (based on the thread title it looks like you are) you might not want to be rigid with your conversion from t.ira to r.ira. There are 2 conflicting goals, one is to get a lot of contributions in the r.ira so you can draw them down pre 59.5, and the other is to pay minimal tax. I'm more concerned with paying minimal tax.

In order to pay less tax it's best to convert when values are low. Always waiting until December to convert allows for potential appreciation all year and requires a conversion in that 31 day window so you might have to do it when values are inflated. I would monitor the value of your holdings throughout the year and convert when you see value. A good read on this topic is the madfientist roth ira horserace from a few months ago.

secondcor521

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Re: Which is best from a tax perspective?
« Reply #11 on: October 03, 2014, 04:04:59 PM »
I'll send you the Word doc via PM.  Although it doesn't reveal much if any additional personal information, please don't pass it along.  If you want to take it and adapt it to your situation and then pass yours along, that's OK.  If you have feedback on my plan, I would appreciate it.  Thanks!

Yes, keeping taxes low is one of my goals.  Getting as much as I can into my Roth is not one of my goals currently (well, it sorta is, but it conflicts with minimizing my taxes).  Basically I plan to convert up to the top of the 15% bracket.

I don't really think I am able to assess valuation of the market within an annual time frame, so I'm not going to try.  (In general I don't market time -- I invest as soon as I have the money and I take money out only when needed (which is very very rare if ever).)  The December/January approach is to delay the conversions as long as possible (not sure if that makes sense) and get access to the money as soon as possible and still meet the Roth 5 year rule.  I believe, for example, that conversions in December 2016 would be avalable for withdrawal in January 2021.  I might be off by a year.

Right now my Roth doesn't have enough to support the 5 year pipeline, so that's what I'm working on for the next year or two and figuring out how to work around that situation if needed.

mxt0133

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Re: Which is best from a tax perspective?
« Reply #12 on: October 03, 2014, 06:35:29 PM »
The December/January approach is to delay the conversions as long as possible (not sure if that makes sense) and get access to the money as soon as possible and still meet the Roth 5 year rule.  I believe, for example, that conversions in December 2016 would be avalable for withdrawal in January 2021.  I might be off by a year.

What Cheddar is saying is that by doing the conversion January 2016 vs December 2016, the idea is that the 'cost basis' is lower and you get to roll over more.  For example say you only have 10k in a tIRA in January 2016, you do the conversion on January 2016 for the full 10k amount.  It is then recorded that the conversion amount is 10k and you will be taxed on that amount.  Say by December 2016 that 10k amount has appreciated to 11k, however your conversion amount is still 10k so your appreciation of 1k was earned tax free.  If you had waited to convert the 10k amount until December 2016 now you have 11k to convert and will have to pay taxes on full 11k instead of 10k if you had converted in January.

Again review the madfientist roth ira horse race for a more detailed explanation but this is the basic principle.

secondcor521

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Re: Which is best from a tax perspective?
« Reply #13 on: October 03, 2014, 11:47:57 PM »
Thank you, yes, I understood what Cheddar was saying.  That is why I wrote "(not sure if that makes sense)".  The other reason I was planning on doing the conversion in December is that I can do better tax planning and adjust both my conversion and withholding amounts.

Another thing is that I would convert - using your numbers - that $10K whether it was January or December.  My conversion amount will be based on my tax situation and my Roth IRA pipeline balance - I plan to convert as much as possible without leaving the 15% bracket.  So using your numbers, I would just leave that $1K of appreciation in the traditional IRA, where it would grow tax deferred during that year and continue to grow tax deferred until withdrawn or converted (as it would in the Roth, of course).  I would at the very least defer the income taxes of $250 on that $1K to a future year, and the deferred income tax amount would also grow tax deferred.

That $1K would eventually be withdrawn and taxed, but it would be down the road.  There might be the potential for me to be bumped up to a higher tax bracket later if my investments do well, or if I receive some additional income or cash somehow or when I hit RMD age in another 25 years.  But I think my current plan is to cross that bridge if or when I come to it, because it is certainly not guaranteed and maybe not even likely.  Also, if my worst problem is getting bumped into the 25% tax bracket, well, that's not a horrible problem to have.  I guess at that point I'd be managing the money for my heirs anyway.  I need to do the math at some point.

I have read the madfientist article but not recently.  Maybe I'll have to read it again, because I thought that I had already incorporated my thoughts about his article into my plan.  Perhaps not.

Thanks for the comments!  I appreciate being questioned and challenged on my plan because it will help me improve it.

Cheddar Stacker

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Re: Which is best from a tax perspective?
« Reply #14 on: October 04, 2014, 07:52:23 AM »
PM received. I will be in touch eventualy after a solid review.