Author Topic: 401k full of bonds  (Read 4058 times)

webguy

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401k full of bonds
« on: February 23, 2016, 12:19:23 PM »
Following the advice of Mr Collins here: http://jlcollinsnh.com/2012/05/30/stocks-part-viii-the-401k-403b-ira-roth-buckets/ he suggests keeping bonds in a tax advantaged bucket:

Bonds.  VBTLX (Vanguard Total Bond Market Index Fund)  Bonds are all about interest.  Tax Advantaged Bucket.

I'm shooting for an 80/20 portfolio which has therefore resulted in my 401k being full of bonds.  This is great from a tax perspective, but is it great from an early retirement perspective?  Once I retire, if there's a downturn in the stock market I may need access to my bonds in order to live off them until the stocks recover, but having them all in my 401k means I'll be penalized for doing so.  I'm self-employed so this is a Solo 401k, and I'm in a very high income tax bracket at the moment so trying to avoid increasing my taxable income when possible.

Any advice? Does anyone keep bonds in their taxable account?

seattlecyclone

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Re: 401k full of bonds
« Reply #1 on: February 23, 2016, 12:28:53 PM »
In this downturn scenario, you'll just sell some stocks in your taxable account and trade an equivalent value of bonds for stocks in your 401(k). The net result is that you have the same amount of stock as before, fewer bonds, and you withdrew $0 from your 401(k).

Mmm_Donuts

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Re: 401k full of bonds
« Reply #2 on: February 23, 2016, 12:57:16 PM »
Someone just posted this in another thread; it provides an alternate viewpoint to the classic "bonds go in registered accounts" theory. Food for thought.

http://whitecoatinvestor.com/asset-location-bonds-go-in-taxable/

ETA: quote from the Bogleheads wiki: https://www.bogleheads.org/wiki/Tax-efficient_fund_placement

Quote
Tax efficiency of bonds

Some investors see bonds or bond funds as tax-inefficient because almost all of the return comes from the dividend yield, which is fully taxed as ordinary income. [note 3] In contrast, stocks get most of their return from price appreciation, which is not taxed until the stocks are sold and is taxed at the capital-gains tax rate. Therefore, these investors regard bonds as being less tax-efficient than stock index funds (which rarely sell stock) and hold bonds in tax-advantaged accounts when possible. However, low-yielding bonds do not have much return to be taxed, and since they do not grow as fast as other investments, an equal percentage lost from an investment is a smaller dollar loss; this makes low-yielding bonds somewhat more tax-efficient. Therefore, some other investors do just the opposite: they hold stocks with a higher expected return in tax-advantaged accounts when possible. You have to strike a balance between the expected return and the tax rate.

Treasury bonds are exempt from state taxes, and thus are tax-inefficient for federal taxes but may be desirable taxable investments for investors who pay high state taxes but low federal taxes. TIPS have the same tax-efficiency as their treasury bond equivalents; however, since taxes need to be paid annually on the inflation component, which isn't received until the bond matures or is sold, this cash flow problem creates an additional reason to hold individual TIPS (as opposed to a fund) in a tax-advantaged account. [1]

Municipal bond funds have a hidden cost; while their interest incomes are not subject to federal tax, they usually earn less than corporate or treasury bond funds of comparable risk. (The risk may be of a different type; intermediate-term municipal bonds have more credit risk than long-term treasury bonds, but less interest-rate risk, and thus may have a similar after-tax yield.) There are special rules regarding the taxation of Social Security benefits - municipal bond interest in a taxable account may result in additional Social Security benefits being taxable. [note 4]
« Last Edit: February 23, 2016, 01:10:00 PM by Mmm_Donuts »

MustacheAndaHalf

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Re: 401k full of bonds
« Reply #3 on: February 23, 2016, 01:24:17 PM »
I'm shooting for an 80/20 portfolio which has therefore resulted in my 401k being full of bonds.
...
Any advice? Does anyone keep bonds in their taxable account?
I skimmed that article, and the one mentioned by a poster above, and I think a hybrid approach in both accounts might work better.  Meaning, have almost all stock in taxable, and almost all bonds in your 401k.  I'm going to assume you have a Traditional 401k.

First your concern about no bonds in taxable.  Respecting that concern, I'd recommend you look at Vanguard Tax-Exempt Bond ETF (VTEB).  The bonds are exempt from Federal taxes, so it doesn't matter what state you live in (CA and NY have state-specific funds that offer state tax-exemption).  And because I don't know your brokerage account, I mentioned an ETF that can be purchased anywhere just like a stock: with symbol "VTEB".  You will need to determine what portion of taxable you want for bonds, depending on how long you think a stock correction could last and your expenses.

For a Traditional 401k, it's better to mostly have bonds.  It's important to know you will eventually pay ordinary income tax on the Traditional 401k.  Bond income already incurs ordinary income tax, so it's no different.  Stocks get most of their benefit from long-term growth and dividends - both of which have tax advantaged rates.  Putting stocks in a Traditional IRA or 401k elects for a higher tax rate.  But there's a subtle point that people not thinking outside the box can miss: you decide what goes in a Traditional 401k, and you decide what gets taxed later.  If you put slower growing bonds in there, you will probably pay less taxes because bonds aren't expected to keep up with stocks.  So another reason I'd recommend a 401k hold mostly bonds is that you are electing to be taxed on slower growing assets, and so electing to pay less tax.

webguy

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Re: 401k full of bonds
« Reply #4 on: February 24, 2016, 05:43:18 AM »
In this downturn scenario, you'll just sell some stocks in your taxable account and trade an equivalent value of bonds for stocks in your 401(k). The net result is that you have the same amount of stock as before, fewer bonds, and you withdrew $0 from your 401(k).

I can't believe this didn't occur to me before. Thanks for pointing it out :)

Someone just posted this in another thread; it provides an alternate viewpoint to the classic "bonds go in registered accounts" theory. Food for thought.

http://whitecoatinvestor.com/asset-location-bonds-go-in-taxable/

ETA: quote from the Bogleheads wiki: https://www.bogleheads.org/wiki/Tax-efficient_fund_placement

Quote
Tax efficiency of bonds

Some investors see bonds or bond funds as tax-inefficient because almost all of the return comes from the dividend yield, which is fully taxed as ordinary income. [note 3] In contrast, stocks get most of their return from price appreciation, which is not taxed until the stocks are sold and is taxed at the capital-gains tax rate. Therefore, these investors regard bonds as being less tax-efficient than stock index funds (which rarely sell stock) and hold bonds in tax-advantaged accounts when possible. However, low-yielding bonds do not have much return to be taxed, and since they do not grow as fast as other investments, an equal percentage lost from an investment is a smaller dollar loss; this makes low-yielding bonds somewhat more tax-efficient. Therefore, some other investors do just the opposite: they hold stocks with a higher expected return in tax-advantaged accounts when possible. You have to strike a balance between the expected return and the tax rate.

Treasury bonds are exempt from state taxes, and thus are tax-inefficient for federal taxes but may be desirable taxable investments for investors who pay high state taxes but low federal taxes. TIPS have the same tax-efficiency as their treasury bond equivalents; however, since taxes need to be paid annually on the inflation component, which isn't received until the bond matures or is sold, this cash flow problem creates an additional reason to hold individual TIPS (as opposed to a fund) in a tax-advantaged account. [1]

Municipal bond funds have a hidden cost; while their interest incomes are not subject to federal tax, they usually earn less than corporate or treasury bond funds of comparable risk. (The risk may be of a different type; intermediate-term municipal bonds have more credit risk than long-term treasury bonds, but less interest-rate risk, and thus may have a similar after-tax yield.) There are special rules regarding the taxation of Social Security benefits - municipal bond interest in a taxable account may result in additional Social Security benefits being taxable. [note 4]

This is interesting. Keeping the investments with the highest expected return tax-sheltered makes sense in a way, but I would only incur taxes on the gains when I sell, which wouldn't be until in retirement when my income tax bracket is a lot lower. Keeping bonds in taxable accounts results in annual income which will be taxed at a high tax rate right now due to the high income tax bracket, so it seems like it would still make sense for me to keep bonds tax-sheltered as much as possible. Unless I'm missing something.

Thanks for the advice @MustacheAndaHalf - I'll look into the fund you suggested!

MustacheAndaHalf

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Re: 401k full of bonds
« Reply #5 on: February 24, 2016, 03:55:13 PM »
Hope it helps.  If you're in a high tax state (New York, California), with a Vanguard account you can purchase mutual funds that are specific to those states for $0 commission.  In a high tax bracket that helps even more.

One warning about switching losing stocks from taxable to tax-deferred:
If you sell in taxable and within 30 days purchase in your Roth, two things happen: you trigger the IRS wash sale rule, so you can't take the capital loss.  And you have to wait until you pay taxes on your Roth IRA... which will never happen.  You can watch a tax loss / capital loss permanently disappear if a Roth account is involved.  Other kinds of wash sales are recoverable (wait 30 days, sell more), but watch out for a buy/sell of the same thing involving your Roth account.

BFGirl

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Re: 401k full of bonds
« Reply #6 on: February 24, 2016, 08:08:14 PM »
I have tax exempt bonds in my taxable account and other bonds in my tax deferred account.  Stocks are split between both.

PhysicianOnFIRE

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Re: 401k full of bonds
« Reply #7 on: February 24, 2016, 09:45:14 PM »
I have all bonds in my 401(k) / 457(b).  If part of my portfolio (10% bonds) is going to grow in a slower, stable fashion, this is where I want it.  And, yes, money is fungible, as SeattleCyclone pointed out.

I've read the WCI post and the Bogleheads wiki.  For my portfolio, I believe bonds belong in tax deferred.

seattlecyclone

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Re: 401k full of bonds
« Reply #8 on: February 25, 2016, 07:59:13 AM »
Yeah, I'm not going to start holding bonds in taxable. My tax bracket is high enough now that I'd rather avoid paying the full rate on all the bond interest from now until FIRE. Instead I fulfill my bond allocation in my traditional retirement accounts. I expect this allocation to grow slower than stocks over the long term, so putting bonds instead of stocks in traditional reduces the amount of taxable income I'll have to deal with in retirement. My taxable account is all stock (tilted toward international to get the foreign tax credit). Roth accounts are a great place to put assets that you expect to grow a lot over the long term, especially ones that aren't particularly tax-efficient. My REIT allocation goes in Roth for that reason, and domestic stock fills up the rest of that bucket.

PhysicianOnFIRE

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Re: 401k full of bonds
« Reply #9 on: February 26, 2016, 02:34:40 PM »
Yeah, I'm not going to start holding bonds in taxable. My tax bracket is high enough now that I'd rather avoid paying the full rate on all the bond interest from now until FIRE. Instead I fulfill my bond allocation in my traditional retirement accounts. I expect this allocation to grow slower than stocks over the long term, so putting bonds instead of stocks in traditional reduces the amount of taxable income I'll have to deal with in retirement. My taxable account is all stock (tilted toward international to get the foreign tax credit). Roth accounts are a great place to put assets that you expect to grow a lot over the long term, especially ones that aren't particularly tax-efficient. My REIT allocation goes in Roth for that reason, and domestic stock fills up the rest of that bucket.

Perfect.  Sounds a lot like mine.  Nearly identical in fact.  My portfolio