Asset location between taxable and tax-exempt accounts

[puppys]

Hello Mustaches,

I am 24, currently in grad school, and trying to develop a savings plan that will lead me to early retirement. I have a Roth IRA and a taxable account, both with Vanguard, and have been maxing out the Roth and then throwing any additional savings into the taxable. This is my current asset allocation:

Roth
45% Vanguard 500 Index Fund (VFINX) - large caps
45% Vanguard Extended Market Index Fund (VEXMX) - small and medium caps
10% Vanguard Total Bond Market Fund (VBMFX) - U.S. bonds

Taxable
100% Vanguard Total Stock Market (VTSMX)

My goal is to have an asset allocation of 90/10 stocks/bonds across the entire portfolio for the time being. My question relates to how to achieve this AA. I currently only have VTSMX in the taxable account, since it is very tax efficient. By now I have read many, many sources that say that I should consider my portfolio as a whole and that I should buy bonds first in my Roth, and then use the taxable account to buy any remaining bonds needed to achieve my asset allocation. I have a couple of issues with this advice (or, perhaps, misunderstandings), which maybe you guys can help clear up for me:

1. Let's say I retire at 35 (purely hypothetical, given that I still earn peanuts as a grad student!). I will have to draw from my taxable account for nearly 25 years before I can start taking penalty-free withdrawals from my Roth. If the taxable account is invested mainly in stocks since I put as many bonds as possible in my Roth, then the money in the taxable account is at significant risk due to stock market volatility, no? Shouldn't I ensure that the money in the taxable account is guarded against undue risk by purchasing an adequate percentage of bonds in this account, too? Municipal bonds would even be federally tax exempt...

2. If Roth ends up being invested in 100% bonds or some other insane percentage, the money will grow very slowly, and possibly be inadequate for the golden years.

What is the correct way to think about this? If this question has been posted before, my apologies - please kindly just direct me to the link.

Long Live The Mustaches,

Evan

[Joel]

You can change your asset allocation every year. When you are close to retirement I would probably keep enough cash to cover two years of expenses to outlast a significant stock market drop. I do that anyways with about my first 15-20k.

[Crash87]

You can withdrawal principle from the Roth without penalty.


These links might answer your questions in more detail:

Build your portfolio:
http://www.bogleheads.org/wiki/Lazy_Portfolios

How to buy the funds in your portfolio:
http://www.bogleheads.org/wiki/Principles_of_Tax-Efficient_Fund_Placement

How a Roth IRA works:
http://www.bogleheads.org/wiki/Roth_IRA

It's also worth checking out the Backdoor Roth IRA link since you'll likely have a 401k when you're out of school.

[puppys]

Thanks guys. Based on this information, I guess the Roth really is the place to make bond investments. Given the example lazy portfolios, I will probably look to add a 10% allocation to REITs in my Roth, taking 5% each from VTSMX and VEXMX.

[Fite4Rite2Party]

Another point you might want to keep in mind is that interest you earn from bonds, like dividends, is taxed as ordinary income rather than at the lower capital gains rate. I think interest from a bond fund actually shows up as a dividend payment; at least that's the case for my bond funds (VMBS, VCSH and VCIT). Also, you incur this tax when the dividend or interest is distributed by the fund, regardless of whether it's reinvested. So, if you have the bond fund in a taxable account, you would incur tax liability even if you're not selling the underlying investment or collecting the interest. For tax-preferred accounts, on the other hand, transactions within the account such as dividend and interest distributions are not taxable. For this reason I have heard that it's good to put high-dividend and interest earning investments into tax-preferred accounts.

[pom]

Due to your age, the answer is not all that straighforward.

You nailed the problem on the head when you mentionned point 2. By investing your Roth in bonds at a young age, you deny the Roth its full growing potential.

Assuming that stocks earn 2% more than bonds, then over 35 years you end up with 2x more in your tax-free Roth if it is in stock vs in bonds. Maybe it's worth paying the taxes on bonds every year to allow the Roth to grow fast.

Right now the question is probably moot as I suppose that you will not have a high tax rate until you graduate. Until then, my advice is to keep the bonds outside of your Roth. Then you can do a simulation but I did a quick and dirty one and it showed that with a timeframe of less than 20 years, the conventional "bonds in Roth" makes sense; with a timeframe between 20 and 40 it depends on the respective return assumptions (dividend, capital appreciation and interest rates); with a timeframe above 40, better keep the higher expected return investment in the Roth.

Maybe someone here can do a proper simulation and check my results.

[pom]

I fugure I'll post my math here.

Lets suppose you want to invest $200 split equally between 50 % stock and 50% bonds.
I'll assume a dividend rate of 2%, capital appreciation rate of 6% and interest on bonds of 4%.
So tax free return on stock, return is 6% + 2% = 8%, taxable return is 6%+ 2%x0.85 = 7.7%
So tax free return on bonds, return is 4%, taxable return is 4%x0.7 = 2.8%

If you put the 100 of bonds in a tax-free fund and the 100 of stocks in a taxable fund as conventional wisdom would dictate you get

After 10 years: 148 in bonds, 210 in stock = 356
After 20 years: 219 in bonds, 441 in stock = 660
After 30 years: 324 in bonds, 926 in stock = 1250
After 40 years: 480 in bonds, 1944 in stock = 2424

Now assume that you do the reverse and put the stocks in the tax-free fund

After 10 years: 132 in bonds, 216 in stock = 348
After 20 years: 174 in bonds, 466 in stock = 640
After 30 years: 229 in bonds, 1006 in stock = 1235
After 40 years: 302 in bonds, 2172 in stock = 2474

So you see the cross-over somewhere between 30 and 40. In this scenario, the crossover is at 34 years.
If you increase the capital appreciation rate on stocks by 2%, then the crossover is at 24 years.
If you increase the interest return to 5%, then the crossover is at 49 years.

I hope this helps, do not hesitate to correct my math or my reasoning if you see anything wrong. This is an interesting issue.

[Fite4Rite2Party]

Pom, thanks for the math. This is an interesting question. Any chance you're motivated enough to set up the simulation in a spreadsheet, so that I can plug in my current numbers and see how things look after 10, 20, 30 years? If I have time I will give it a try, although my excel skills are fairly basic. It gets even more complicated if you take into account that retirement accounts may be split between Roth and traditional, and the expected tax bracket at 10, 20 and 30 years. It would be nice if there was a general rule of thumb to follow for those of us (including myself) who are too lazy to do a proper simulation.

[puppys]

Pom, thanks for crunching these numbers. They suggest that the answer depends on several factors, which is what I was thinking but could not find much support for.

I ran your numbers in excel and found the same results. I also changed the asset allocation from 50/50 stocks/bonds to 75/25 stocks/bonds. If I did the math correctly, I found that the crossover time was reached much faster - 8 years! This would appear to imply that bonds should be bought in the taxable account, especially when the investor uses more aggressive asset allocations.

But, the thought occurs to me that these results assume linear growth in both stocks and bonds. Are we missing something by not taking into account that stocks will undergo periodic corrections and lose a lot of value in some years? Maybe that is why you guys want to do a simulation?

[pom]

Hi all,

Here is my spreadsheet.

puppys - I only did a scenario type simulation, not a real stochastic simulation. It is possible that using a stochastic simulation we would get somewhat different results.

Here is the spreadsheet. I added a field if you want to consider deferred taxes on the stock's capital appreciation (assuming that you will at some point or another sell those shares and pay long term capital gain on them).

It is a draft, all comments are welcome.

[aj_yooper]

Thanks guys. Based on this information, I guess the Roth really is the place to make bond investments. Given the example lazy portfolios, I will probably look to add a 10% allocation to REITs in my Roth, taking 5% each from VTSMX and VEXMX.

I think the REITs are a good idea in the Roth; bond like but with more kick.

[aj_yooper]

Some international funds in taxable might also be good in order to get the foreign tax credit.  You have to check that it is available in the fund.  If you are looking for ER, dividend stocks (qualified) in taxable could help provide cash without disturbing the equities.  It is good to get your Roth going as early as you are.

[Fite4Rite2Party]

Awesome. Thanks for the spreadsheet pom.