Author Topic: bond allocation between taxable and tax-deferred accounts (vs mtg pay down)  (Read 1122 times)

BrainDoc

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Apologies for the long first post (long-time lurker) and what sounds like a very un-mustachian situation. My wife and I have good jobs that pay well. While not dying to RE, this site has been a valuable source of inspiration and guidance. We try to spend mindfully while investing/saving for FI.  Meanwhile, our jobs are a source of satisfaction (especially mine since I donít have the aggravating colleagues my wife deals with) and we have meaningful goals we want to achieve. I just want to better understand how to allocate our investments so I donít jeopardize the nascent FI that we already have achieved.

Here is our situation:
Me: age 57; spouse age 51; son age 10
Combined 401K/403B: $1,700,000 nearly 100% equities (US/International) with small exposure to REIT and precious metals
Taxable Investments: $1,600,000 (68% US equities; 32% short term bonds)
Stock options (wifeís company): ~$2M after tax (at current market value)
529: ~$130K
Home equity: ~$400K
Mortgage principle: ~$1.1M
Emergency fund: $50K plus ~$100K HELOC
Other debt: none
Combined gross income: ~$700K
Yearly savings: ~50% of after tax (after maxing retirement contributions, employer insurance, etc.) ~$240K

Mindset: Although we are lucky to have good jobs and amazing incomes (this only has been true the last 10 years) we always tried to live well below our means and save/invest as much as we can (given the vagaries of life). My wife and I both came from solid middle-class families but no financial help after college. Despite demanding jobs we have sufficient flexibility to never hire a nanny. We strive to be parents to our boy without the need for surrogates.

Retirement plans: I have the least stressful job but bring in only ~40% of our combined wage income. Iím happy in my job and have one last project that Iíd be happy to spend the next 5-6 years to see through. That time would also allow me to vest a decent pension, add more to my 403B (plus nearly 50% employer match). I have many interests/hobbies, but it is hard for me to imagine what I could do that is more meaningful than what Iím working on.

On the other hand, my wife works in biotech and is very stressed out with her job. She is reluctant to quit because she also has project in which she is invested (and wants to see through completion), earns great money (I have not included her bonuses in this equation) and would feel like a ďloserĒ if she ďgave inĒ to the ďa-holesĒ who are making her life miserable in the company (she is a fighter).

Between the two of us, she is the better candidate for early retirement. Iíve run the numbers and have assured her that if she cashed her options tomorrow, she could walk away and the family would be fine. Sheís not ready. For now, she wants to get a new medication approved that could help thousands of people who currently have no treatment options.  I get it. I just wish it was easier for her.

Questions:

1.   Should I keep some bond exposure in our portfolio in case my wife does what she threatens to do nearly every week: quit!  That would allow us to have some flexibility in our finances (although we could meet current expenses with my salary, just not much savings). Conventional wisdom says that bonds should be in our tax-deferred accounts, but then those funds arenít  readily accessible. Right now I have them in our taxable account. Should I leave them there?
2.   I wonít be taking RMDs for another 13 years or so (My wife for another 19 years). Should we have bond holdings in our tax deferred accounts?. Or is our time horizon sufficiently long that we can ride out market down turns?
3.   Another scenario: take our $500K of short-term bond holdings (taxable account) and pay down our 3.75% mortgage. Calculators say we would pay off shortly after we plan to retire (9 vs 27 yr if all goes according to plan) and save $527K in interest (that seems too good to be true). Given the low interest rates now, even paying down a 3.75% loan seems like a better return than short term bonds.  I know the mortgage payment vs bond investment argument has been discussed but I keep wondering whether I am missing something? 
4.   Are there any red flags that Mustachians see in my investment plan? What should I be doing differently?

Radagast

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Stock options (wifeís company): ~$2M after tax (at current market value)

Questions:

1.   Should I keep some bond exposure in our portfolio in case my wife does what she threatens to do nearly every week: quit!  That would allow us to have some flexibility in our finances (although we could meet current expenses with my salary, just not much savings). Conventional wisdom says that bonds should be in our tax-deferred accounts, but then those funds arenít  readily accessible. Right now I have them in our taxable account. Should I leave them there?
It might not be technically optimal but doesn't make a huge difference... just make sure your are using the correct bonds for your tax situation.
2.   I wonít be taking RMDs for another 13 years or so (My wife for another 19 years). Should we have bond holdings in our tax deferred accounts?. Or is our time horizon sufficiently long that we can ride out market down turns?
Up to you. 10% in bonds won't hurt much, but also might not help. I would use intermediate (or even longer) term bonds with this time horizon if you decide to include bonds, rather than short term.
3.   Another scenario: take our $500K of short-term bond holdings (taxable account) and pay down our 3.75% mortgage. Calculators say we would pay off shortly after we plan to retire (9 vs 27 yr if all goes according to plan) and save $527K in interest (that seems too good to be true). Given the low interest rates now, even paying down a 3.75% loan seems like a better return than short term bonds.  I know the mortgage payment vs bond investment argument has been discussed but I keep wondering whether I am missing something? 
I would personally rather pay off a 3.75% mortgage than have bonds at 2%, as you will have plenty of money left over to not be at risk from this exchange. The argument for not paying off a mortgage is in comparison to stocks, which currently have a higher "expected" return over the next decade than 3.75%.
4.   Are there any red flags that Mustachians see in my investment plan? What should I be doing differently?
Note: wife's stock options are very undiversified. By my ignorant math, this makes the difference between 15x and 25x your annual expenses, the difference between safe and unsafe retirement. Get rid of these at the earliest opportunity.

Your expenses are very high, saying you have ample room to cut back would be a big understatement.

https://www.bogleheads.org/forum/viewforum.php?f=1&sid=4d57c861f62d7f013c456efeda588ca6
The Bogleheads personal investment forum might get you more and better answers, most posters here are not familiar with your situation.

waltworks

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Red flag: If you make $280k a year on your own, and are worried that your wife might quit and you won't be able to afford that, you are in the wrong freaking place. You have something in the ballpark of $5 million dollars and you're worried about money? FAIL.

You do not have an investing problem, or a mortgage payoff problem, or any other money problem. You have a throwing money down the toilet problem of some kind.

Let your wife quit if she wants. You can quit too, anytime you feel like it. Figure out where the hell your money is going, and make some decisions about spending on what actually makes you happy. Spend more time with your kid. Put your skills to work to make the world a better place, money be damned. Done.

-W

SeattleCPA

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Gosh, you are way heavier on stocks than I'd personally feel comfortable with.

Maybe a 120%-ish allocation to stocks once you account for your mortgage as, indirectly, just a way to invest another $1.1M into stocks?

One tangential comment... in your case, paying off the mortgage probably isn't a bad way to deleverage your portfolio--and the after-tax returns will probably be pretty good. Especially that first $100K you pay off.

More info:

Why early mortgage repayment makes sense for high income taxpayers


New mortgage interest deduction rules








BrainDoc

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Thank you all for your responses.

SeattleCPA: very useful articles

Radagast: I will also check on Bogleheads. Very useful site.  I'm also realizing that maybe my issue might be irrelevant to many here. I thought I'd give it shot.

waltworks: I hear you. I was expecting a face punch or two. We earn and spend a lot. We live in a HCOL area (NYC environs). In our defense, we do save about 50% of our aftertax income but certainly we could do better in containing costs. Regarding our careers, I've struggled with whether I'm in denial or whether I really like my work. I don't think I'm in denial. I have a great, meaningful gig.  It may not seem apparent, but I think we are both trying to make the world a better place using our training and expertise. FWIW, I do medical research on brain development and how exposures during pregnancy can derail optimal maturation of the brain. As I said, I've had one project in particular that I've spent 15 years on and I think that in 5 or so years, the results may change medical practice and the future health of a bunch of kids.  I also do a lot of mentoring, teaching, and am in a position to help other scientists grow their careers.  My wife is an idealist and what is driving her to stay in her work is the possibility to develop a medication that treat a condition without any current treatments. If she succeeds it would help relieve a lot of suffering. Her drug is in Phase III and like me she can see the finish line. Unlike me, her work environment is more toxic, but she doesn't want to quit (not yet anyway). So yes, we are unmustachian in not racing towards early retirement but trying to achieve/maintain FI. Despite our work, we have quite a bit of freedom to work from home and have flexible hours. Our son gets a lot of time with us. We eat all of our meals together as a family. Don't have a nanny and rarely spend time away from our boy. He seems to be doing great. Maybe this all sounds defensive, but we are amazingly lucky.

In any case, I was hoping to get some advice on how to think about bonds in our overall investment strategy. I got some good pointers.  FWIW, the mustachian approach to life resonates with me: efficiency, simplicity, mindfulness, vigilance about luxury and hedonic adaptation, etc. I'll keep reading and learning.

SeattleCPA

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In any case, I was hoping to get some advice on how to think about bonds in our overall investment strategy. I got some good pointers.  FWIW, the mustachian approach to life resonates with me: efficiency, simplicity, mindfulness, vigilance about luxury and hedonic adaptation, etc. I'll keep reading and learning.

Braindoc, one other thought based on something that didn't dawn on me first time I read your post... you possibly haven't had big stock market allocations in a really bad market yet--or maybe not big stock allocations relative to your income. (I say this because it looks, given your high savings rate and current balances, as if you've saved most of your money since the 2008 meltdown.)

If this guess is right, I think it's pretty likely you overestimate your ability to bear stock market risk. And the obvious way to dial down your stock market risk is to dial up your bond allocation. (You can also try to spread your allocations around a bit more so you're a little less vulnerable to any one asset class like US stocks.)

BTW, I'm 58 and have been though three big stock market crashes and then also experienced the pain of the stagflation of early 70s (because that basically hosed the college savings fund my parents had set aside for me). The '87 crash (a few years after I'd finished up my MBA in finance) only looked like an opportunity. The dot.com crash didn't hit me hard for reasons I've disclosed in another thread here. But the 2008 thing really sucked. Total bummer.

Reflecting these experiences, I use David Swensen's asset allocation (see Portfolio Chart's discussion of this) for my traditional asset holdings... and then try to apply Swensen's logic to the my nontraditional stuff. That formula, BTW, results in a 30% allocation to treasuries.

P.S. As noted earlier, the easiest and probably no-brainer change to make in your situation is to at the very least pay off the mortgage balance you can't deduct interest on...

BrainDoc

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Thank you SeattleCPA.  I am 57 and I took a hit with the dot.com bubble (not too bad though). My 403B took a beating in 2008. I didn't sell, but if I had had more in bonds at that time, I'm not sure I would have had the courage to buy more equities in the down market. It was a very uncertain time. But, the bull market since 2009 has made everyone feel like an investment hero. I believe that it does make more sense to get more bond exposure at this point in our careers. This is my current plan:
1. Pay down the mortgage enough to allow full interest deduction;  2) Shift our tax-deferred portfolio to an 80/20 mix  (since RMDs won't occur for at least 13 years). 3) Diversify our taxable portfolio
by selling my wife's company shares more aggressively and reinvesting in a 60/40 mix (probably munis to be more tax efficient). Invest future savings 50% into mortgage principle and 50% into the same 60/40 mix of our taxable portfolio.

Thoughts? Thanks again for your advice.

SeattleCPA

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Thank you SeattleCPA.  I am 57 and I took a hit with the dot.com bubble (not too bad though). My 403B took a beating in 2008. I didn't sell, but if I had had more in bonds at that time, I'm not sure I would have had the courage to buy more equities in the down market. It was a very uncertain time. But, the bull market since 2009 has made everyone feel like an investment hero. I believe that it does make more sense to get more bond exposure at this point in our careers. This is my current plan:
1. Pay down the mortgage enough to allow full interest deduction;  2) Shift our tax-deferred portfolio to an 80/20 mix  (since RMDs won't occur for at least 13 years). 3) Diversify our taxable portfolio
by selling my wife's company shares more aggressively and reinvesting in a 60/40 mix (probably munis to be more tax efficient). Invest future savings 50% into mortgage principle and 50% into the same 60/40 mix of our taxable portfolio.

Thoughts? Thanks again for your advice.

To me, those sound like reasonable steps... though I might look at being 100% stocks in the taxable space and then load up on the bonds in the tax-deferred space to get the overall bond percentage to whatever you want.

Note: Not that far down the road, you can be earning lots of qualified dividends and long-term capital gains and be taxed pretty lightly.

And this thought.. I really don't think you're going too heavy on bonds. I'm 30% treasuries as I pm-ed you... With no borrowing.... I feel okay about this. Yes, the bonds have tamped down my returns over last few years. But I think that's okay. I should not be risking capital for additional return I don't actually need.

BrainDoc

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"I should not be risking capital for additional return I don't actually need."  Precisely the thought I had as I was digesting where we were in the whole FI thing. I can dial back ROI on our portfolio and we'd still do fine.

The whole "do bonds go in the taxable or tax-deferred buckets?" seems tricky (or maybe I'm making it so). The argument for putting them in the taxable bucket: measly interest rates offered lately don't generate much taxable revenue but provide the stability factor. They also provide a source of liquidity that can be tapped without much tax risk. The argument for putting bonds into the tax-deferred bucket is that they are not taxed, but the tax deferred portfolio has the longest time horizon and could ride out a bear market. Does this evaluation make sense? I feel like I'm missing something.

MustacheAndaHalf

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With about $5MM in assets you have about $0.5MM in bonds.  That's the allocation of someone 40 years from retirement, not under 10 years to retirement.  Vanguard Target Retirement 2030 holds 30% bonds for people retiring in 12 years.  And it sounds like your wife wants to retire much sooner, so consider allocating far more to bonds.

At $700k/yr income, your bond holdings should be be tax-exempt.  There's no chance taxable bonds beat tax-exempt bonds in your tax bracket.  Vanguard Tax-Exempt Bond ETF (VTEB) can be purchased at any brokerage, and yields 2.46% tax-exempt.  But that isn't a short-term bond fund, in case that's significant to your portfolio.

About 40% of your net worth could fluctuate wildly depending on clinical trials of one biotech company.  Does your wife need the full $2MM in stock options to prove she was right?  Or could she stomach selling 1/4th or 1/3rd of this amount, making it a smaller piece of your overall net worth?

BrainDoc

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Moustacheandahalf: yes. I agree and plan to have my wife divest more aggressively (she is limited by SEC rules) and put nearly all proceeds into bonds/mortgage pay down. There are naysayers that think the 60/40 rule is dead, but I don't think that applies in our case. Thanks for your input.  Very helpful. More bond exposure is in our future.