Questioning the wisdom of tax-fficient fund placement

[jpdx]

I have reconfigured my portfolio to take advantage of tax-fficient fund placement, as described here:

https://www.bogleheads.org/wiki/Tax-efficient_fund_placement

I moved all bonds from taxable to traditional IRA accounts in order to reduce current taxes on dividends, which also helps to maximize my ACA premium tax credit. But now I am second guessing this approach...

When I achieve FIRE (estimating 15-20 years) and I begin drawing on my taxable account first, this account will be unbalanced. It will contain 100% stocks -- fine if stocks are up, but what if they are way down?

[terran]

Money is fungible. Say you have $100 in IRA and $100 in taxable. Bonds stay steady, stocks loose 50%. You want to withdraw $50. Do you have more money at the end if you invest taxable in stocks and your IRA in bonds or taxable in bonds and your IRA in stocks?

In scenario 1 you end up with $0 in taxable and $100 in your IRA, in scenario 2 you end up with $50 in taxable and $50 in your IRA. Either way you still have $100 that you can reallocate as you want.

You will notice that you now have less in taxable in one scenario so you will need to make sure you have enough accessible money to make it until your chosen withdrawal strategy from tax advantaged accounts. Assuming you're going to use a Roth conversion ladder and you're near 5 years in penalty free money then you may have a point, but even then you'll have to compare the tax drag from now until then to the penalty.

[MDM]

...15-20 years....

That gives you time to adjust your asset allocation to your comfort level.

See also How to withdraw funds from your IRA and 401k without penalty before age 59.5.

[nickelwise]

Say you need to make a withdrawal to cover your expenses for the month. Because bonds are up and stocks are down, you need to sell bonds for this withdrawal, but all of your bonds are in your tax-advantaged account. Simultaneously, you'll do the following:

1. In your taxable account, put through an order to sell the appropriate amount in stocks and transfer to your banking account.
2. In your tax-advantaged account, put through an order to buy the identical amount of identical stocks, and sell the corresponding value in bonds.

Your stock purchase and sale are a wash because you bought and sold the same amount of the same stock at the same time. You've sold the necessary amount of bonds in order to cover your expenses, and that amount is now in your bank account. And the rebalancing was all done within the tax-advantaged account, avoiding any tax consequences aside from the gains or losses on your withdrawal from your taxable account. If everything was done with Vanguard funds, you haven't even paid any transaction fees.

[jpdx]

Nickelwise, that makes sense! Thank you for explaining this so clearly.

[jacoavluha]

The only potential downside to this scenario is that if stocks are down such that you are actually selling at a loss in taxable, and you purchase the identical security in your IRA within 30 days of the sale in your taxable account this is a wash sale, so you can’t claim the capital loss on your taxes. Typically you don’t actually lose the tax benefit, ultimately, because the disallowed capital loss is eventually earned because the basis of the replacement shares that you purchased is adjusted up equal to the amount of the disallowed loss. Now, the problem with a wash sale where the loss is in taxable and the replacement shares are in the IRA is that you completely lose the benefit of the tax loss because the adjustment to the basis of the replacement shares doesn’t matter because they’re in a tax protected space (the IRA) where capital gains or losses taxes don’t apply. Does that make sense?

Which is why in the scenario presented, if you’re selling securities at a loss in your taxable account, you should purchase a security in your IRA that is very similar, but not substantially identical, to the security you sold. Then, you don’t create a wash sale, and you can claim the tax loss. Example: sell total stock market index in taxable, buy SP 500 index (and some extended index if you like) in IRA

[nickelwise]

jacoavluha, I was not aware that the wash sale rule still applied when the purchase was within a tax-advantaged account. Thank you for the education!

[MDM]

jacoavluha, I was not aware that the wash sale rule still applied when the purchase was within a tax-advantaged account. Thank you for the education!

IRAs have been mentioned by the IRS in this regard.  401k/403b/457b plans have not.  Unclear whether the omission is intentional.

[MustacheAndaHalf]

jpdx - Have you looked at tax-exempt bond funds?  That would allow you to allocate tax-exempt bonds in a taxable account, and regular bonds in an IRA.  Then you could balance things out like you wish.

Depending on your tax bracket, tax-exempt bonds might also be a better option.

[jpdx]

Good idea. However, I'm currently in a lower tax bracket. If only Vanguard had an Oregon muni bond fund...

[harvestbook]

I keep a chunk of intermediate tax-exempt bonds in my taxable account for this purpose. My wife and I also have intermediate in a shared account that serves as our second-tier emergency fund.

I'm getting real-life experience drawing out of a 529 for a new college freshwoman. The allocation is 40 bond/30 total stock/30 total international. It should last four years, with any remainder for post-grad. Since US stocks are up, I'm selling out of the total stock portion, and delaying international (because they're down) and bonds (because that's the safety net.) Of course, it could all collapse on me but I'm taking the bet of growth over the next three-plus years and I might be able to squeeze by with just the bonds anyway. Since medical school is going to be expensive, this makes more sense to me than just going to 80 or 100 percent bonds right now. We'll see!

[talltexan]

I like your 529 plan, although if your horizon is four years, I think you probably want more like 60% bonds.