Author Topic: Where to put bonds? IRA or taxable?  (Read 8384 times)

frugalnacho

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Where to put bonds? IRA or taxable?
« on: February 10, 2015, 08:09:56 AM »
I have a long time (probably 10+ years) until I FIRE, so I have all of my investments in stocks.  Here are my accounts:

401k: $87k in 3 different funds, all high risk stocks no bonds. 
IRAs: about $30k all in VTSAX (this is split between  me and wife, and traditional and roth)
taxable: about $19k all in VTSAX

My original plan was to go with all stocks as they give the best long term return, and I can ride out the volatility (even though I would not like seeing my stocks drop during my accumulation phase, it was a conscious decision to have that extra volatility in exchange for better overall returns).  Now I am thinking I should add some bonds to our portfolio. 

Am I being too risky being 100% in stocks?  Does this approach make sense assuming I have stable employment/income and can stomach watching my portfolio get cut in half during another recession?

If my next investment purchase is $3k worth of bonds in vanguard that only gives me 3k out of 139k in bonds, or about 98/2 stocks/bond split.  Should I be investing more into bonds?

Where should I put my money into bonds to get the most  bang for my buck?  Into a tax sheltered IRA account?  Taxable account? 

More info:  We are squarely in the 15% tax bracket and I don't anticipate ever reaching the 25% bracket before FIRE.  Therefore I anticipate my capital gains and dividends in my taxable account will be taxed at 0%.  In this respect it appears that a taxable account is even better than a roth account for us, because we can use that money at any time (just like a roth) but with a little planning we can also use all of the growth in that account anytime (unlike a roth which locks that growth up until 59.5), and all that growth will be tax free (just like a roth). 

Dodge

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Re: Where to put bonds? IRA or taxable?
« Reply #1 on: February 10, 2015, 08:59:41 AM »
I have a long time (probably 10+ years) until I FIRE, so I have all of my investments in stocks.  Here are my accounts:

401k: $87k in 3 different funds, all high risk stocks no bonds. 
IRAs: about $30k all in VTSAX (this is split between  me and wife, and traditional and roth)
taxable: about $19k all in VTSAX

My original plan was to go with all stocks as they give the best long term return, and I can ride out the volatility (even though I would not like seeing my stocks drop during my accumulation phase, it was a conscious decision to have that extra volatility in exchange for better overall returns).  Now I am thinking I should add some bonds to our portfolio. 

Am I being too risky being 100% in stocks?  Does this approach make sense assuming I have stable employment/income and can stomach watching my portfolio get cut in half during another recession?

If my next investment purchase is $3k worth of bonds in vanguard that only gives me 3k out of 139k in bonds, or about 98/2 stocks/bond split.  Should I be investing more into bonds?

Where should I put my money into bonds to get the most  bang for my buck?  Into a tax sheltered IRA account?  Taxable account? 

More info:  We are squarely in the 15% tax bracket and I don't anticipate ever reaching the 25% bracket before FIRE.  Therefore I anticipate my capital gains and dividends in my taxable account will be taxed at 0%.  In this respect it appears that a taxable account is even better than a roth account for us, because we can use that money at any time (just like a roth) but with a little planning we can also use all of the growth in that account anytime (unlike a roth which locks that growth up until 59.5), and all that growth will be tax free (just like a roth).

I recommend keeping this thread about "Where to put bonds", and not "Do I need bonds".  There are already many threads on the former, and your original question will get lost in the discussion.

From the math I've seen, there's really no difference between bonds in taxable vs bonds in IRA.  The general advice is to keep them in the IRA:

http://www.bogleheads.org/wiki/Principles_of_tax-efficient_fund_placement

But some advocate bonds in taxable, and have a strong mathematical argument for it:

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

Indeed even the Bogleheads link above acknowledges that bonds in taxable might be better.  In my opinion, it's a wash either way.  Do what helps you sleep at night :)

GGNoob

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Re: Where to put bonds? IRA or taxable?
« Reply #2 on: February 10, 2015, 09:07:26 AM »
Personally, I would not put bonds in a Roth IRA. I would want my Roth in all stocks and/or higher risk stocks to hopefully get a higher return tax free at retirement. So my preference would be bonds in a taxable account or a tax-deferred IRA or 401k.

But some advocate bonds in taxable, and have a strong mathematical argument for it:

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

+1

frugalnacho

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Re: Where to put bonds? IRA or taxable?
« Reply #3 on: February 10, 2015, 09:34:38 AM »
Do the dividends from bond funds count the same as dividends from an index fund of stocks?  It seems like some of the arguments i'm reading say that bonds generate dividends as opposed to capital appreciation, therefore they force you to realize those dividends as income immediately which is what makes them tax inefficient in taxable accounts.  Since I anticipate paying 0% on long term gains and qualified dividends for my entire accumulation phase, does this really even affect me?

beltim

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Re: Where to put bonds? IRA or taxable?
« Reply #4 on: February 10, 2015, 09:37:56 AM »
I prefer holding bonds in a taxable account in order to allow stocks, my highest growth investment, the most tax-free space. This depends a lot on individual tax situations and investment returns. See my post at http://forum.mrmoneymustache.com/investor-alley/which-parts-of-a-portfolio-do-you-want-in-your-tax-sheltered-accounts/msg389772/#msg389772 for an example of how holding bonds in a taxable outperforms holding them in a Roth.  However, if you think you'll remain in the 15% bracket forever, I think the math favors you putting bonds into a tax-advantaged account.

beltim

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Re: Where to put bonds? IRA or taxable?
« Reply #5 on: February 10, 2015, 09:38:59 AM »
Do the dividends from bond funds count the same as dividends from an index fund of stocks?  It seems like some of the arguments i'm reading say that bonds generate dividends as opposed to capital appreciation, therefore they force you to realize those dividends as income immediately which is what makes them tax inefficient in taxable accounts.  Since I anticipate paying 0% on long term gains and qualified dividends for my entire accumulation phase, does this really even affect me?

Most bond interest is taxed as ordinary income, not as qualified dividends, and so is taxed at your marginal income tax rate.

Scandium

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Re: Where to put bonds? IRA or taxable?
« Reply #6 on: February 10, 2015, 10:31:37 AM »

But some advocate bonds in taxable, and have a strong mathematical argument for it:

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


Despite the hard to read (and incorrect) two spaces after period, the linked post was interesting. So the good doctor recommends just muni bonds in taxable? That obviously helps since those don't generate income tax. But are there any issues having all your bonds being munis? I'd like to see what happens using total bonds market or similar in taxable. Which for the doctors would result in 33% or more tax on the yield. Is there an effective tax rate cutoff?

edit: also then need to consider that munis have less growth than total bond
http://quotes.morningstar.com/chart/fund/chart?t=VWLUX&region=usa&culture=en-US&dataParams=%7B%22zoomKey%22%3A11%2C%22version%22%3A%22US%22%2C%22showNav%22%3Atrue%2C%22defaultShowName%22%3A%22name%22%2C%22mainSettingId%22%3A%22main%22%2C%22navSettingId%22%3A%22nav%22%2C%22benchmarkSettingId%22%3A%22benchmark%22%2C%22sliderBgSettingId%22%3A%22sliderBg%22%2C%22volumeSettingId%22%3A%22volume%22%2C%22defaultBenchmark%22%3Afalse%2C%22id%22%3A%22FOUSA02SLT%7CFOUSA02TYI%22%2C%22type%22%3A%22FO%7CFO%22%2C%22name%22%3A%22XNAS%3AVWLUX%7CXNAS%3AVBTLX%22%2C%22baseCurrency%22%3A%22USD%22%2C%22defaultBenchmarks%22%3A%5B%22%22%2C%22%22%5D%2C%22chartType%22%3A%22growth%22%2C%22startDay%22%3A%2202%2F20%2F1987%22%2C%22endDay%22%3A%2202%2F09%2F2015%22%2C%22chartWidth%22%3A955%2C%22SMA%22%3A%5B%5D%7D

holyhell, how do I make that link less horrible?
Is there a howto on posting M* charts?
« Last Edit: February 10, 2015, 10:55:21 AM by Scandium »

beltim

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Re: Where to put bonds? IRA or taxable?
« Reply #7 on: February 10, 2015, 10:33:38 AM »
Bonds pay interest, but then bond funds distribute that interest as dividends, which will be qualified dividends if you meet the relevant requirements.

This is wrong.  The requirements for qualified dividends cannot be met by bond funds holding taxable bonds.  See:
https://advisors.vanguard.com/VGApp/iip/site/advisor/investments/taxcenter/yearendfigures
http://budgeting.thenest.com/bond-etfs-qualified-dividends-24564.html
http://individual.troweprice.com/public/Retail/Planning-&-Research/Tax-Planning/Prepare-Your-Taxes/Fund-Specific-Tax-and-Reclassification-Info/Qualified-Dividend-Income-Percentage

GGNoob

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Re: Where to put bonds? IRA or taxable?
« Reply #8 on: February 10, 2015, 10:36:28 AM »
Bonds pay interest, but then bond funds distribute that interest as dividends, which will be qualified dividends if you meet the relevant requirements.

Note, however, that a bond fund may also distribute capital gains, some of which may be short-term capital gains. Of course, a stock index fund can distribute capital gains as well, so that's not unique to a bond fund.

Bond funds do not distribute qualified dividends.

https://advisors.vanguard.com/VGApp/iip/site/advisor/investments/taxcenter/yearendfigures
Quote
Equity and balanced funds are likely to distribute QDI to shareholders; money market and bond funds will not distribute QDI.

Left

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Re: Where to put bonds? IRA or taxable?
« Reply #9 on: February 10, 2015, 10:51:43 AM »
I left mine in taxable. I want it to replace my job eventually, or part of it. I don't mind paying income tax while working, I don't mind doing it while retired when dividends get taxes.

Yeah, paying taxes suck, but I also kind of want to keep the US at least functioning, or do my part of it with taxes. If US goes under, well there goes ALL my retirement :S

frugalnacho

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Re: Where to put bonds? IRA or taxable?
« Reply #10 on: February 10, 2015, 10:53:27 AM »
Well it sounds like I would get penalized by holding bonds in a taxable account, where as the bonds in the IRA would grow tax deferred (and I anticipate them eventually being tax free as I slowly convert it via the roth pipeline).  I will get more growth in my taxable account with vtsax as opposed to bonds, but being below the 25% income bracket all that growth will be harvested and be tax free.

So bonds in my IRA, and VTSAX in my taxable account gives me the lowest taxes paid now and in the future.

frugalnacho

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Re: Where to put bonds? IRA or taxable?
« Reply #11 on: February 10, 2015, 11:00:53 AM »
I left mine in taxable. I want it to replace my job eventually, or part of it. I don't mind paying income tax while working, I don't mind doing it while retired when dividends get taxes.

Yeah, paying taxes suck, but I also kind of want to keep the US at least functioning, or do my part of it with taxes. If US goes under, well there goes ALL my retirement :S

My personal contribution to the US government is literally insignificant.   If the country collapses it will almost certainly not be because I tried to optimize and lower my tax bill.  Also fuck em, I would like to pay as little as possible even if my contribution did matter.

RapmasterD

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Re: Where to put bonds? IRA or taxable?
« Reply #12 on: February 11, 2015, 08:25:52 PM »
Bonds pay interest, but then bond funds distribute that interest as dividends, which will be qualified dividends if you meet the relevant requirements.

This is wrong.  The requirements for qualified dividends cannot be met by bond funds holding taxable bonds.  See:
https://advisors.vanguard.com/VGApp/iip/site/advisor/investments/taxcenter/yearendfigures
http://budgeting.thenest.com/bond-etfs-qualified-dividends-24564.html
http://individual.troweprice.com/public/Retail/Planning-&-Research/Tax-Planning/Prepare-Your-Taxes/Fund-Specific-Tax-and-Reclassification-Info/Qualified-Dividend-Income-Percentage

My statement was technically not wrong, since I said "if you meet the relevant requirements". What you are saying is that my statement was vacuous, not that it was wrong. :P

<<The tables below show the percentages of 2014 dividend and net short-term capital gains distributions, by Vanguard fund and share class, that are eligible for reduced tax rates as "qualified dividend income" (QDI) under the Jobs and Growth Tax Relief Reconciliation Act of 2003. Equity and balanced funds are likely to distribute QDI to shareholders; money market and bond funds will not distribute QDI.>>

I figured this out at the beginning of the year. For 2015 I anticipate saving approximately $6,000 in income taxes because I moved the Vanguard BND ETF into tax deferred accounts.

SOURCE: https://advisors.vanguard.com/VGApp/iip/site/advisor/investments/taxcenter/yearendfigures

beltim

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Re: Where to put bonds? IRA or taxable?
« Reply #13 on: February 11, 2015, 08:36:02 PM »
The fact that Vanguard bond funds don't distribute qualified dividends is because the funds are structured as shares of a trust. If they were structured as a corporation, the distributions could be qualified dividend income.

No, this is still false.  Bonds can't distribute qualified dividends, because they don't distribute dividends.  Distributions from a bond fund are interest income, not dividend income.  See the 3 links I had earlier.

Unless you're trying to argue that you could set up a business that simply owned bonds, and that corporation issued dividends.  The problem with that is that interest income to corporations is taxable, and then the company itself would pay income taxes.  Unless you structured it as a partnership, in which case the interest income would flow through to every partner on a K-1.

There is no case that bond interest can be considered a qualified dividend.

beltim

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Re: Where to put bonds? IRA or taxable?
« Reply #14 on: February 11, 2015, 08:42:43 PM »
Again, it is not false. As you point out, nothing stops you from setting up a corporation that owns bonds and then distributing that income as dividends. Whether that saves you money is irrelevant to whether the dividends are qualified dividends.

Also, as a side note, in Canada, some mutual funds actually are set up that way, although I don't think anyone does it in the USA.

No, no one does it that way in the US, because it would be more expensive than a mutual fund or ETF.

RWD

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Re: Where to put bonds? IRA or taxable?
« Reply #15 on: February 11, 2015, 08:54:19 PM »
holyhell, how do I make that link less horrible?

Link

You can choose different text for the link than the url itself like this:
Code: [Select]
[url=http://www.example.com]Example Text[/url]

johnny847

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Re: Where to put bonds? IRA or taxable?
« Reply #16 on: February 11, 2015, 09:16:12 PM »
Personally, I would not put bonds in a Roth IRA. I would want my Roth in all stocks and/or higher risk stocks to hopefully get a higher return tax free at retirement. So my preference would be bonds in a taxable account or a tax-deferred IRA or 401k.
This argument for not putting bonds in a Roth IRA and favoring a traditional IRA sounds good on the surface. However, if you were to actually use tax-adjusted asset allocation, all of this goes away http://thefinancebuff.com/stocks-or-bonds-in-roth.html.

Now obviously, it's hard to predict what your tax rate on withdrawals will be in practice. But this whole avoid bonds in Roth if possible thing is not actually a thing.