Author Topic: Which account to buy bonds?  (Read 1257 times)

Southeast

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Which account to buy bonds?
« on: February 01, 2020, 01:01:34 PM »
Hello,

This may be a very elementary question with an obvious answer, but I would appreciate some clarity.
If you were to adjust your asset allocation from 100 percent stocks to 70/30 stocks/bonds, and you had both a taxable account and a tax advantaged account (401k), do you create that 70/30 allocation in both accounts?

Or would you possibly have different allocations between the accounts but with the overall allocation being 70/30?

Thank you!

terran

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Re: Which account to buy bonds?
« Reply #1 on: February 01, 2020, 01:15:00 PM »
Bond interest is taxed at ordinary income tax rates while most of the dividends from stock investments are taxed at lower long term capital gain rates, so keeping the bonds in tax advantaged would be preferable. See https://www.bogleheads.org/wiki/Tax-efficient_fund_placement for more.

Southeast

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Re: Which account to buy bonds?
« Reply #2 on: February 01, 2020, 01:37:48 PM »
Thank you!

Lucky13

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Re: Which account to buy bonds?
« Reply #3 on: February 01, 2020, 01:50:38 PM »
Holding bonds is a taxable account is worse from a tax optimization perspective. But if you get this "wrong" it's not the end of the world (on the order of a 0.5% tax drag). And some financial pros even recommend to keep the same asset allocation in all accounts, to simplify rebalancing. https://www.youtube.com/watch?v=vTFP36EfZa0  Search on "asset location" for more details and good luck!

Southeast

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Re: Which account to buy bonds?
« Reply #4 on: February 01, 2020, 10:29:09 PM »
Thanks Lucky13! That was interesting and well explained.

MustacheAndaHalf

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Re: Which account to buy bonds?
« Reply #5 on: February 02, 2020, 01:14:18 AM »
Take a look at tax-exempt bond funds before you decide.  Starting out, I might go with 70/30 in both accounts (tax-exempt bond funds in taxable).  It makes thinking about it easier, and less complicated when you rebalance.

You didn't say where you're investing, but you can buy ETFs anywhere.  So Vanguard Tax-Exempt Bond ETF (VTEB) could be bought at Schwab, Fidelity or Vanguard in your taxable account.

beltim

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Re: Which account to buy bonds?
« Reply #6 on: February 02, 2020, 02:58:02 AM »
It turns out the answer is neither elementary nor obvious.  Basically, it depends on your personal financial situation in terms of current and future tax rates, along with the future returns of both stocks and bonds.  Terran provides a good link to get started, but make sure you read the "Criticisms of this tax placement strategy" section on that page.

Some discussions we've previously had on this topic:
The ones you want to put in tax deferred accounts are ones that generate the most taxable events, like bonds, or high turnover funds.  Index funds with low turnover and low yields would be ideal in your taxable accounts.

Unfortunately it's not this simple.  The goal IS NOT to minimize taxes paid.  The goal is to maximize the after-tax dollar amount.  This depends on the return of the investment and the type of investment as well as the investor's current tax bracket, future tax brackets, and the particular retirement vehicles involved.

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.

Despite the nifty graphic on the Bogleheads site, the better advice is in the text, in particular the "tax efficiency of bonds" section.  Besides that, here's why I think bonds should not go in your tax advantaged accounts: the bond fund you're looking at, VBTLX, is nearly two thirds government (read: tax-free) bonds.  Why would you put tax-free bonds in a tax-deferred account?  Plus, consider the total amount of tax.  VBTLX is yielding ~2.2%.  Let's say half of that is tax free (tax free bonds generally yield less than taxable bonds).  So only 1.1% is taxable, so the maximum tax per year is about 0.4%.

Now compare that to stocks.  Profits from stocks held in a taxable account can be taxed from 0% (qualified dividends at certain tax brackets) to about 43.4% (short term capital gains in the highest tax brackets).  If you estimate 8% annual returns (including inflation, since cost basis is not indexed for inflation), and assume that most people will realize long term capital gains at the 15% rate, then the annual tax cost is .15*.08 = 1.2%.

Since 1.2% is larger than 0.4%, the average tax bill for stocks is much higher than the maximum tax bill for bonds.  To minimize taxes, then, stocks belong in tax-advantaged accounts.

TomTX

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Re: Which account to buy bonds?
« Reply #7 on: February 02, 2020, 07:01:13 AM »
And some financial pros even recommend to keep the same asset allocation in all accounts, to simplify rebalancing.

How does that simplify rebalancing? It requires you have transactions in all accounts every time.

Let's say you have $100k in an IRA and $100k in taxable. Your desired asset allocation is 75:25.

IRA: $50k bonds, $50k stocks
Taxable: $100k stocks

Lets say the stock market goes up 20%, bonds stay flat:

IRA: $50k bonds, $60k stocks
Taxable $120k stocks.

Within the IRA, you convert $7.5k from stocks to bonds. Done with a single transaction.

If you did rebalancing per-account, you need to to two transactions.

As a point of reference, between the wife and I we have 8 investment accounts with no real way to consolidate.
« Last Edit: February 02, 2020, 08:02:33 AM by TomTX »

Southeast

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Re: Which account to buy bonds?
« Reply #8 on: February 02, 2020, 08:38:52 AM »
It turns out the answer is neither elementary nor obvious.  Basically, it depends on your personal financial situation in terms of current and future tax rates, along with the future returns of both stocks and bonds.  Terran provides a good link to get started, but make sure you read the "Criticisms of this tax placement strategy" section on that page.

Thanks beltim for listing all of those previous posts concerning the topic.

Lucky13

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Re: Which account to buy bonds?
« Reply #9 on: February 04, 2020, 05:20:22 PM »
And some financial pros even recommend to keep the same asset allocation in all accounts, to simplify rebalancing.

How does that simplify rebalancing? It requires you have transactions in all accounts every time.

Let's say you have $100k in an IRA and $100k in taxable. Your desired asset allocation is 75:25.

IRA: $50k bonds, $50k stocks
Taxable: $100k stocks

Lets say the stock market goes up 20%, bonds stay flat:

IRA: $50k bonds, $60k stocks
Taxable $120k stocks.

Within the IRA, you convert $7.5k from stocks to bonds. Done with a single transaction.

If you did rebalancing per-account, you need to to two transactions.

As a point of reference, between the wife and I we have 8 investment accounts with no real way to consolidate.

HI Tom, yes you're right it's possible to construct an example that proves your point. It's also possible to construct an example that proves my point. :D for example consider the common case where an investor will be contributing monthly to his/her 401K plan through work. if the asset allocation in that account is different than the AA in their taxable account, they may will need to rebalance (depending on how "out of balance" they want to be before rebalancing). But if the AA in all accounts is the same, then contributions to the 401k can go in already "balanced" so to speak.  Same scenario applies when this investor's 401K is "maxed" for the year and they then start contributing to the taxable account. Basically if the AA is not the same in all accounts, contributing into one account only, which is a common scenario, will throw off the AA. Just something to consider.

TomTX

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Re: Which account to buy bonds?
« Reply #10 on: February 08, 2020, 01:47:40 PM »
And some financial pros even recommend to keep the same asset allocation in all accounts, to simplify rebalancing.

How does that simplify rebalancing? It requires you have transactions in all accounts every time.

Let's say you have $100k in an IRA and $100k in taxable. Your desired asset allocation is 75:25.

IRA: $50k bonds, $50k stocks
Taxable: $100k stocks

Lets say the stock market goes up 20%, bonds stay flat:

IRA: $50k bonds, $60k stocks
Taxable $120k stocks.

Within the IRA, you convert $7.5k from stocks to bonds. Done with a single transaction.

If you did rebalancing per-account, you need to to two transactions.

As a point of reference, between the wife and I we have 8 investment accounts with no real way to consolidate.

HI Tom, yes you're right it's possible to construct an example that proves your point. It's also possible to construct an example that proves my point. :D for example consider the common case where an investor will be contributing monthly to his/her 401K plan through work. if the asset allocation in that account is different than the AA in their taxable account, they may will need to rebalance (depending on how "out of balance" they want to be before rebalancing). But if the AA in all accounts is the same, then contributions to the 401k can go in already "balanced" so to speak.  Same scenario applies when this investor's 401K is "maxed" for the year and they then start contributing to the taxable account. Basically if the AA is not the same in all accounts, contributing into one account only, which is a common scenario, will throw off the AA. Just something to consider.

That explanation isn't making any sense to me. It still requires rebalancing more accounts. Just have the 401k auto-contribute at your preferred AA ratio. Both accounts will skew over time, but you still only need to rebalance using one of them.


MustacheAndaHalf

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Re: Which account to buy bonds?
« Reply #11 on: February 09, 2020, 08:26:07 PM »
Just to give an exaggerated example, start with all stocks in taxable and all bonds in an IRA.  Stocks tend to outgrow bonds, which means rebalancing by selling stocks in taxable - and buying bonds in taxable.  Even though taxable started by holding all stocks, it won't end up that way.

I progressed from equal allocations to a spreadsheet that let me track more complicated allocations.  I favor slower growing bonds in my Traditional IRA, because the slower growth means less taxes when I convert to Roth IRA.  In turn, my Roth IRA has more stocks since they'll never be taxed again.  And then I hold stocks and tax-exempt bonds in taxable.

Sometimes I rebalance in taxable, other times I rebalance in tax-advantaged accounts.  Using a spreadsheet lets me know how much I need to buy or sell of each asset class, regardless of which account(s) I use to rebalance.