Asset Location: Do Bonds Really Belong in Retirement Accounts? – SWR Series Part 35

Welcome back to another installment of the Safe Withdrawal Rate Series. This one is about taxes. Amazing, how after 30+ installments in the series, I have written conspicuously little about taxes. Sure, I’ve done some Case Studies where, among many other issues, I delved into the tax planning, most recently in the Case Study for Becky and Stephen. But I’ve never written much about taxes and tax planning in the context of the Series.

There are two reasons why I kept the tax discussion on such a low burner: First, my background: If I had an accounting Ph.D. and CPA instead of an economics Ph.D. and a CFA charter, I would have written a whole lot more about taxes! Second, pinning down the Safe Withdrawal strategy and the safe withdrawal rate is my main concern. Most (early) retirees will have extremely low tax liabilities as I outlined in a post last year. You’d have to try pretty hard to pay more than a 5% federal effective tax rate in retirement. So, as long as you stay away from anything clearly irresponsible on the tax planning side, you’re fine. Don’t stress out over taxes in retirement unless you have a really, really large nest egg and taxable income deep into the six-figures during retirement.

But you don’t want to leave any money on the table either. So, I still want to write about taxes if I encounter something that captures my attention. And I came across a topic that’s most definitely interesting from a withdrawal strategy perspective: Asset Location (as opposed to Asset Allocation).

Imagine you target a particular asset allocation, say 60% stocks and 40% bonds. Or 70/30, or 80/20, or whatever suits your needs the best. How should we allocate that across the different account types? If we put all the different accounts into three major buckets…

1. Taxable, i.e., your standard taxable brokerage account: Interest, dividends and realized capital gains are taxable every year they show up on your 1099 tax form. But you don’t have to pay taxes on capital gains until you realize them.
2. Tax-deferred, i.e., your 401(k) or your Traditional IRA. Your account grows tax-free until you actually withdraw the money (or roll it over to a Roth). So, so can realize as much in interest income, dividends, capital gains along the way, as long as you keep the money inside the account.
3. Tax-free, i.e., your Roth IRA or your HSA. The money grows tax-free and you can withdraw tax-free as well.

… then where do we put our bonds and where do we put our stocks? It would be easy, though likely not optimal to simply keep that same asset allocation in all three types of accounts. But is there a better way to allocate your stock vs. bond allocation?

Sure, there is! One of the oldest pieces of “conventional wisdom” investment advice I can remember is this:

“Keep stocks in a taxable account and bonds in your tax-advantaged accounts.”

Or more generally:

“Keep the relatively tax-efficient investments in a taxable account and relatively tax-inefficient investments in a tax-advantaged account.”

Most stocks would be considered more tax-efficient than bonds because a) dividends and capital gains are taxed at a lower rate than interest income and b) you can defer capital gains until you actually withdraw your money, which is a huge tax-advantage (more on that later).

So, it appears that we should ideally load up the taxable account with stocks and the tax-advantaged accounts with bonds. Hmmm, but that doesn’t sound quite right, does it? Why would I want to “waste” the limited shelf space I have in my tax-advantaged accounts with low-return bonds while I expose my high-return stocks to dividend and capital gains taxes? So, it would be completely rational to be skeptical about this common-sense advice!

So who’s right? Conventional wisdom or the skeptics? Long story short: they’re both wrong! You can easily construct examples where either conventional wisdom or the skeptics prevail. So neither side should claim that their recommendation is universally applicable. The asset location decision depends on…

1. Your expected rates of return,
2. Your expected tax rates,
3. Your investment horizon. Yup, you heard that right, it’s possible that you want to go either one way or the other depending on the horizon. Though, this is not really a separate case but really only a result of asset allocation drift. Accounting for that, we’re back to the two cases, but more on that later!

Let’s look at the details…

Before we even jump into weeds here, let’s just cover a few Tax 101 and Tax 102 topics:

Tax 101: Tax-efficient vs tax-inefficient assets

Tax-efficient assets:

• Stocks, Mutual Funds, ETFs (especially with low dividend yield). Ideally, index funds with very little turnover and zero or very small capital gains distributions
• Municipal Bonds and mutual funds and ETFs investing in them
• Real Estate (most of the time)
• Section 1256 contracts: options, futures, options on futures. (caveat: they are still tax-inefficient in absolute terms but tax-efficient relative to non-1256 derivatives contracts)

Tax-inefficient assets:

• REITs, because their dividends are taxed as ordinary income
• Taxable bonds, because interest is taxed at the personal income tax rate
• Stocks with a high dividend yield (incl., high-dividend yield stock ETFs, replicating, for example, the Dividend Aristocrats Strategy, etc.). This is mostly an inefficiency if you plan to reinvest the dividends in the accumulation phase and less of a problem in the withdrawal phase when you intend to live off your dividends.
• Mutual funds and ETFs that are actively managed, creating a lot of turnover and taxable capital gains along the way. Too much turnover and short holding periods may also create a higher portion of your dividend income falling into the non-qualified category.
• Target Date Funds, even if they are based on index funds (e.g., the Fidelity Freedom Index or Vanguard class of TDFs). Not only will they hold tax-inefficient asset classes (bonds, sometimes REITs) but the target weights of the assets change over the years (by definition) and even in the short-term, the funds are regularly rebalanced back to their target weights. Turnover creates taxable events and tax-inefficiency.
• Single-stock options trading strategies (covered-calls, naked puts, short straddles/strangles, Iron Condor, etc.)

And to mention it again, notice that efficiency vs. inefficiency is never a 0/1 thing. This is about relative efficiency. Again, the prime example is that in absolute terms, Section 1256 contracts are still tax-inefficient. But they are more efficient than the single stock options. Also, notice that there’s some overlap: Some Target Date Funds also use actively-managed funds (Fidelity Freedom, i.e., without the “Index” in the name), so please don’t interpret this list as mutually exclusive (nor exhaustive!!!).

Tax 102: The power of deferring capital gains!

Stocks are a (relatively) tax-efficient asset class because dividends and capital gains are taxed at lower rates than interest income. But stocks also have an additional, equally important benefit. You pay taxes on the capital gains only when you realize them. (A caveat: there are now some proposals in Washington, D.C. to change that and force you to pay taxes on gains every year. Let’s hope that this nonsense never passes!)

So, this is not exactly tax-avoidance, but tax timing. Paying capital gains taxes only once in the end rather than over time has a crucial benefit. Let’s go through a really simple example to illustrate this. Imagine you have an initial investment and you achieve a 50% return in year 1 and another 50% return in year 2. Yeah, yeah, I know that seems excessive but I like to show this tax advantage through a visual aid and in order to see this better in the diagrams, let’s take large round numbers!

Also, assume that the tax rate on capital gains is 50% (a large round number again for the same reason). So, deferring capital gains works just like in the diagram below:

• You first grow your portfolio by 50% in year 1, so you now own this rectangle comprised of the blue square plus the green rectangle on the right.
• The year 2 returns are added along the vertical axis. Again, you grow your rectangle by 50%, going up.
• After year 2, you pay the capital gains taxes and you’re left with the blue square plus the two (smaller) green bars on the right. Notice that you don’t owe any money on your cost basis, so you only lose half of the green area to the tax-man (or woman).

(a side note: If you’re so very troubled by the 50% return you can also interpret this as the first period lasting 5 years with an average compound return of 8.45% for a total of 50% and the second period as the same length again)

How about if we realize capital gains along the way. Let’s look at the diagram below.

• After year 1, we pay our taxes and then reinvest the balance.
• In year 2, we add capital gains again by extending the rectangle along the vertical axis.
• And we pay capital gains taxes on that new gain. But not on the year 1 gain because that’s already after-tax and added to the cost basis!

At first glance, the after-tax return looks exactly identical to the deferral case. But there is one difference. You lose that one little square marked in the chart above. And that’s because taxes in the first year reduce the amount you have invested in the market. And this loss, this drag from taxes if you get taxed every year along the way will compound over the years. It could make a significant difference over the years!

Compounding is a beautiful thing. Compounding losses due to the tax drag isn’t!

So, the lesson so far: It’s tax-efficient to buy-and-hold stocks in taxable accounts. There is a (small) drag from having to pay taxes on dividends every year but a) the dividend yield is often relatively small compared to capital gains and b) the tax on dividends is also smaller than the ordinary income tax rate.

But notice how a bond portfolio in a taxable account gets hit by this compounding of taxes. That’s probably the main rationale for that conventional wisdom “stocks in taxable, bonds in retirement accounts,” which brings us to the main topic for today…

Asset Location: taxable vs. tax-advantaged accounts

Let’s calculate the pros and cons of the different asset location strategies.  Consider an investor with the following parameters:

• A taxable account and a Roth IRA, each with a $100 account balance (scale it to any value that you like!)
• The retiree has a 50% Stock, 50% Bond target overall.
• In the taxable account, dividends and interest will be taxed every year. Both after-tax-dividends and after-tax interest are reinvested in the same asset class that it came from.
• If stocks are in the taxable account, we keep track of the cost basis (initial investment plus all the after-tax-dividend reinvestments over time) and we pay capital gains taxes at the end of the horizon.

(Side note: what happens if you have a Traditional IRA or 401k account instead of the Roth IRA? In this simple example with a flat ordinary income tax, the pros and cons for investing in taxable vs. retirement accounts are the same if you simply re-interpret your 401k account valued at $X as a Roth IRA worth $X*(1-T) where T is the tax rate on ordinary income. Without loss of generality, I just assume that the investor has only one taxable and one Roth account.)

To calculate all the pertinent numbers here’s a Google Sheet

—> Link to Asset Location Google Sheet <—

As always: This is a clean copy posted on the web for everyone’s reference. Hence, I cannot give permission to edit this sheet. Please save your own copy if you like to enter your own parameters: Menu: File->Make a copy

You can enter your own parameters in the orange fields. All other fields are calculated!

Let’s look at the three different cases

Case 1: Conventional wisdom prevails – Stocks belong in the taxable account!

• Stock expected returns are 8% p.a., of which 2% come from dividends and 6% from capital gains
• Bond returns are 5% p.a. (I know this seems high, but there are some bond funds with a yield that high! I’ve seen some Preferred Shares with dividend yields around 8%, paid as ordinary income/interest. Also, we may eventually leave the current low-yield environment and return to more reasonable bond yields, even for government and investment-grade corporate bonds).
• Tax rates are 5% for dividends and capital gains and 17% for ordinary income. This would be an individual who’s in the second federal tax bracket (currently 12%), still within the 0% bracket for long-term capital gains and qualified dividends but also faces a 5% flat tax on the state level.
• A horizon of 20 years.

Let’s look at the results, in the table below.

• Loading up on stocks in the taxable account gets you $709.29 after 20 years. That’s a bit more than the $691.62 from investing the Roth in stocks. The after-tax IRR is 6.53% vs. 6.40%. It doesn’t look like a huge difference, but 0.13% (13 basis points) is nothing to sneeze at. Considering how much hoopla people make out of few basis points between this index fund and that index fund…
• The reason for the outperformance of the “stocks in taxable” is very easy to pin down. Let’s look at the table right under the parameters: The After-Tax Value of $100 account value today. Stocks obviously outperform bonds in either account. But if we look at the ratio S/B, the outperformance is larger in the taxable account (1.9686 vs. 1.7567). Thus, stocks belong in the Taxable account!    (Note: to make this easier to spot the differences, I color-coded the relevant measures in red vs. green to mark the smaller vs. larger number!)
• We can also look at the opposite ratio: the ratio of investment outcomes Roth divided by Taxable. For stocks, you get a ratio of 1.049854 and for bonds 1.176523. So, by that measure, bonds belong in the Roth. Same result!
• The line of reasoning in the last two bullet points should sound familiar. If you’ve ever taken microeconomics and/or international economics: this is the concept of comparative advantage, i.e., the Ricardian model of international trade. Actually, not just international trade, but any trade. And here’s an example where one asset has an absolute advantage over the other in both accounts ($443.96>$225.52 and $466.10>$265.33), but stocks have the comparative advantage over bonds in the taxable account, and bonds have a comparative advantage over stocks in the Roth IRA. Sorry, this may sound like jibberish, but as an economist, I couldn’t resist pointing that out! 🙂
• A similar route of showing the comparative advantage is to look at the after-tax IRRs. In the taxable account, stocks have a roughly 3.6% return advantage but only a 3.0% advantage in the Roth. Likewise, bonds get a 0.85% return boost in the Roth but stocks only 0.26%! Same story here: Stocks belong in the taxable account!

Also, I like to quickly confirm that this result is really independent of the time horizon. Let’s look at the chart that plots the time series of the “stocks in Roth” advantage over “stocks in taxable” and no matter what your horizon is whether 1 year or 30, Stocks in the Roth will always be worse than Stocks in the Taxable. And the effect increases over time. (but note an important caveat, please see below)

So, summary thus far: conventional wisdom prevails in this example. The rationale of this has to do with the Tax 102 lesson above. You want to keep the compounding of taxes low. Because stock dividends are taxed a rate of only 5% you keep the compounding of the tax drag relatively small. Much smaller than a 17% tax on 5% interest every year. Even the fact that capital gains are taxed once at the end at 5% cannot reverse this math.

Case 2: Conventional wisdom fails – Stocks belong in the tax-advantaged account!

And, you guessed it, here’s an example where bonds should be in the taxable account. Let’s assume the same parameters as above, but we lower the bond yield to 2% and raise the tax rates to 15% for dividends and capital gains and 33% for ordinary income.

All the results are reversed now:

• After 20 years, you’ll get to $596.60 with stocks in the Roth and $549.63 with stocks in the taxable account (all after-tax). That’s a very large impact in the IRR (5.62% vs. 5.18%).
• And that result is perfectly intuitive because stocks do have a comparative advantage in the Roth (3.136691 vs. 3.072983).
• And you can also quickly confirm that this result is robust over different time horizons one through 30 years (chart not displayed here in the post).

So, what’s going on here. It’s pretty obvious, the bond yield is so low that even with the significant tax rate (33%) the drag on the bond portfolio in the taxable account is relatively low (0.66%). You’d actually have more tax drag from stocks in the taxable portfolio (0.8089%) than from bonds.

So, hands-down here’s an example where conventional wisdom fails you!

Case 3: Depends on the horizon!

Next, let’s look at the one really peculiar case. Let’s take the same parameters as above in case 2 but make two changes: 1) increase the bond yield to 5% again and raise the investment horizon to 30 years. The results are in the screenshot below. And they are really confusing!!!

• The comparative advantage calculations point to placing stocks in the taxable portfolio: And it’s not even close! 3.085604 vs. 2.328272 in the S/B ratio for the taxable vs. Roth IRA, respectively.
• And yet, after 30 years, putting stocks in the Roth slightly outperforms the Stocks in taxable case!

If that’s not confusing yet, let’s look at the time series chart for the “Stocks in Roth advantage” – see below. The comparative advantage calculations are indeed consistent with the final portfolio values if your horizon is between one and 25 years. But after that, you cross the zero line and stocks in the Roth are better again. What’s going on here???

Well, here’s an explanation for this phenomenon: Drift in the asset allocation! You see, here’s the final after-tax net worth that came from stocks:

• Stocks in taxable, Bonds in Roth: 65.74%
• Stocks in Roth, Bonds in taxable: 78.92%

So, it’s no wonder you outperform loading up on stocks in the Roth: You had much higher (after-tax) exposure to stocks and thus also much higher (after-tax) stock risk along the way. So, if we compare 100% Stocks in taxable plus 100% in the Roth with 100% Stocks in the Roth plus 100% bonds in the taxable, we’re really comparing apples and oranges. The two portfolios drift apart over time if measured by their (after-tax) asset allocation and that explains why you get these counterintuitive results.

So, how do we account for the asset allocation drift? Two potential methods come to mind:

First, when we start with stocks in the Roth, I could periodically adjust the Roth allocation to keep the true after-tax allocation in-line with the other setup (stocks in the taxable). This would mean that we slowly shift from stocks to bonds in the Roth, which we can do without tax consequences!

Second, and this is the method I will use here in the Google Sheet because it feels a lot more intuitive and it’s easier to calculate as well. The results for this method are in the Google Sheet in a table to the right of the main results. It goes through the following thought experiment:

• Let’s start with a 50/50 asset allocation in both accounts and assume that we don’t rebalance the portfolio, so dividends and interest are reinvested (after paying taxes) in that same asset class. Notice that due to the different average returns, you still get the drift toward a stock portfolio and end up with 72.37% from stocks in the final value ($917.73 out of $1,268.19). Not a bad idea, because remember, I showed that a glidepath shifting out of bonds into stocks (relatively) is a partial hedge against Sequence Risk (see SWR Series Part 19 and Part 20).
• Next, we move to the middle panel, where we shift the entire taxable account into stocks, but in the Roth, we keep $8.80 in stocks and invest only $91.20 in bonds. How did I pick that number? I want to keep the final after-tax value due to stocks constant at $917.73. Since the taxable portfolio growth is hampered by the tax drag on the dividends, I have to set aside a small stock share in the Roth to compensate!
• We could also do the opposite, i.e., move to the panel on the right where I go to 100% bonds in the taxable account. If I do so, I want to invest slightly less than $100 in stocks in the Roth, again to exactly target the $917.73 in final net wroth coming from stocks. That’s because the Roth IRA with its tax advantage will generate much faster growth, so to account for the asset allocation drift, I’d have to invest 91.20%/8.80% in stocks/bonds.
• Also, I included the outcomes of the 100/0/0/100 and 0/100/100/0 approach again in the bottom panels in the middle and on the right, for comparison.
• The outcome in this particular example is that it’s optimal to go 100% in the taxable account and 8.8%/91.2% in the Roth: $1,311.90 final after-tax portfolio value. That even beats the 100% stocks in the Roth plus 100% bonds in the taxable setup the optimal strategy when looking only at the corner solutions with 100% or 0% allocations. And you beat the 0%/100%/100%/0% even though you have a lower share of final net worth coming from stocks!

So, long story short: accounting for asset allocation drift, it’s optimal to invest the taxable account in stocks, if you also allocate a small share of the Roth to stocks to compensate for the tax drag in the taxable account!

Revisiting Case 2: How much of the “Stocks in Roth” advantage is really due to asset allocation drift?

Let’s revisit Case 2 (where stocks belong in the Roth IRA). That scenario generated a $596.60 final value, much better than the stocks in the taxable case: $549.63. So, the “right” asset location will increase the final portfolio value by a pretty impressive 8.55% over 20 years. But how much of that is due to the better tax efficiency and how much comes from the asset allocation drift? Let’s answer that question with the same table as in case 3, see below. Changing the allocation to either 100%/0% or 0%/100% in the taxable account, while fixing the final equity value at $433.56 (the same it would have been in a 50/50 portfolio) through the “correct” allocation in the Roth will produce only a tiny difference. Sure, stocks still belong in the Roth but the advantage is tiny: $574.44 vs. $571.79, a gain of 0.46% over 20 years. So, before the proponents of the “stocks in the Roth” approach spike the football (sorry couldn’t help but use the football reference – congrats to the KC Chiefs for an awesome game last Sunday), keep in mind that out of the 8.55% advantage, really only 0.46% comes from the tax efficiency and the rest from the asset allocation drift.

How does this differ from the White Coat Investor analysis?

I’m not the first person to write about this topic. Most inspiring and informative was the exhaustive discussion on Dr. Dahle’s White Coat Investor blog:

• “Asset Location – Bonds Go In Taxable!” (2014)
• “My Two Asset Location Pet Peeves” (2016)
• “Six Principles of Asset Location” (2019)

WCI and I clearly agree on the following points:

1: “Stocks in taxable, bonds in retirement account” is not a universally optimal strategy.

2: If assets have very similar expected returns then sure, the tax-efficient asset goes in the taxable account and the tax-inefficient asset belongs in the Roth.

3: If you have a high-return, low-tax-efficiency asset, and a low-return, high-tax-efficiency asset then it’s a no-brainer: Put the former in the retirement account and latter in the taxable account.

4: If you are faced with a high-return, high-tax-efficient asset, and a low-return, low-tax-efficiency asset it gets more complicated. The pros and cons crucially depend on tax rates and – very importantly – on the expected returns!

5: Careful with asset allocation across different account types: $100 in stocks in a Roth and $100 in bonds in a 401k may give you a higher expected final after-tax net worth than $100 bonds in a Roth and $100 stocks in the 401k. But there’s no free lunch here! You have to factor in the tax implications! Your $100 in a 401k is worth only $80 if you have a 20% tax rate. So, the different final results come entirely from a different (after-tax) asset allocation, not at all from tax-arbitrage!      (WCI Pet Peeve #2)

And here’s where we disagree:

1: Muni bonds don’t add much to the discussion if you do a proper apples-to-apples comparison, i.e., Munis vs. taxable bonds with similar duration, default and prepayment risks. More on that below.

2: While I agree that different expected returns impact the asset location decision, we have to separate the effects of pure tax arbitrage and asset allocation drift. Not doing so will give you nonsensical results (see case 3 above, identical to one of the WCI case studies!). In that sense, WCI commits the exact mistake he laments in his Pet Peeve #2 (“Thinking That Locating Higher Expected Return Asset Classes into Tax-free Accounts is A Free Lunch”). If you notice, every single one of WCI’s simulations is of the form either 100% or 0% of one asset in the Roth and the opposite in the taxable account. But that’s ignoring the fact the $100 of assets in a taxable account are a very different animal from $100 in a Roth.

Admittedly, the “conversion” of nominal asset value into “true” tax-adjusted asset value is a little bit harder than in the Roth vs. 401k comparison, where you just apply a haircut equal to the marginal ordinary tax rate to the tax-deferred account. But there is a haircut to be applied to the taxable account and it depends not just on tax rates but also expected returns and the horizon.

But just because the haircut is more complicated to calculate doesn’t mean we can all pretend it’s not there! In my Google Sheet, I calculate that conversion factor. Here’s the calculation for Case 3, please see the chart and table below.

• As you can see, $100 of assets in a 401k/Traditional IRA are worth only $67 due to the 33% marginal tax rate. That’s simple! It’s independent of the asset class, expected returns or the time horizon. Everybody should be on board with that one!
• We can do the same conversion for the taxable account. This is calculated by scaling the after-tax final portfolio values to Roth=$100. Notice that $100 in stocks in a taxable account is worth only about $82.40 after accounting for the tax drag. That’s why we can’t compare a 100/0/0/100 allocation with a 0/100/100/0 portfolio. We can compare a 100% stocks in taxable plus 8.8% stocks in and 91.2% bonds in the Roth with a 100% bonds in the taxable plus 91.2% stocks and 8.8% bonds in the Roth, because they both have the same after-tax exposure to stocks, using the conversion factors below.
• And again, really rubbing it in here, notice how the haircut for stocks in the taxable account is less than for bonds. That means stocks belong in the taxable. And 100% stocks in taxable plus 8.8%/91.2% allocation in the Roth gives you the highest final after-tax value.

How about Muni Bonds? A Red Herring!

Another potential reason to put bonds in the taxable portfolio: Municipal Bonds (“Munis”) offer tax-free income. Of course, there’s no free lunch: the tax-efficiency is already baked into the muni bond price (and hence the yield). So, if your taxable bond fund has a yield of x% then expect your tax-free bond fund to yield roughly x*(1-t)% and the implicit tax rate t would be somewhere around the tax rate of the typical marginal muni bond investor, which is someone in the top or at least top-two federal income tax brackets (35-37%).

For example, White Coat Investor runs his calculations once with a 2.69% taxable yield and 2.16% Muni yield and once with a 5% taxable yield and 4% Muni yield. Uhm, unfortunately, that’s unrealistic. Each case would imply only a 20% implicit tax rate. I’ve talked to some of my buddies who still work in the industry and specifically in the Muni bond sector and they confirmed that this is impossible. A 4% Muni bond would likely have risk characteristics (duration risk, default risk, prepayment risk, etc.) of a 6+% taxable bond. Comparing a 4% Muni bond in the taxable account with a 5% taxable bond in the Roth IRA is like comparing apples and oranges. Markets are not that wildly inefficient! If there is a non-arbitrage condition in the bond market and if you’re in the highest tax bracket you’re roughly indifferent between the two instruments. And if you happen to be a tax bracket below the top one then the Muni route would even worsen the result for the “bonds in taxable” route!

Still not convinced? Let’s put some data out here: On bloomberg.com you can get Treasury and Muni yields, please see the table below. Over 1 to 5-year maturities, you can indeed see that Munis have a roughly 40% marginal tax rate built-in. Much higher than the 20% used by WCI and much more in line with the top tax rates. That implicit tax rate goes down when you look at longer horizons but that’s easily explained by noting that long-term Munis have a much lower credit quality than Treasury Bonds. Over relatively short horizons, nobody really expects Muni defaults now, but over longer horizons, that’s definitely in the cards! Looking at you, Illinois and New Jersey!

So, people can always come up with whacky examples like, hey, the Vanguard Muni Bond ETF (VTEB) yield of 2.3% is almost as high as the Total Bond Market ETF (BND) at 2.72%, but that’s comparing apples and oranges! Look at the maturities (much longer in the VTEB) and the credit ratings (lower in the VTEB) and that explains why the yield is so high. I’m only waiting for someone to point out that Munis actually have higher yields than taxable bonds: Look at the Nuveen NMZ: 4.9% distribution rate, vs. the 1.5% yield in Treasuries! Unfortunately, the NMZ is also a highly speculative, leveraged closed-end fund.

So, long story short: Muni bonds are a complete red herring in the context of these calculations here!

Some additional caveats

Just for the record:

• With volatile asset returns, one could make an additional case for stocks in the taxable accounts not properly accounted for in my calculations here: Tax-Loss Harvesting.
• Most retirees will already have large equity positions in their taxable account(s) with large built-in gains. Even if they wanted to hold bonds in the taxable account and stocks in the Roth, it would be too costly to first liquidate all the stock holdings in the taxable accounts. Another reason to keep stocks in the taxable account. Defer those gains in taxable accounts, see lesson 102 above!
• There’s another advantage of keeping stocks in the taxable account. If you die before running out of money you can leave your highly appreciated stock portfolio to your heirs and they get the so-called “step-up basis,” so they can walk up the cost basis of the inherited asset (not just stocks but also real estate) to the value at the time of your passing. It’s effectively setting the cap gains rate to zero. You still have the drag from the dividend taxation before you die but the step-up basis is a hugely powerful estate planning tool. I was reminded of that tax hack when my buddy Justin from RootOfGood.com started an interesting Twitter discussion over the weekend on the step-up basis. But caution: that step-up tax hack might go away if greedy politicians have their way. I wouldn’t want to rely on this being available in 30, 40 or even 50 years!
• In the calculations for case 1 (where stocks go in the taxable account)  I noticed that for a long enough horizon (51 years and longer), you get the same kind of reversal as in case 3. So, as long as your stock capital gains are taxed at a positive rate, it’s only a matter of time before the asset allocation drift will swing the pendulum in the favor of “Stocks in the Roth IRA” simply because the high-return assets grow the most there over time. But again, if you account for the asset allocation drift, the conventional wisdom prevails: Case 1 calls for stocks in the taxable account!

Conclusion

I almost feel sorry for writing such a long post to establish the really trivial insight that no asset location rule of thumb, neither the conventional wisdom (“stocks in taxable!”) nor skeptics claim (“stocks in Roth!”) can ever be universally optimal. You just look at the two extreme cases:

1. Stock returns are tax-free because you’re in the 0% bracket for dividends and capital gains on your federal return and you live in one of the tax-haven states without an income tax. Then, you’d obviously put bonds in the Roth and stocks in the taxable account!
2. Bond returns are very low or zero or even negative! Hey, it happened in Germany, Switzerland, Japan, etc. and might come to the U.S. eventually. Then you’d have to be crazy to put bonds in the Roth IRA!

And then all cases in between have to be carefully examined. The asset location advice has to be a lot more nuanced especially for the intra-asset-class location with very different expected returns. With today’s low yields, one could certainly make the case that bonds belong in the taxable account!

But I learned something new: Looking at the 100/0/0/100 and 0/100/100/0 corner solutions isn’t very informative in this context. I have provided a few more intuitive and more consistent calculations to weigh the tradeoff. And it all goes back to comparative advantage, how amazing is that???

And how much money can you squeeze out of this tax arbitrage? Not very much if you account for the asset allocation drift. That’s why I write so little about tax issues. But this one was certainly an interesting topic!

Thanks for stopping by today! Please leave your comments and suggestions below! Also, make sure you check out the other parts of the series, see here for a guide to the different parts so far!

Title Picture Source: Pixabay.com