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…

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

How much can we earn in retirement without paying federal income taxes?

Update 11/22/2019: After I published a shorter version of this piece on MarketWatch and the story was picked up by YahooFinance as well I got a lot more readers! Thanks and welcome to my blog! Make sure you subscribe to be notified of future blog posts! Both on Yahoo and MarketWatch I saw the expected assortment of hate comments. They fall into two categories, see below plus my response:

  • “I’m a CPA and this doesn’t make any sense!” My response: You’re either not a CPA at all or you’re a really bad & incompetent one. The standard deduction and the 0% bracket for capital gains are all very well-known in the financial/tax planner community. The same goes for the taxability worksheet for Social Security.
  • “How unfair that you retired already and don’t pay taxes while I’m working so hard and pay a lot of taxes!” My response: I hear ya! I’ve paid a ton of taxes throughout my work life. A seven-figure sum, more than most people pay over their entire lifetime. Keep that in mind if you complain about the unfairness of the U.S. federal tax system!

* * *

The question “how much can we earn without paying federal income taxes” is relatively easy to answer for most people. The standard deduction for a married couple is $24,400 in 2019 (if both are under 65 years old) and the top of the no-tax bracket for capital gains is $78,750. So, we can make a total of $103,150 per year, provided that our ordinary income stays below the standard deduction and the rest (2nd bracket + any leftover from the std. deduction) comes from long-term capital gains and/or qualified dividends. With our daughter, we also qualify for the child tax credit ($2,000 p.a.), so we could actually generate another $13,333 per year in dividends or capital gains, taxed at a 15% so that the tax liability of $2,000 exactly offsets the tax credit for a zero federal tax bill.

Once people file for Social Security benefits, though, things become a bit more complicated. That’s due to the convoluted formula used to determine how much of your Social Security is counted as taxable income, see last week’s blog post! So, calculating and plotting the tax-free income limits is a tad more complicated. Oh, and talking about tax planning in retirement: as promised, I will also go through an update on the Roth Conversion strategy for the Becky and Stephen case study from two weeks ago.

Let’s get started…

Continue reading “How much can we earn in retirement without paying federal income taxes?”

Taxation of Social Security: The Tax Torpedo & Roth Conversion Tightrope

I was always working under the assumption that once we claim Social Security, 85% of our benefits will be counted as ordinary income on our federal tax return. That may also be a good assumption for a lot of retirees, especially if their overall income in retirement – pensions, capital gains, dividends, distributions from retirement accounts, Social Security, etc. – is high enough. Then, indeed, exactly 85% of your benefits will be taxed. This 85% figure is also the absolute maximum you’ll ever have to include in your federal taxable income. So, as a conservative estimate, it’s fine to use this 85% figure for our retirement cash flow and tax planning.

But in practice, the calculation is a lot more complicated. In fact, that share is calculated through a pretty convoluted formula that takes into account not just your Social Security benefits but also other income, even some ostensibly tax-free income like Municipal bond interest. In the chart below, the x-axis is for the annual Social Security benefits for a married couple filing a joint return (0-$80k), and each line corresponds to a level of all the other income (e.g., pensions, annuities, interest, capital gains, dividends, etc.) also going from $0 to $80,000 in $1,000 steps, so there are exactly 81 lines going from blue via yellow to red. When I plotted this function it looks like the folks at the IRS created a piece of art; that portion in the upper left looks almost like a Bifurcation diagram or Mandelbrot fractal!

SocSecTaxes Chart01
The share of Social Security subject to Federal Income taxes (Married filing Jointly). x-axis=Social Security benefits and each line is for a different level of other taxable income (e.g., pensions, annuities, interest, capital gains, dividends, etc.). There are 81 “other income” lines corresponding to income levels from $0 to $80,000 in steps of $1,000.

In any case, for retirement planning, doing a more thorough analysis of our tax on Social Security rather than using the lazy rough estimates has at least four advantages:

  1. The 85% estimate is likely way too conservative so you may over-prepare for retirement and over-accumulate assets. Why not enjoy your money now? Case in point, the Becky and Stephen case study last week; I was way too cautious with the tax assumptions in retirement and underestimated the sustainable, historical fail-safe retirement budget by about $2,500 per year!
  2. The exact calculation of taxes on Social Security benefits has implications on your Roth conversion strategy: There’s no need to be aggressive with your Roth conversions if only a tiny fraction of Social Security is taxable and you have not much other income to fill up your federal Standard Deduction!
  3. But for others, the convoluted formula also has a different, not-so-nice side effect. For some retirees, 401k or Traditional IRA distributions might be taxed at a higher rate than you might think. It’s called the retirement “Tax Torpedo,” more details on that below. So, if you don’t do enough Roth conversions and then later distribute money from a 401k you might face a higher tax burden than expected!
  4. Even some of the ostensibly tax-free income (municipal bond interest or dividends/long-term capital gains in the first two federal tax brackets) may not be so tax-free after all. Because that income is included in the Social Security tax computation, you might face backdoor taxation of seemingly tax-free income. How sneaky!!! It might be optimal to do some tax gain harvesting prior to claiming Social Security!

So, in any case, I will go through some detailed calculations here today, and also link to an easy-to-use Google Sheet I created for you if you want to calculate your own retirement tax estimates. Let’s take a look…

Continue reading “Taxation of Social Security: The Tax Torpedo & Roth Conversion Tightrope”

Where are they now? A Case Study Update with “Captain Ron”

From 2017 until early 2018 I ran a series of ten case studies for readers who volunteered to open their books and serve a real-world safe withdrawal rate guineapigs. The second case study in July 2017 was for Captain Ron (not his real name) who was planning to FIRE and enjoy early retirement with his wife on a sailboat! That title picture you see up there, that’s their actual boat! Sounds like a great adventure, not just the financial aspects but also the lifestyle changes are daunting! So, how did that all go? Captain Ron just sent me an update on how life has been, so Ron, please take over the wheel…

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We retired in September 2017 as planned and are really enjoying life. Financially things are great and we have adjusted to the sailing life, but that first year of cruising was a surprisingly difficult transition. More on that later.

Continue reading “Where are they now? A Case Study Update with “Captain Ron””

Here’s an idea for a new ETF

Actually, not one ETF, but two! Or more! How can there be a need for a new ETF? Aren’t there enough already? Earlier this year, Motley Fool argued there are too many ETFs (1,929 at that time, probably over 2,000 by now) and they are covering pretty much every thinkable (and unthinkable) benchmark. Soon we might have more ETFs than publicly traded equities in the U.S., how crazy is that??? Why would I propose a new ETF that doesn’t already exist?

Here’s some background. I’m an index investor at heart and I like tax optimization. For so many years now, I’ve held equity index ETFs and Mutual Funds in both taxable accounts and tax-deferred accounts (both retirement and deferred compensation at work). It’s so painful to see the dividend payments in the taxable accounts getting taxed every year. Sure, it’s only about 1.9% dividend yield in the S&P500 right now but for us, that’s taxed at 15% federal, 10+% state (California!) and 3.8% Obamacare tax, for a total of almost 30% marginal tax! Isn’t there a better way? Sure! Simply put the taxable equity allocation into stocks that pay zero (or close to zero) dividends and keep the high-dividend stocks in the tax-deferred account where they can compound in peace and be taxed only once upon withdrawal rather than every year along the way! So, the two ETFs that I wish existed would exactly replicate the S&P500 if held in equal shares. But individually they’d have non-index weights and one would hold the equities with the lowest dividend yield and the other with the high-yield equities!

Notice that most folks already do this tax optimization across asset classes: Hold the tax-inefficient asset classes (bonds, REITs, etc.) in tax-deferred accounts and equities in taxable accounts. So, why not do this within the equity asset class as well for additional tax efficiency? How much extra after-tax return would we get out of this? Let’s look at the numbers…

Continue reading “Here’s an idea for a new ETF”

Our Net Worth as of 3/31/2018

I wish the first quarter had ended on January 26 when the S&P500 peak reached the all-time high of 2,872! But in the end, the first quarter of 2018 was really nothing to write home about. And the second quarter is off to a volatile start as well! But I started with this series exactly a year ago and I might as well keep going! Besides, looking at the visitor stats, these posts are some of the most popular! I don’t blame you for being nosy because net worth updates are some of my favorites to read on other blogs, too! 🙂 Soooo, where do we stand as of 3/31/2018? Let’s take a look at the cold hard numbers…

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My podcast appearance on Millionaires Unveiled

Late last year, I chatted with Jace Mattinson and Clark Sheffield at Millionaires Unveiled. It’s a fairly new podcast but they’ve already lined up an impressive list of guests including Dr. Dahle, aka White Coat Investor and Mindy and Carl from 1500 Days. I also particularly appreciate the diversity of different investment styles. Not everybody becomes a millionaire by investing in VTSAX! We can also learn from real estate investors and business owners! But first, of course, please listen to Episode 15 with yours truly, which was released today…

—> Click here for the podcast on iTunes <—

—> Click here for the podcast on Stitcher <—

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Ten Lessons From Ten Safe Withdrawal Rate Case Studies

Last week, we published the Tenth Safe Withdrawal Rate Study! Amazing how time flies! I did about one case study every three weeks for the last 6 months! And I could even include another one if I were to count the one I did for the ChooseFI podcast back in 2017. In fact, the ChooseFI appearance (Episode 23R and Episode 26R) started the idea because our first volunteer reached out to me after he heard me on the podcast. Since then I’ve published 10 posts, worth almost 30,000 words that generated tons of clicks, feedback and encouragement:

  • “John Smith”: Seven-figure net worth, but not quite ready for FIRE yet. Big ERN would recommend a few more years in the workforce!
  • “Captain Ron”: Early retirement on a sailboat. How much can they withdraw from their $3m portfolio to stay afloat (pun intended) in retirement?
  • “Rene”: No need to worry about the recent layoff: You are more than ready for early retirement!
  • “Mrs. Greece”: More than ready to retire due to large portfolio size and moderate living expenses, especially if the husband keeps working!
  • “Mrs. Wish I Could Surf”: Alternative investments (real estate hard money loans). Keep the mortgage or pay it off? Either way, more than ready to retire!
  • “Mr. Corporate”: Geographic Arbitrage by moving to a low-cost European country. Roth Conversions and zero tax liability!
  • “Ms. Almost FI”: Your name is a misnomer. You are ready to retire now even when self-funding substantial long-term care expenses in the future!
  • “Mr. Corporate Refugee”: How to deal with a large portion of the net worth tied up in a house in a high-cost-of-living area?
  • “Mrs. Wanderlust”: Substantial supplemental cash flows due to buying an RV and then selling it later.
  • “Mr. and Mrs. Shirts”: Ready to retire this year, but should Mr. Shirts work for another nine months for some additional big payday?

But, alas, all good things have to come to an end! I have decided to take a break from the case studies, at least for now. I might revive the series again later but for next few weeks and months, I will pursue other topics! Thanks to all volunteers who submitted their data. And thanks to all other folks who didn’t get their case studies published. I’m not even sure I properly responded to everyone whose request was denied. I think I may have some inquiries from October last year that I haven’t responded to. If you submitted a request for a case study and haven’t heard from me back, sorry, I’m just a bit disorganized!

Sooooo, ten case studies: what have I learned from them? Plenty, because that’s the topic for today’s post…

Continue reading “Ten Lessons From Ten Safe Withdrawal Rate Case Studies”

Ask Big Ern: A Safe Withdrawal Rate Case Study for “Mr. and Mrs. Shirts”

Welcome to the 10th episode of our Case Study Series! Today’s case study is for Mr. and Mrs. Shirts. They run their own blog Stop Ironing Shirts and I encourage everyone to head over and check out their outstanding work. Mr. Shirts and his wife face a dilemma; they have already amassed a pretty impressive nest egg, probably large enough to retire later this year. But the temptation to work a little longer to cash in that next financial milestone around the corner (bonus, vesting date, etc.) is a pretty strong incentive to stay onboard for just a little bit longer. Otherwise known as the One More Year Syndrome. In fact, in the Shirt’s case, it’s only nine months (June 2018 vs. March 2019). So, what are the tradeoffs, what are the pros and cons of retiring in 2018 vs 2019? Let’s look at the details…

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Our Net Worth as of 12/31/2017

Happy New Year! Another quarter-end, I can’t believe how fast time flies! And we all know what that means, right? Net Worth updates across the Financial Independence blogosphere! For us, this is a special NW update because it’s the last one before we both give notice at work in two months! And the last NW update before our apartment goes on the market! In other words, this better looks good, otherwise, we might get cold feet, also known as One More Year Syndrome. Soooo, where do we stand financially? Here are the numbers…

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