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” →