Spoke with an investment rep a couple of weeks ago. He tossed off a casual remark that most people manage their tax-sheltered and taxable portfolios together, while what they ought to be doing is managing them differently. Specifically, in a drawdown phase, keeping the income investments in the taxable account, and the growth investments in the tax-sheltered account.
I didn't discuss this with him, but am curious about what others think. My own thinking, ever the one to disagree for the sake of disagreeing
, is the opposite. If one keeps the income (e.g. bonds/bond funds) in a tax-sheltered account, then one has investments that are taxed at a lower rate (equities) in the taxable account. When one needs to draw, you can sell off some equities.
At the same time, you use the cash from your income investments in your IRA (or whatever) to buy back those equities (equity funds, etc.) in the IRA. What this accomplishes is to leave you in the same position as if you'd had the bonds in the taxable account and just drawn the interest. But the tax treatment is better.
If the equities appreciated, wonderful, you've gotten the income (via appreciation) at a lower tax rate. If they've gone down in value, you harvest a capital loss that you wouldn't have recognized in the IRA. (You do have to be careful in this case to buy in the IRA securities that are not "substantially identical" to the ones you just sold at a loss, otherwise you'll have a wash sale.) And you'll still be back to where you would have been had you followed "conventional wisdom" and kept the equities in the IRA all along.
Am I missing something that is obvious to the rest of the world?
Comments
In this respect, I disagree with this investment rep. My understanding is like you. Income producing products should be tax sheltered while growth products (i.e those that that do not throw much income should be in taxable.
1) That way if you are re-investing the income produced by the income products you are not paying off current taxes. So, your assets can grow over time better. During distribution phase bond income will be taxed as income just like any withdrawal from IRA's. So, there is no disadvantage of placing bonds in tax-sheltered accounts. You pay the same tax rate.
2) Growth instruments do not throw out excessive income. So, current taxes are low. However, since long term capital gains are taxed at lower rate, holding these outside of tax-sheltered accounts could better.
3) You can also do capital loss harvesting for equities in taxable by selling lots that have lost and pairing those with sales from that appreciated.
These assume that tax code will stay similar to current situation and you do not turn over your holdings in taxable account much.
By keeping the income products in the IRA, one's taxes are reduced (we are both stating the obvious here). What I was suggesting is that income is income - the fact that the income shows up in the IRA doesn't matter. One can get the generated income out of the IRA by selling equities in the taxable account and buying them back in the IRA. In that way, one maintains the same overall position, but has moved the cash out of the IRA into the taxable account (and equities from the taxable account into the IRA).
The reason people want income generating investments in retirement is that they don't want to be selling volatile equities at the wrong time. It's dollar cost averaging in reverse - when the market is down, you sell more shares (to get the same number of dollars out), and when the market is up, you sell fewer shares. So you wind up selling more at the worst times.
But with the technique I suggested above, you're not altering your market exposure. You keep the same equity investments, and you have the income generated in the IRA (thus sheltering it from taxes). At least that's my theory.
I think that what you're suggesting is that since munis pay so much, it might even make sense to keep them in taxable accounts instead of keeping taxable bonds in IRAs. Though one defers taxes for years in the IRA, ultimately one could be paying over 1/3 in taxes (combined fed/state/local) - a much bigger bite than the 10-20% lower yield from munis.
Using munis (in a taxable account) instead of taxable bonds (in an IRA) could make sense for US government/corporate bonds. Less so for foreign bonds, since foreign bonds provide a different type of diversification. Nevertheless, a very good point. Worth thinking about moving bonds around.
For risk management perspective allocation to munis bond in taxable account makes sense to manage volatility while generating decent income. Vanguard offers a low cost vehicle, Tax-Managed Balanced Index fund (VTMFX) - 50/50 S&P500 - federal munis at 0.12% ER.
https://personal.vanguard.com/us/funds/snapshot?FundId=0103&FundIntExt=INT
IRAs at withdraw are tax at one's current tax bracket, and that can be sizable as you mentioned. The common wisdom (or lack of) is that he/she will most likely in lower tax bracket at retirement, but that is not a guarantee depending on a number of situation. Thus the combined federal & state income tax would take as much as 1/3 of one's IRA withdraw each year. Only Roth IRA (paid with after tax dollars) would exempt from tax, but this may change.