Tax Efficiency vs. Taxable Stability

[Tyler]

Hi All.  I'm a new convert to the PP and am thrilled to have finally found what I feel like I've been looking for in the investment world for many years. 

I'm currently in the process of converting my assets over to the PP, and am struggling with the issue of allocating the Stocks, LTTs, Gold, and Cash across my various taxable and tax-sheltered accounts in order to optimize for taxes or optimize for stability in the taxable account. 

Based on most discussions on the forum, it seems like the consensus recommendation is to fill the tax-sheltered accounts with LTTs and cash and use the taxable for gold and stocks.  This makes absolute perfect sense for tax efficiency if you look at all of your accounts as a whole and have the same retirement time horizon for all of them.

My wife and I are 35, and we have a (realistic) goal of retiring in 10 years.  So we would need to rely on the taxable account for 15 years before we could touch the rest.  As Harry Browne would say, you simply can't predict the future, and an account we're depending on for income that is a majority stocks and gold could be tremendously volatile.  And drawing down on only (the most volatile) half the portfolio for income rather than properly rebalancing seems like a really bad idea.

So my gut instinct is to manage two separate PPs -- one taxable (for early retirement), and one that utilizes all of the various 401Ks and IRAs that my wife and I share (for long-term retirement).  I'd be sacrificing tax efficiency in the near term, but gaining stability in the accessible side of our money during early retirement.  If anyone here is dealing with a similar situation or sees a better way to handle this, I'd really appreciate your input.

[TripleB]

Maximize tax efficiency. It means you have more money. It's very important because less taxes = greater total (net) return. Worrying about saving 0.1% ER on a mutual fund is silly if you're paying 10% more taxes because you neglected tax efficiency.

You can do tax-free transfers of assets between taxable and retirement accounts because money is fungible.

i.e. suppose you need to sell bonds because the stock market crashed and your bonds doubled. But you have only stocks in taxable and bonds in retirement accounts. You can exchange bonds for stocks within the retirement account, and then sell the stocks in taxable.

The net result is you removed money from the PP, and reduced your bond allocation. Even though the IRS thinks you "sold" stocks because on a tax-basis that's what you sold.

If you do this, I'd suggest exchanging the bonds in retirement accounts for a slightly different stock mutual fund then you held in taxable. That will let you take a tax-loss that won't be a wash sale. Then if the tax loss is high enough, do a small 401k/traditional IRA conversion to a Roth IRA for "Tax-Free" up to the limit of your "loss."

But, you might say, what if your stocks/gold drop, and that's all you have in taxable. You need to stretch taxable to 15 years before you can touch retirement accounts, so all the fancy above tricks are nice, but if you don't have the money in taxable to live, you're screwed! Nope. Google 72T SEPP.

If you run out of money in taxable, then just tap your retirement accounts early, penalty free, using a 72T. Consider that if you're using the PP, and if your taxable accounts take a huge dive, it means your retirement accounts took a huge gain. So you still have the "correct" amount of total money for retirement, it's just in different locations. So instead of living off taxable for 15 years before going to retirement, you might only live off taxable for 5 to 10 years before you run out, but now your retirement account is so huge that you still have enough money to live on, and with a 72T it's penalty free.

[moda0306]

I would qualify what TripleB is saying a little bit.

A few things to consider:

There's three reasons to keep cash in taxable accounts... 1) Cash is likely to underperform the rest of the PP (more valid given roth options), 2) we're in an extremely low-rate period, and 3) the purpose of cash, first and foremost, is liquidity.

I mean right now the S&P dividend rate is much higher than interest rates, so even with the tax-deferral aspect of its growth, the S&P is throwing out more potentially taxable income than cash (though, at a lower rate).

Also, in a Roth, you'll almost assuredly never pay tax on that income.  So we can't treat that the same as a traditional IRA in terms of tax-deferral.

Here's my thing... if you put long-term bonds in a traditional IRA and stocks, gold and cash in various places including Roth and taxable accounts (don't put cash in a roth, though), you're going to do just fine.

I do have a general rule, though, that if you aren't maxing out your retirement contributions and have a comfortable emergency fund, contribute to a Roth.  You almost can't go wrong doing so.

[Tyler]

Thanks for the advice.  I've never heard of a 72T -- I've got some research to do.

Honestly, I don't want to over-think it.  The biggest step is just getting into the PP, and I feel great about that.  Even the best-made plans regarding retirement can fall apart two years from now, much less ten.  So I can see the argument for minimizing taxes now and reevaluating our allocation plan 5-7 years from now if early retirement looks like it may actually happen and isn't just a pipe dream.  No need to plan the "perfect" system so far ahead of time.

So along those lines, maybe I'll simply place all of the LT Bonds (they seem like the biggest tax issue by far) into the IRAs / 401Ks and divide whatever space is left over between the other three classes to make rebalancing easier exclusively in the tax-deferred accounts.  That should help keep the taxable events at a minimum, I'd imagine.  Please let me know if I'm missing something important.

That should maximize my returns while I take the time to properly research how to manage our assets down the line.  After all, I can always change the mix later if necessary.  The volatility within the individual accounts still makes me a little uncomfortable, but then again I just need to dive in to really have a feel for what to expect anyway.

[Tyler]

So after thinking about it more, the counter argument in my mind is that getting too cute with tax allocations, adding risk to your easily accessible early retirement funds, and depending on a retirement account loophole (that may no longer exist ten years from now) as part of your plan in order to save a few tenths of a percent in taxes in terms of your total portfolio may also break a few of HBs rules in the process. Like don't do something you don't understand, don't try to predict the future, and don't chase returns over safety. 

I can see both sides, which makes this a much harder point in my mind even than choosing the PP over other portfolios.  But doing something is better than doing nothing while you worry about the details, so I'm sure I'll just pick a method to start and tweak as I go through added contributions and rebalancing. 

Thanks again for the input.

[moda0306]

Tyler,

Yes... I pay rigorous attention to retirement account rules, the tax code, etc.  If you're not in a position to keep up on all of that, the following are some relatively safe decisions.

1) Get a nice, big, fat taxable emergency fund made up of short-term treasury bonds and physical cash (you keep at home or a safety deposit box), a short-term treasury bond fund, or an FDIC insured savings account, in that order of preferance, but even the latter being pretty darn safe... put that in a taxable account that you know how to access very well.

2) If you feel comfortable, get some physical gold and put it somewhere you feel that it's safe, or a combination of places, much like your physical cash.

3) Get both an IRA & Roth IRA opened at a reliable brokerage, if you don't already.  Try to fund these before resorting to your 401(k) plan.  Start buying up the other assets of the PP.  At this point, search our board for discussions on the advantages on the tax-treatement of Roth vs Traditional IRA vs taxable accounts.  There's lots of good info.  Keep your brain working and thinking and you'll start enjoying seeing the paths instead of being afraid of them.

4) Obviously getting to 4x25 is more important than getting everything tax efficient.  One very important tool to use if you're not fully funding your retirement accounts is a Roth IRA for any excess savings beyond emergency fund & retirement, which principal can be pulled out on tax/penalty free.  If there is any retirement plan nuance to keep an eye on, it's the ability to pull principal out of your Roth.  I believe this will stay the way it is, but it can divert thousands of dollars into "preferred" accounts every year that you would have kept in taxable accounts, so try not to invest thousands of dollars every year in a taxable account unnecessarily if you can get comfortable with the Roth rules.

If you do this, and try to keep your bonds out of taxable accounts (and cash, later, if rates get oppressive), you're 95% of the way there.

We've got lots of good threads on this stuff, and you are already probably going through the process of enjoying thinking about these ideas, so I think you're headed the right way.