"Asset Location Fundamentals (which investments to own in which accounts)"

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Taylor Larimore
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"Asset Location Fundamentals (which investments to own in which accounts)"

Post by Taylor Larimore »

Bogleheads:

Many of us have several different type of accounts (Taxable, IRA (before tax), Roth IRA (after tax), 401K)

This article by Oblivious Investor will help us decide which account(s) to use:

https://obliviousinvestor.com/asset-loc ... h-account/

Our Boglehead Wiki has similar but more complicated suggestions.

Best wishes.
Taylor
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by retired@50 »

Thanks for posting Taylor.

I've bookmarked the article so I can refer new forum members to it later on. It seems to be in agreement with the Boglehead wiki page on tax efficient fund placement, but may be more digestible by some readers.

Regards,
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by Stubbie »

retired@50 wrote: Mon Mar 27, 2023 4:14 pm I've bookmarked the article so I can refer new forum members to it later on. It seems to be in agreement with the Boglehead wiki page on tax efficient fund placement, but may be more digestible by some readers.
Mike makes everything more digestible!
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by retiredjg »

Mike Piper has a way of making things simple and understandable. This is yet another good example.
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by longinvest »

This post is copied (and slightly modified) from the One-Fund Portfolio thread. Enjoy!

Three investors each have $100,000 split between a $50,000 traditional IRA and a $50,000 Roth IRA. They share the same 50/50 stocks/bonds allocation and, like most investors, they don't tax-adjust their allocation. In other words, they all initially hold $50,000 in stocks and $50,000 in bonds.

They differ in their asset location strategy:
  • Investor A prioritizes the placement of stocks into the Roth IRA first.
  • Investor B prioritizes the placement of stocks into the traditional IRA first.
  • Investor C maintains a 50/50 stocks/bonds allocation in each account.
The three investors intend to deplete their accounts over a fixed 30 year period, taking withdrawals at the beginning of the year. Traditional IRA withdrawals are taxed 20%. The portfolio is rebalanced when taking the annual withdrawal.

A simple approach, often used to analyze outcomes, is to use a constant real growth rate for stocks and for bonds. Let's pick simple numbers: 5% for stocks and 2% for bonds. In other words, in real terms, the portfolio annually grows by a constant ((5% X 50%) + (2% X 50%)) = 3.5% rate.

NOTE: Calculation tables are provided in a separate post of the One-Fund Portfolio thread to keep this post readable.

If everything goes according to plan, the three investors withdraw an identical total of $157,598 from their accounts over 30 years, before tax, because the asset location strategy has no impact on portfolio growth in tax-sheltered accounts.

Investor A withdraws a total of $64,276 from the traditional IRA, pays a total of -$12,855 in taxes, and withdraws a total of $93,322 from the Roth IRA. Total net income: ($64,276 + -$12,855 + $93,322) = $144,743.

Investor B withdraws a total of $93,322 from the traditional IRA, pays a total of -$18,664 in taxes, and withdraws a total of $64,276 from the Roth IRA. Total net income: ($93,322 + -$18,664 + $64,276) = $138,934.

Investor C withdraws a total of $78,799 from the traditional IRA, pays a total of -$15,760 in taxes, and withdraws a total of $78,799 from the Roth IRA. Total net income: ($78,799 + -$15,760 + $78,799) = $141,838.

The difference in total net income of the three investors is only due the amount of taxes paid.

It's surprising how small the impact of choosing the worst asset location strategy is when everything goes according to plan. While investor B pays a total of (($18,664 / $12,855) - 1) = 45% more in taxes than investor A (which might look impressive), the impact on net income is only (($138,934 / $144,743) - 1) = -4% less.

The impact of investor C choosing a mirror allocation in all accounts on net income is only (($141,838 / $144,743) - 1) = -2% less than the best asset location strategy, when everything goes according to plan.

Obviously, when everything goes according to plan, investor A wins because, by prioritizing the placement of the slower growing asset into the traditional IRA, less money is withdrawn from it resulting into a smaller total tax bill.

First lesson: It's best focus on the big numbers that matter, like total net income available to spend after taxes, instead of focusing on ratios between small numbers with little impact on the retiree's wellness, like ratios of between tax amounts.

Unfortunately, everything doesn't always go according to plan in life. A simple and very effective approach to estimate the impact of unfavorable outcomes is to first apply an immediate -50% loss to the stock allocation of the portfolio, then to conduct the same simple analysis with constant growth rates.

If stocks lose -50% of their value just before taking the first withdrawal, the three investors withdraw an identical total of $118,199 from their accounts over 30 years, before tax, because the asset location strategy has no impact on portfolio growth in tax-sheltered accounts. That's (($118,199 / $157,598) - 1) = -25% less than when everything goes according to plan, corresponding to the impact of losing (-50% X 50% of portfolio) = -25% of portfolio.

Investor A withdraws a total of $69,281 from the traditional IRA, pays a total of -$13,856 in taxes, and withdraws a total of $48,917 from the Roth IRA. Total net income: ($69,281 + -$13,856 + $48,917) = $104,342. That's (($104,342 / $144,743) - 1) = -28% less than when everything goes according to plan.

Investor B withdraws a total of $48,917 from the traditional IRA, pays a total of -$9,783 in taxes, and withdraws a total of $69,281 from the Roth IRA. Total net income: ($48,917 + -$9,783 + $69,281) = $108,415. That's (($108,415 / $138,934) - 1) = -22% less than when everything goes according to plan.

Investor C withdraws a total of $59,099 from the traditional IRA, pays a total of -$11,820 in taxes, and withdraws a total of $59,099 from the Roth IRA. Total net income: ($59,099 + -$11,820 + $59,099) = $106,379. That's (($106,379 / $141,838) - 1) = -25% less than when everything goes according to plan.

The difference in total net income of the three investors is only due the amount of taxes paid.

Investor A is now the loser, trailing investor B (winner) and investor C (average). The overall impact of choosing an asset location strategy remains small. Investor A gets (($104,342 / $108,415) - 1) = -4% less than the winner, and investor C gets (($106,379 / $108,415) - 1) = -2% less than the winner.

The after-tax impact of stocks losing -50% of their value varies according to asset location strategy. As a result of stocks losing -50% of their value, investor A loses -28% in total net income because the loss happens in the Roth IRA. In contrast, investor B only loses -22% in total net income because the loss happens in the Traditional IRA. For investor C, the after-tax loss impact is identical to the before-tax loss impact.

What we see is a typical risk/reward outcome. It's as if, after tax, investor A is taking more risk than a 50/50 stocks/bonds allocation by prioritizing the placement of stocks in the Roth IRA, winning when things go well and losing when they don't. It's also as if, after tax, investor B is taking less risk than a 50/50 stocks/bonds allocation by prioritizing the placement of stocks in the Traditional IRA, losing when things go well and winning when they don't.

Investor C, in contrast, seems to be taking, after tax, the same amount of risk as a 50/50 stocks/bond allocation. In other words, investor C's asset location strategy doesn't seem to change the amount of risk taken before and after taxes.

Another way to view this is to consider that an outcome similar to investor A can probably be achieved, in the above scenario, by increasing the stock allocation to (-2 X -28%) = 56% of the portfolio and adopting an identical asset allocation in both the traditional IRA account and the Roth IRA account. Similarly, investor B could probably achieve a similar outcome by reducing the stock allocation to 44% and adopting a mirrored allocation. Actually, this has been verified in this post of the One-Fund Portfolio thread.

Second lesson: It's a mistake to only consider good scenarios and ignore risk, when evaluating the after-tax impact of asset location strategies. A complex strategy delivering better outcomes when things go well and worse outcomes when they don't, when compared to a simpler strategy, unnecessarily complicates the life of its investor. A slightly-higher stock allocation with the simpler strategy is likely to deliver similar outcomes.


Summary: An identical asset allocation in all portfolio accounts (a mirrored asset allocation) doesn't affect the effective riskiness of the portfolio, even after taxes. In contrast, so called "tax-efficient" asset location strategies often promise better "expected" outcomes without disclosing that they do so by increasing the effective after-tax risk of the portfolio. In other words, a mirrored asset allocation is not only good enough, it also delivers more consistent outcomes.
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by FoundingFather »

longinvest wrote: Mon Mar 27, 2023 4:41 pm This post is copied (and slightly modified) from the One-Fund Portfolio thread. Enjoy!
This post, read in the other thread, was incredible helpful to me - thank you for taking the time to walk through it so carefully!

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Re: The One-Fund Portfolio as a default suggestion

Post by AlwaysLearningMore »

[This post and the two replies have been moved to the indicated thread that deals with asset location - Moderator Misenplace]

Serious question: will you be amending the BH Wiki with counterpoint arguments with regards to tax efficient fund placement?
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Re: The One-Fund Portfolio as a default suggestion

Post by Lastrun »

AlwaysLearningMore wrote: Wed Mar 29, 2023 9:20 am Serious question: will you be amending the BH Wiki with counterpoint arguments with regards to tax efficient fund placement?
The wiki does have a prominent warning and a critisizm section that are easily overlooked.
Tax rates and brackets change frequently. What was a logical tax location one year may turn out to be a poor choice a few years later.

Consider if it is worth the effort (added complexity) to take this approach.

Consider the various criticisms of the suggested tax placement strategy.
See Wiki Here: https://www.bogleheads.org/wiki/Tax-eff ... t_strategy

See Thread Here: viewtopic.php?t=126556
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Re: The One-Fund Portfolio as a default suggestion

Post by AlwaysLearningMore »

Lastrun wrote: Wed Mar 29, 2023 11:20 am
AlwaysLearningMore wrote: Wed Mar 29, 2023 9:20 am Serious question: will you be amending the BH Wiki with counterpoint arguments with regards to tax efficient fund placement?
The wiki does have a prominent warning and a critisizm section that are easily overlooked.
Tax rates and brackets change frequently. What was a logical tax location one year may turn out to be a poor choice a few years later.

Consider if it is worth the effort (added complexity) to take this approach.

Consider the various criticisms of the suggested tax placement strategy.
See Wiki Here: https://www.bogleheads.org/wiki/Tax-eff ... t_strategy

See Thread Here: viewtopic.php?t=126556
Thank you for the links.

Recently Taylor Larimore posted the following link on asset location from a prominent BH:

https://obliviousinvestor.com/asset-loc ... h-account/
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by longinvest »

AlwaysLearningMore wrote: Wed Mar 29, 2023 9:20 am Serious question: will you be amending the BH Wiki with counterpoint arguments with regards to tax efficient fund placement?
AlwaysLearningMore,

As Lastrun wrote, the Tax-efficient fund placement wiki page already contains a criticisms section which clearly states: "It is possible under some combinations of lifetime investment results and lifetime individual tax situations to be better off doing the opposite of the strategy recommended here.".

The page contains a prominent notice:
Tax regulations can be complex and contain subtle details that may escape inexperienced investors. If this article seems overly complicated, then just remember a few key points:
  • ...
  • Tax rates and brackets change frequently. What was a logical tax location one year may turn out to be a poor choice a few years later. Consider if it is worth the effort (added complexity) to take this approach.
  • Consider the various criticisms of the suggested tax placement strategy.
The page also contains a link to the Tax-adjusted asset allocation which states: "losing $100K in your Roth IRA will reduce your standard of living (or require more additional savings to keep the same standard) by more than losing $100K in your traditional IRA or taxable account does."


I'll concede that my posts (including the above post and other posts of the One-Fund Portfolio thread) go beyond this, though:
  • They explain that prioritizing the placement of specific assets into specific accounts changes the effective after-tax riskiness of the portfolio.
  • They explain how a mirrored asset allocation elegantly preserves an identical portfolio riskiness, before and after tax.
  • They provide a (simple and short) proof that a mirrored allocation will never be the worst asset location strategy, regardless of future returns, future tax law changes, and unanticipated future investor circumstances.
Some people might consider this mathematical guarantee, of not being the worst asset location strategy, "not very attractive", yet I have not seen a mathematical proof of a "more attractive" asset location strategy that is guaranteed to always beat a simple mirrored allocation strategy. It's quite similar to indexing, when you think about it. William Sharpe's theorem guarantees that a simple total-market cap-weighted index investment strategy will never be worse than average (before fees). Some people might consider this mathematical guarantee "not very attractive", yet I have not seen a mathematical proof of a "more attractive" investment strategy that is guaranteed to always beat it.

I simply don't have the time for writing this stuff into the Bogleheads wiki.

Other wiki editors should feel free to read my posts and add the ideas into the wiki (with links to source posts, when appropriate), if they think that this could help others.
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by grabiner »

One minor point which isn't immediately clear from the article: foreign stocks may not be more tax-efficient despite the foreign tax credit. The article does note that high-dividend stocks and stocks with non-qualified dividends are less tax-efficient. Foreign stocks have had higher dividends than US stocks since 2008, and have more non-qualified dividends. Depending on your tax situation, this may cost more than the tax benefit of the foreign tax credit.
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by zonto »

One of the best resources I've seen on this topic is from Betterment. Ignore the marketing speak and focus on the substance. It's wonderful and cites much of the relevant literature. Link: https://www.betterment.com/resources/as ... ethodology.

Summarized as follows:

Image
However, Kitces augments the graph in short order, recognizing that the basic "smile" does not capture a third key consideration—the impact of liquidation tax. Because capital gains will eventually be realized in a taxable account, but not in a [tax exempt account], even a highly tax-efficient asset might be better off in a [tax exempt account], if its expected return is high enough. The next iteration of the "smile" [shown above] illustrates this preference.
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by Exchme »

longinvest wrote: Mon Mar 27, 2023 4:41 pm Summary: An identical asset allocation in all portfolio accounts (a mirrored asset allocation) doesn't affect the effective riskiness of the portfolio, even after taxes. In contrast, so called "tax-efficient" asset location strategies often promise better "expected" outcomes without disclosing that they do so by increasing the effective after-tax risk of the portfolio.
Yes, I believed the "tax efficient" idea to be free money at first until I ran the numbers in Pralana Gold. In that program, you can select either account level asset allocation (mirrored) or portfolio level (the so called tax efficient portfolio). My target 80/20 ends up equivalent to something around 82.5 or 84% stocks/17.5-16% bonds when I test various bull and bear markets using our tax brackets, size of accounts, etc. At first the variation from case to case troubled me. It finally dawned on me that this variation was caused by how full of bonds my tax deferred space happened to be when the markets roared or crashed when replaying various historical sequences. In other words, not only are you taking more risk than you intended with the "tax efficient" portfolio - you can't know how much more.
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by FIRWYW »

Just wanted to say thanks for the discussion above regarding whether tax efficient placement matters. I have wasted more time thinking about/ trying to optimize asset location since finding bogleheads and WCI 18 months ago than on any other thing. This shows for the most part that is a waste of time and I should move on. Was using just target date funds in all accounts before and that keeps contributions and rebalancing fairly simple (didn’t have enough to start taxable until about the same time). Only thing I really see is that target date funds should NOT be held in taxable.

However to make sure I understand correctly- the above scenarios from the wiki assume that you are drawing from traditional, roth, and taxable at the same time. Does it change if you are drawing from different types of accounts at different times over the years? (Maybe I just need to test this in pralana as indicated above to see).

For example, I have thought we would spend nongovernmental 457 first in early retirement, then taxable, then wifes 401k and not touch my 401k (25% roth currently from prior contributions but they don’t separate out investment options with roth vs traditional) and Roth IRAs until later in retirement. (use Hsa savings where costs arise along the way after early retirement). Reasons: 1) my 457 has 10 years to spend and keeps that balance lower. Also if lower value gives less money lost for the extremely rare instance my hospital system uses the 457 for creditors) 2) Roth grows more over time and avoids some of the “widow tax” later. I Have thought that we should keep bonds in 457 and wifes 401k so that stocks grow the tax free accounts more and over longer time horizons stocks have higher returns on average.

After reading above, I think I might be playing mental trickery with myself. In other words since I have to rebalance bonds to the other accounts as I withdraw over time anyway that probably doesn’t matter much and an optimized portfolio at 80/20 is roughly the same as far as risk/reward as a nonoptimized 85/15.
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by retired@50 »

FIRWYW wrote: Fri Mar 31, 2023 8:18 am Just wanted to say thanks for the discussion above regarding whether tax efficient placement matters. I have wasted more time thinking about/ trying to optimize asset location since finding bogleheads and WCI 18 months ago than on any other thing. This shows for the most part that is a waste of time and I should move on. Was using just target date funds in all accounts before and that keeps contributions and rebalancing fairly simple (didn’t have enough to start taxable until about the same time). Only thing I really see is that target date funds should NOT be held in taxable.
The blue sentence in your paragraph is inconsistent with thinking that asset location doesn't matter. :confused

If you're avoiding target date funds in a taxable account, it's precisely because you're paying attention to asset location (and income taxes).

Regards,
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by Call_Me_Op »

Thanks Taylor - that's a great summary. Mike Piper is a pretty amazing guy.
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by AlwaysLearningMore »

longinvest wrote: Wed Mar 29, 2023 7:16 pm
AlwaysLearningMore wrote: Wed Mar 29, 2023 9:20 am Serious question: will you be amending the BH Wiki with counterpoint arguments with regards to tax efficient fund placement?
AlwaysLearningMore,

As Lastrun wrote, the Tax-efficient fund placement wiki page already contains a criticisms section which clearly states: "It is possible under some combinations of lifetime investment results and lifetime individual tax situations to be better off doing the opposite of the strategy recommended here.".

The page contains a prominent notice:
Tax regulations can be complex and contain subtle details that may escape inexperienced investors. If this article seems overly complicated, then just remember a few key points:
  • ...
  • Tax rates and brackets change frequently. What was a logical tax location one year may turn out to be a poor choice a few years later. Consider if it is worth the effort (added complexity) to take this approach.
  • Consider the various criticisms of the suggested tax placement strategy.
The page also contains a link to the Tax-adjusted asset allocation which states: "losing $100K in your Roth IRA will reduce your standard of living (or require more additional savings to keep the same standard) by more than losing $100K in your traditional IRA or taxable account does."


I'll concede that my posts (including the above post and other posts of the One-Fund Portfolio thread) go beyond this, though:
  • They explain that prioritizing the placement of specific assets into specific accounts changes the effective after-tax riskiness of the portfolio.
  • They explain how a mirrored asset allocation elegantly preserves an identical portfolio riskiness, before and after tax.
  • They provide a (simple and short) proof that a mirrored allocation will never be the worst asset location strategy, regardless of future returns, future tax law changes, and unanticipated future investor circumstances.
Some people might consider this mathematical guarantee, of not being the worst asset location strategy, "not very attractive", yet I have not seen a mathematical proof of a "more attractive" asset location strategy that is guaranteed to always beat a simple mirrored allocation strategy. It's quite similar to indexing, when you think about it. William Sharpe's theorem guarantees that a simple total-market cap-weighted index investment strategy will never be worse than average (before fees). Some people might consider this mathematical guarantee "not very attractive", yet I have not seen a mathematical proof of a "more attractive" investment strategy that is guaranteed to always beat it.

I simply don't have the time for writing this stuff into the Bogleheads wiki.

Other wiki editors should feel free to read my posts and add the ideas into the wiki (with links to source posts, when appropriate), if they think that this could help others.
Thanks for your response.

As I look at my municipal bond returns, I'm not sure that holding an all in one fund (which contains a total bond market fund) in a taxable account is superior, especially considering the ACA tax exemption for municipal bonds. Especially at the highest tax brackets. Perhaps I'm missing something?
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by FIRWYW »

retired@50 wrote: Fri Mar 31, 2023 9:13 am
FIRWYW wrote: Fri Mar 31, 2023 8:18 am Just wanted to say thanks for the discussion above regarding whether tax efficient placement matters. I have wasted more time thinking about/ trying to optimize asset location since finding bogleheads and WCI 18 months ago than on any other thing. This shows for the most part that is a waste of time and I should move on. Was using just target date funds in all accounts before and that keeps contributions and rebalancing fairly simple (didn’t have enough to start taxable until about the same time). Only thing I really see is that target date funds should NOT be held in taxable.
The blue sentence in your paragraph is inconsistent with thinking that asset location doesn't matter. :confused

If you're avoiding target date funds in a taxable account, it's precisely because you're paying attention to asset location (and income taxes).

Regards,
Fair point. In taxable I would use muni bond funds instead for the target date bond portion since my marginal tax rate is right at the cusp of 25-32% to decrease tax drag. What I meant more is that I have looked at different scenarios of breaking up the components of the target date funds across the different accounts and differentiating between traditional and Roth. Seems to make rebalancing and contributions a pain even with excel- Ie across eight accounts (Ie my old 403b (that fidelity says I can’t roll into my current 401k), my 401k, wifes 401k, both Roth IRAs, 457, taxable, HSA). If any benefit to fine tuning locations is the same as just having a target date fund in all those accounts and then just “creating” the same thing with components in taxable and using munis, and carrying a higher portion of stocks- seems like that is the smarter asset location plan then what I have been trying to figure out the other mess. (0.08 ER for TDF vs about 0.031 if I create my own allocation, but the time saved may be worth it)
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by marcopolo »

longinvest wrote: Mon Mar 27, 2023 4:41 pm This post is copied (and slightly modified) from the One-Fund Portfolio thread. Enjoy!

Three investors each have $100,000 split between a $50,000 traditional IRA and a $50,000 Roth IRA. They share the same 50/50 stocks/bonds allocation and, like most investors, they don't tax-adjust their allocation. In other words, they all initially hold $50,000 in stocks and $50,000 in bonds.

They differ in their asset location strategy:
  • Investor A prioritizes the placement of stocks into the Roth IRA first.
  • Investor B prioritizes the placement of stocks into the traditional IRA first.
  • Investor C maintains a 50/50 stocks/bonds allocation in each account.
The three investors intend to deplete their accounts over a fixed 30 year period, taking withdrawals at the beginning of the year. Traditional IRA withdrawals are taxed 20%. The portfolio is rebalanced when taking the annual withdrawal.

A simple approach, often used to analyze outcomes, is to use a constant real growth rate for stocks and for bonds. Let's pick simple numbers: 5% for stocks and 2% for bonds. In other words, in real terms, the portfolio annually grows by a constant ((5% X 50%) + (2% X 50%)) = 3.5% rate.

NOTE: Calculation tables are provided in a separate post of the One-Fund Portfolio thread to keep this post readable.

If everything goes according to plan, the three investors withdraw an identical total of $157,598 from their accounts over 30 years, before tax, because the asset location strategy has no impact on portfolio growth in tax-sheltered accounts.

Investor A withdraws a total of $64,276 from the traditional IRA, pays a total of -$12,855 in taxes, and withdraws a total of $93,322 from the Roth IRA. Total net income: ($64,276 + -$12,855 + $93,322) = $144,743.

Investor B withdraws a total of $93,322 from the traditional IRA, pays a total of -$18,664 in taxes, and withdraws a total of $64,276 from the Roth IRA. Total net income: ($93,322 + -$18,664 + $64,276) = $138,934.

Investor C withdraws a total of $78,799 from the traditional IRA, pays a total of -$15,760 in taxes, and withdraws a total of $78,799 from the Roth IRA. Total net income: ($78,799 + -$15,760 + $78,799) = $141,838.

The difference in total net income of the three investors is only due the amount of taxes paid.

It's surprising how small the impact of choosing the worst asset location strategy is when everything goes according to plan. While investor B pays a total of (($18,664 / $12,855) - 1) = 45% more in taxes than investor A (which might look impressive), the impact on net income is only (($138,934 / $144,743) - 1) = -4% less.

The impact of investor C choosing a mirror allocation in all accounts on net income is only (($141,838 / $144,743) - 1) = -2% less than the best asset location strategy, when everything goes according to plan.

Obviously, when everything goes according to plan, investor A wins because, by prioritizing the placement of the slower growing asset into the traditional IRA, less money is withdrawn from it resulting into a smaller total tax bill.

First lesson: It's best focus on the big numbers that matter, like total net income available to spend after taxes, instead of focusing on ratios between small numbers with little impact on the retiree's wellness, like ratios of between tax amounts.

Unfortunately, everything doesn't always go according to plan in life. A simple and very effective approach to estimate the impact of unfavorable outcomes is to first apply an immediate -50% loss to the stock allocation of the portfolio, then to conduct the same simple analysis with constant growth rates.

If stocks lose -50% of their value just before taking the first withdrawal, the three investors withdraw an identical total of $118,199 from their accounts over 30 years, before tax, because the asset location strategy has no impact on portfolio growth in tax-sheltered accounts. That's (($118,199 / $157,598) - 1) = -25% less than when everything goes according to plan, corresponding to the impact of losing (-50% X 50% of portfolio) = -25% of portfolio.

Investor A withdraws a total of $69,281 from the traditional IRA, pays a total of -$13,856 in taxes, and withdraws a total of $48,917 from the Roth IRA. Total net income: ($69,281 + -$13,856 + $48,917) = $104,342. That's (($104,342 / $144,743) - 1) = -28% less than when everything goes according to plan.

Investor B withdraws a total of $48,917 from the traditional IRA, pays a total of -$9,783 in taxes, and withdraws a total of $69,281 from the Roth IRA. Total net income: ($48,917 + -$9,783 + $69,281) = $108,415. That's (($108,415 / $138,934) - 1) = -22% less than when everything goes according to plan.

Investor C withdraws a total of $59,099 from the traditional IRA, pays a total of -$11,820 in taxes, and withdraws a total of $59,099 from the Roth IRA. Total net income: ($59,099 + -$11,820 + $59,099) = $106,379. That's (($106,379 / $141,838) - 1) = -25% less than when everything goes according to plan.

The difference in total net income of the three investors is only due the amount of taxes paid.

Investor A is now the loser, trailing investor B (winner) and investor C (average). The overall impact of choosing an asset location strategy remains small. Investor A gets (($104,342 / $108,415) - 1) = -4% less than the winner, and investor C gets (($106,379 / $108,415) - 1) = -2% less than the winner.

The after-tax impact of stocks losing -50% of their value varies according to asset location strategy. As a result of stocks losing -50% of their value, investor A loses -28% in total net income because the loss happens in the Roth IRA. In contrast, investor B only loses -22% in total net income because the loss happens in the Traditional IRA. For investor C, the after-tax loss impact is identical to the before-tax loss impact.

What we see is a typical risk/reward outcome. It's as if, after tax, investor A is taking more risk than a 50/50 stocks/bonds allocation by prioritizing the placement of stocks in the Roth IRA, winning when things go well and losing when they don't. It's also as if, after tax, investor B is taking less risk than a 50/50 stocks/bonds allocation by prioritizing the placement of stocks in the Traditional IRA, losing when things go well and winning when they don't.

Investor C, in contrast, seems to be taking, after tax, the same amount of risk as a 50/50 stocks/bond allocation. In other words, investor C's asset location strategy doesn't seem to change the amount of risk taken before and after taxes.

Another way to view this is to consider that an outcome similar to investor A can probably be achieved, in the above scenario, by increasing the stock allocation to (-2 X -28%) = 56% of the portfolio and adopting an identical asset allocation in both the traditional IRA account and the Roth IRA account. Similarly, investor B could probably achieve a similar outcome by reducing the stock allocation to 44% and adopting a mirrored allocation. Actually, this has been verified in this post of the One-Fund Portfolio thread.

Second lesson: It's a mistake to only consider good scenarios and ignore risk, when evaluating the after-tax impact of asset location strategies. A complex strategy delivering better outcomes when things go well and worse outcomes when they don't, when compared to a simpler strategy, unnecessarily complicates the life of its investor. A slightly-higher stock allocation with the simpler strategy is likely to deliver similar outcomes.


Summary: An identical asset allocation in all portfolio accounts (a mirrored asset allocation) doesn't affect the effective riskiness of the portfolio, even after taxes. In contrast, so called "tax-efficient" asset location strategies often promise better "expected" outcomes without disclosing that they do so by increasing the effective after-tax risk of the portfolio. In other words, a mirrored asset allocation is not only good enough, it also delivers more consistent outcomes.

I know you made simplifying assumptions to make the calculations clearer. But, that is part of the problem, analysis like this is quite complex. One of the motivations for keeping fixed income in taxable accounts is to limit their growth so that large RMDs in the future do not push you into a higher tax bracket. By keeping a constant tax rate for the various scenarios, thisbl analysis likely underestimates the benefit of asset location for investor A. Likewise, it probably underestimates their risk in the 50% drop case.

I do think it is important to point out the asymmetric nature of the risk. This is similar to doing Roth Conversions. It can provide favorable outcomes when things go well and you don't really need the extra money, but costs you money in the rarer portfolio loss scenario where the extra money is most likely to be useful.

I think most people lean towards playing the odds and doing things that payoff most often.
Once in a while you get shown the light, in the strangest of places if you look at it right.
longinvest
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by longinvest »

AlwaysLearningMore wrote: Fri Mar 31, 2023 12:30 pm As I look at my municipal bond returns, I'm not sure that holding an all in one fund (which contains a total bond market fund) in a taxable account is superior, especially considering the ACA tax exemption for municipal bonds. Especially at the highest tax brackets. Perhaps I'm missing something?
AlwaysLearningMore, all my congratulations on reaching the highest tax bracket!

It's easy to forget about risk. My previous post explains (with a detailed illustration) that when risk is taken into account, the so-called "tax-efficient" asset location strategy might be no better than a much simpler and consistent mirror strategy. By consistent, I mean that the effective after-tax risk remains identical to the pre-tax risk. As forum member Exchme so elegantly wrote, "not only are you taking more risk than you intended with the "tax efficient" portfolio - you can't know how much more".

There are risks to replacing a total-market bond ETF with a municipal bond ETF. Let's look at that.

If I compare, for example, the iShares Core U.S. Aggregate Bond ETF (AGG) with the iShares National Muni Bond ETF (MUB) over the 2008-2012 period, I see that the muni bond was significantly more volatile:

Source: Portfolio Visualizer

Code: Select all

AGG Standard deviation: 4.53%
MUB Standard deviation: 6.32%
Image
Variable Percentage Withdrawal (bogleheads.org/wiki/VPW) | One-Fund Portfolio (bogleheads.org/forum/viewtopic.php?t=287967)
AlwaysLearningMore
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by AlwaysLearningMore »

longinvest wrote: Fri Mar 31, 2023 4:45 pm
AlwaysLearningMore wrote: Fri Mar 31, 2023 12:30 pm As I look at my municipal bond returns, I'm not sure that holding an all in one fund (which contains a total bond market fund) in a taxable account is superior, especially considering the ACA tax exemption for municipal bonds. Especially at the highest tax brackets. Perhaps I'm missing something?
AlwaysLearningMore, all my congratulations on reaching the highest tax bracket!

It's easy to forget about risk. My previous post explains (with a detailed illustration) that when risk is taken into account, the so-called "tax-efficient" asset location strategy might be no better than a much simpler and consistent mirror strategy. By consistent, I mean that the effective after-tax risk remains identical to the pre-tax risk. As forum member Exchme so elegantly wrote, "not only are you taking more risk than you intended with the "tax efficient" portfolio - you can't know how much more".

There are risks to replacing a total-market bond ETF with a municipal bond ETF. Let's look at that.

If I compare, for example, the iShares Core U.S. Aggregate Bond ETF (AGG) with the iShares National Muni Bond ETF (MUB) over the 2008-2012 period, I see that the muni bond was significantly more volatile:

Source: Portfolio Visualizer

Code: Select all

AGG Standard deviation: 4.53%
MUB Standard deviation: 6.32%
Image
Many thanks for your detailed explanation. A lot to digest. And thank you for the links.

My guess is that the mirror asset allocation is best started when an investor is young enough not to have accumulated a lot of embedded capital gains in their taxable portfolio. Those of us of a certain "vintage" would have to unwind a lot of capital gains-laden positions to adopt this.
Retirement is best when you have a lot to live on, and a lot to live for. * None of what I post is investment advice.* | FIRE'd July 2023
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by grabiner »

AlwaysLearningMore wrote: Fri Mar 31, 2023 12:30 pm As I look at my municipal bond returns, I'm not sure that holding an all in one fund (which contains a total bond market fund) in a taxable account is superior, especially considering the ACA tax exemption for municipal bonds. Especially at the highest tax brackets. Perhaps I'm missing something?
If you do hold bonds in a taxable account, balanced funds have the additional disadvantage that they lock you in to the bond allocation. If you want to hold fewer bonds, or a different type of bonds, or bonds in a different account, the balanced fund means that there is a tax cost for doing so. If you hold a separate bond fund, you can sell for little or no tax cost. This is why I don't like target-date funds in taxable, nor Vanguard Tax-Managed Balanced Fund which holds munis.

If you are in a low tax bracket (my rule of thumb is a lower marginal tax rate than 25%), you will prefer taxable bonds. If you are in a high tax bracket (24%+3.8% Net Investment Income Tax puts you over the 25% rule of thumb), you will prefer munis, as you noted. If you move to CA, you will prefer CA munis in a high tax bracket, or Treasury bonds in a lower bracket to avoid the high CA tax.
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by LilyFleur »

I wonder if this is an argument for keeping a 401k/401k. My current 401k gives me the option of withdrawing tax-deferred or tax-free from any investments that I hold. Might this be better to keep rather than rolling it over into a separate IRA and Roth IRA?
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by retired@50 »

LilyFleur wrote: Sat Apr 01, 2023 5:17 pm I wonder if this is an argument for keeping a 401k/401k. My current 401k gives me the option of withdrawing tax-deferred or tax-free from any investments that I hold. Might this be better to keep rather than rolling it over into a separate IRA and Roth IRA?
I would imagine the Roth 401k wouldn't be subject to RMDs with the new SECURE 2.0 law, so you'd still be subject to withdrawing RMDs from the pre-tax portion, whether it's a traditional pre-tax 401k or a traditional IRA.

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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by TheRoundHeadedKid »

"Asset location does not guarantee higher after tax returns".

"This is all very confusing and my default suggestion is that it's best to just replicate the same allocation in all your accounts",

from the "Asset Location" YouTube video by Ben Felix. He did Monte Carlo analysis, statistical analysis, read papers by financial analysts to come to that conclusion.

So, I will follow that advice with the exception of tax-exempt Vanguard ETFs (VTES, VTEB, VTEC, VTEI) being kept in a taxable account only.
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by Gecko10x »

longinvest wrote: Mon Mar 27, 2023 4:41 pm ... Really good stuff...
This is a great write up that manages to elucidate my experience with the "optimal" asset location strategies typically espoused here, leading me to ultimately adopt the mirror approach. Thank you for this. :beer
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by AlwaysLearningMore »

Another issue with the mirrored allocation is the inability to tax loss harvest. Over a long investment lifetime that can be meaningful.

And, as has been pointed out in discussions about this non-traditional asset location approach, embedded capital gains can make changing AA problematic.
Retirement is best when you have a lot to live on, and a lot to live for. * None of what I post is investment advice.* | FIRE'd July 2023
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Re: "Asset Location Fundamentals (which investments to own in which accounts)"

Post by cabfranc »

I still keep international in taxable even though in recent years that dividend taxes have been higher than the tax credit.

The question is where would they be kept if not in taxable? My 401k has an international fund that excludes developed countries, which defeats some of the diversification benefit of international.

If I kept them in my Roth, U.S. would shift from Roth to taxable. If U.S. grows more than international, I would be paying more taxes on withdrawal because U.S. would be in taxable and international in Roth.
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