By Dr. James M. Dahle, WCI Founder
Asset location is a fairly advanced topic in the first place. Many investors don't pay any attention to it at all. However, what surprises me is that so many of those who actually do pay attention to it get it wrong. Let's be clear, of course–in the grand scheme of things, asset location doesn't matter all that much. It's much less important than your savings rate. It pales in comparison to your income. Asset allocation matters far more. Getting your investment expenses down into the realm of reasonable is also going to make a bigger difference. Heck, I don't even think good asset location can make enough of a difference to justify hiring an advisor. But it can boost returns a little bit and so if you're one of those willing to put in a little effort to bank that benefit, at least make sure you're doing it right.
Pet Peeve #1 – Only Paying Attention to the Tax-Efficiency of the Asset Class
I see this one all the time- in blog posts, in internet forums, out of the mouths of financial advisors, and even in the books of people I have a great deal of respect for. But it's wrong, wrong, wrong. When deciding whether to locate an asset in a tax-protected account or in a taxable account, you have to pay attention to BOTH the tax-efficiency AND the expected return of the asset. The problem with paying attention only to the tax-efficiency is that you don't account for the benefit of improving your ratio of tax-protected to taxable. A quick example will demonstrate what I mean.
Consider two asset classes. The first has an expected return of 2% and all 2% is paid out every year and is taxable at your full marginal tax rate. We'll call that 40%. It is maximally tax-inefficient but has a low expected return. The second has an expected return of 10% but pays out nothing in any given year and when it is sold in a taxable account, the gains are paid at the capital gains rate, let's call that 20%. Let's say your asset allocation calls for 50% in each asset, and you have two accounts, a tax-free account (such as a Roth IRA) and a taxable account, which are equal in size, $10K a piece. You're going to invest for 10 years, then pull it all out, pay any taxes due, and spend it. To keep things simple, we won't rebalance, although it could be argued that you should be tax-adjusting the two accounts to account for the effect of the slowly increasing tax liability of the taxable account. Let's look at your two options:
Option #1 Put tax-inefficient, low-return asset class into the tax-free account and the tax-efficient, high-return asset class into the taxable account
After ten years, your tax-free account has grown to
=FV(2%,10,0,-10000) = $12,190
And your taxable account has grown to
=FV(10%,10,0,-10000) = $25,937
Of course, you must apply the appropriate tax rate to the taxable account.
=85%*(25937-10000)+10000= $23,546
The total of the two account is $35,736. Now let's compare to the second option.
Option #2 Put tax-efficient, high-return asset class into the tax-free account and the tax-inefficient, low-return asset class into the taxable account
After ten years, your tax-free account has grown to
=FV(10%,10,0,-10000) = $25,937
And your taxable account has grown to
=FV(2%,10,0,-10000) = $12,190
Again, you must apply the appropriate tax rate to the taxable account. Since the returns are taxed at 40% each year (not at the end), and 40% of 2% is 0.8%, then we can just change there return figure in the Future Value function from 2% to 1.2%.
=FV(1.2%,10,0,-10000) = $11,267
=RATE(10,0,-20000,35736) = 5.98%
=RATE(10,0,-20000,37204) = 6.40%
6.40% – 5.98% = 0.42%
Clearly, in at least some situations, the least tax-efficient asset class SHOULD NOT be put preferentially into the tax-protected account. I announced this in a post with the admittedly click-baity title Bonds Go In Taxable! and have caught lots of crap about it ever since by people who can't do math (including a Boglehead who told me he doesn't read anything I write since that post.)
Back in the Real World
Now, that's all good and fine. All of you who have completed sixth-grade math now agree with me that there are times when theoretically it can make sense to preferentially put a tax-inefficient asset class into a taxable account. But here in the real world, we have to deal with the hand we are dealt, rather than perfectly tax-efficient asset classes returning a perfect 10% a year and perfectly tax-inefficient asset classes returning a perfect 2% a year. When you add all of those other factors in, it can get a lot more complicated. In fact, it gets so complicated that to truly arrive at the right answer for you, you will have to make guesses about the unknowable future including tax rates, when you will die, future returns of asset classes, and what will happen to your assets when you die. Good luck with that. However, there are some general rules you can apply to your situation.
General Rule # 1 – Tax-inefficient asset classes with a high expected return should go into a tax-protected account.
This includes things like REITs, peer to peer Loans, or hard money loans.
General Rule # 2 – Tax-efficient asset classes with a low expected return should go into a taxable account (assuming your tax-protected accounts are full. If not, everything should go into tax-protected accounts if possible.)
This includes things like muni bond funds and any investment that has a high probability of going down in value (although I suppose if you knew that, you wouldn't buy it in the first place.)
General Rule # 3 – Don't spend a lot of time or effort trying to decide where to put tax-inefficient, low returning asset classes or tax-efficient, high-returning asset classes.
If there is a BIG difference in expected return (let's say 5%+), go with the high-returning asset class in tax-protected. If the difference is small, (say <2%), go with the tax-inefficient asset class in tax-protected. If the expected return difference is between 2-5%, then you really shouldn't worry about it. Your expense ratios will make a bigger difference. For example, if you have a 1% CD and an emerging market index fund you expect 7% from in the long run, put the index fund in the tax-protected account. But if you have a bond fund paying 5% and you only expect 6% out of your total stock market index fund over your investment horizon, then put the bond fund in tax-protected. But if you have a fund that is slightly more tax-efficient and has a slightly lower expected return (think TSM vs SV), then it is a no-brainer to put it in taxable. If you have a bond fund with a 3% yield and a stock fund that you expect 7% from…well, don't worry about it. You're not going to know which was the right decision for years and the consequences won't be that large anyway.
General Rule # 4 – When choosing between two asset classes, pay attention to the bigger difference.
If one asset class is only slightly more tax-efficient, but has a significantly higher expected return, put it in the tax-protected account. Likewise, if an asset has only a slightly lower expected return, but is much more tax-inefficient, put it preferentially in the tax-protected account.
If you're not sure what the expected return is for your asset class, join the club, but Rick Ferri gives some reasonable guidelines with his crystal ball which seems to be somewhat clearer than mine. (If you care, he predicts 3.9% for 10 year treasury bonds and 7% for US Large Cap stocks over the next 30 years.)
His sister was making fun of him until she realized that “Captain Underpants” was wearing her underpants
Pet Peeve #2 Thinking That Locating Higher Expected Return Asset Classes into Tax-free Accounts is a Free Lunch
Another mistake I often see otherwise intelligent people make is to try to give recommendations about what asset class should go into your tax-deferred account (think 401(k)) and what asset class should go into your tax-free account (such as a Roth IRA.) The common recommendation is to put the higher expected return asset class into the tax-free account and the lower expected return asset class into the tax-deferred account. What these folks don't seem to get is that a tax-deferred account is simply a tax-free account plus an account you are investing for the government's benefit. The only part of that tax-deferred account you will ever get to spend is the tax-free portion. When you look at it that way, you really just have two tax-free accounts (plus a government account that goes along for the ride for a few decades.)
So when you put the asset with the higher-expected return asset class preferentially into the tax-free account without acknowledging that a significant chunk of the tax-deferred account doesn't actually belong to you, you are really just changing your asset allocation to a riskier asset allocation. Yes, over the long run that is likely to give you a higher overall return, but only because you are taking on additional risk. It's not the free lunch these complex asset location process gurus would like you to think it is.
Let's do some math to illustrate. Let's assume you have a $10,000 tax-deferred account and a $10,000 tax-free account and you have two asset classes- one of which you expect a 10% return from and one that you expect a 5% return from. We will also assume the effective tax rate at withdrawal from the tax-deferred account is 20%.
What you really have is:
- $10,000 tax-free account
- $8,000 tax-free account
- $2,000 government account
If you put the 10% expected return asset class into the larger tax-free account, and the 5% expected return asset class into the smaller tax-free account and the government account, and then let it ride for ten years, you end up with:
=FV(10%,10,0,-10000) + FV(5%,10,0,-8000) = $38,969 and the government ends up with =FV(5%,10,0,-2000) = $3,258
If you put the 5% expected return asset class into the larger tax-free account, and the 10% expected return asset class into the smaller tax-free account and the government account, and then let it ride for ten years, you end up with:
=FV(5%,10,0,-10000) + FV(10%,10,0,-8000) = $37,039 and the government ends up with =FV(10%,10,0,-2000) = $5,187
Basically, if you asset locate properly, you get $1,930 more and the government gets $1,930 less. That's like getting a return that is 0.54% higher (6.90% to 6.36%) Cool, right? But it shouldn't be surprising given what you now know. In the first situation, you had this after-tax asset allocation:
- $10,000/$18,000 = 56% asset class with 10% expected return
- $8,000/$18,000 = 44% asset class with 5% expected return
And in the second situation you had
- $8,000/$18,000 = 44% asset class with 10% expected return
- $10,000/$18,000 = 56% asset class with 5% expected return
Of course a 56/44 asset allocation is going to have a higher expected return than a 44/56 asset allocation. You didn't do anything smart. You just took on additional risk. Now, sometimes behavior trumps math, and if you somehow were able to fool yourself into taking on more risk than you thought you were, and that helped you stay the course with a more aggressive asset allocation, then maybe you did yourself a favor. But there's no magic under the hood here. It's just a bunch of hand-waving.
The truly advanced at this point will point out that Roth IRAs aren't subject to RMDs, providing another reason to go with the higher returning asset class in the tax-free account. That's true, but it's a rather minor point for most of us who actually plan to spend most of our money in retirement.
Back in the Real World
Of course, back here in the real world nobody is adjusting their asset allocation for taxes. Try it and you'll see why. It's hard enough to figure out what your effective tax rate on tax-deferred withdrawals will be. Now try to figure it out with your taxable account! That's what I thought. Talked you out of it didn't I. So in the real world, throwing your higher expected return asset classes preferentially into Roth is a reasonable thing to do, even if it isn't a free lunch. Just realize that if Great Depression II occurs you'll wish you had done the opposite.
What do you think? What do you do with asset location? What has your biggest dilemma with it been? Do you try to put your highest expected return assets into your Roth IRA? Why or why not? Comment below!
Great article. Minor quibble with last part. I do in fact tax-adjust my various accounts on my net worth excel sheet. It’s easy. Sure it’s an estimate but far more accurate than doing nothing. Roth = 1.0. Taxable = 0.9. 401ks = 0.8. 457b = 0.75 (some will come out prior to full retirement of both spouses). 457f = 0.65.
The major argument for putting higher return, higher risk assets into Roth is precisely if one plans to spend them down last or pass on to heirs. One can minimize the risk adjusted return by diversifying among high risk lower correlated elements in ones Roth. For example 25% small cap value, 25% REITs, 25% international small cap, 25% emerging market (which is what I use). This protects me slightly against a larger Roth drawdown should one of these take a 50% hit any given period.
You’re a rare person to actually tax-adjust your asset allocation. Most people don’t even have a net worth excel sheet. It’s fine. It’s even “the right thing” to do. But it’s pretty rare because most people don’t even understand that point.
I would argue a few things against your second point. First, it’s probably not a good idea to just “spend the Roth last.” You’ll pay less in overall taxes to use the Roth as you go along to keep you from going into the next tax bracket, effectively allowing you to pick your tax rate in retirement. Second, a tax-deferred account is just a Roth + a government account aside from the RMDs, which should probably be spending anyway if you don’t want to die the richest guy in the graveyard. Third, while I would rather inherit a Roth account than a tax-deferred account, in many ways it is best to leave the tax-deferred account to the heir. For example, if you have an heir in a much lower bracket than you (good chance if you’re on this site that you’l have at least one)- better to leave the tax-deferred account and live off the Roth account. It’s also a great account to use for charity.
I also correct for future taxes and find that a lot easier and more intuitive than asset location decisions.
I can also get the exact amount of unrealized gains in my taxable account at Vanguard for each fund in about 2 seconds, allowing much more accurate data
For example I used to correct +10% for taxable and +20% for Roth (you could do the same negatively but I think in terms of income) but this ends up being way off for bonds in taxable that have almost no ongoing gains
“Taxable = 0.9. 401ks = 0.8”
Why is 401k taxed more than Taxable?
A 401(k) is tax-deferred money. It has never been taxed and is taxed at full marginal rates at withdrawal. Taxable money is already partially taxed (the basis) and the remainder can be taxed at LTCG rates.
Small correction: Pet Peeve #1 states capital gains tax of 20% in the text but 15% in the calcs . . .
Of course, it could be both/either, just not for the same person in the same year.
Great writeup. (I think Steve F is just kindly pointing out that your stated assumption is a capital gain rate of 20%, but your calculations show the math with 15%).
With that said, I’m still struggling with where I should put my bonds (15% AA). Should they go in my 403b (DODIX, ER 0.5), or in my taxable account with vanguard tax-exempt intermediate term fund (VWIUX, ER 0.09)….or maybe 7.5% in each? Moving my bonds to taxable would allow me to use my tax-deferred space for more equity (VTMGX) which probably has higher expected return. I’m a newbie DIY’er, still struggle with this stuff! thanks for all your help
The point of the post is that it doesn’t matter much. As rates rise, however, it will matter more. I’ve actually currently got bonds in both taxable and tax-deferred.
I’ll add a caveat though it’s almost impossible to manage at this level. Tax advantage accounts don’t just reduce the tax on your return, they can also help drop you below adjusted gross income cutoffs like making less then 196 k for Roth contributions(admittedly there ware ways around that but not for all such items). As such there is some aspect of putting income producing assets in a tax advantages account if you make near a cutoff. Again almost impossible to manage.
Now that the “Stretch IRA” seems very likely to be done away (except for a $450,000 exclusion per spouse) in the next 12 months,
http://www.paytaxeslater.com/articles/the-ultimate-retirement-and-estate-plan-for-your-million-dollar-ira-addendum.pdf
will the “death of the Stretch IRA” not complicate the asset location decision?
For example, I would surmise that inheriting “stepped up basis” high expected return assets (of say $1,000,000) from a taxable account would seem to be a better option than inheriting a similar large amount of assets ($1,000,000 over the $450,000 exclusion) from a Traditional IRA, 401-k, etc and having to distribute all $1,000,000 as ordinary income over a 5 year period.
Complicating the decision making process will be the “pro rata” rules mentioned in Jim Lange’s article.
Great point Sam on Stretch IRA changes, BUT Trump’s tax plan also proposes getting rid of step-up basis on death with deals a blow to taxable accounts as well. That 450,000 exclusion per heir on stretch IRA should hopefully still go a long way with me, if inflation indexed, and spread among 4 kids. We’ll see how it pans out. Roths are definitely not without the risk of additional future change as well, such as forced distributions when above 5 mil (see recent Wyden proposal which supposedly has some bipartisan support).
I still favor riskier assets in Roth if planning to hold them longer and spend down or convert traditional IRA first.
Gipper,
Per Jim Lange’s article, the $450,000 exclusion is per IRA holder not per beneficiary. There is still unlimited exclusion for a spouse; but, then upon the death of the surviving spouse, the IRAs, (Roth and Tradtional) along with all other retirement accounts (ie. 401-k) would only have a $450,000 (indexed to inflation) exclusion.
But, as you point out, if the “stepped up basis” is done away for the taxable account, then that would also need to be factored in as well as whether it makes financial sense to convert traditional IRA (401-k) to Roth account.
Lots of decisions to consider!
Jim is never afraid to write about something that is merely proposed as though it is sure to become fact. It gets him out in front of the pack with regards to when something actually changes, but I like the Boglehead forum policy approach of no talking about tax law changes until they actually become law. There are so many pump-fakes in this regard that just never take place.
But with regards to this particular proposed change, I don’t think the death of the stretch IRA changes the asset location decision significantly because the stretch IRA aspect is only one favorable reason to have more in tax-protected accounts. You also get easier estate planning (designated beneficiaries), better asset protection, lower taxes, better returns etc. Obviously the amount you inherit has to be adjusted for taxes due on it (I’d rather inherit $1 Million taxable than $1 Million tax-deferred even if I could stretch the tax-deferred over many years. It takes a lot of years of tax-protected growth to make up for the fact that the entire account is pre-tax.)
WCI,
You make good points….particularly that the “death of the stretch IRA” has not become law as well as the importance of adjusting for income taxes.
However, as you noted in prior posts, there are other benefits to investing in higher expected return assets (i.e equities) in taxable accounts:
1) tax efficient donations to charities for equities that have appreciated in value (and held over 1 year)
2) tax loss harvesting
3) the stepped up basis at death (current estate law)
4) the 10% tax penalty and being taxed at the highest marginal rate, should there be a good reason for needing more money than your emergency fund and the rest of your taxable account would be able to provide and you are “forced” to dip into one of your pre tax retirement accounts.
5) the relatively low tax rate (on long term capital gains)
6) the ability, at age 70 and 1/2 and upon death to avoid income taxes altogether by donating and/or bequeathing money to charity…and avoiding income taxes altogether.
But, as you state early in your opening paragraph, the decision of the asset location pails in comparison with so many of the other investment and financial decisions and in particular, the savings rate decision.
In conclusion, not disagreeing with your conclusions (bonds in taxable and equities in tax deferred) and do agree, in principal, with your 4 general rules.
Thank you! Articles like these are fantastic and why I am a regular reader!
Yup, if you’re advanced, you like the advanced articles. If you’re just starting out, the simpler articles are great. I just showed one of my employees soon to deliver that if she put the $4K she has saved up to pay for her baby into an HSA for a day before writing the check she’ll save $1000-1500. Free money just for knowing the rules about an HSA. Not particularly advanced, but if you don’t know it already or have never thought about it….it’s new to you!
BTW, one other thing that many people aren’t yet alert to is the Obamacare net investment income tax. Who knows what will happen with ACA, but the Sec. 1411 thresholds aren’t indexed for inflation, which means that any diligent young investor will ultimately face these taxes if the legislation or its taxes stays around. And that tax tips the scales toward putting your best performing assets into a tax-advantaged account.
I would say 99% certainty the ACA net investment tax is gonzo. As for the rest of Obamacare who knows. Stephen, remind me is the ACA 0.9% Medicare surtax a separate tax or tied into the same 3.8% net investment tax.
You don’t pay the 3.8% Sec. 1411 net investment income tax on anything you’re paying the 3.8% medicare tax on (the combo of the regular 2.9% medicare tax and the .9% surtax)… nor on anything you’re paying the 3.8% self-employment tax
But my point is that if the Obamacare surtax stays–and again happy to stipulate that’s a GIANT question mark–the NIIT needs to be considered when you think about taxes during retirement.
Given that the thresholds ($200K for single and $250K for married) aren’t indexed for inflation, many disciplined savers will be subject to tax on their net investment income three or four or five decades from now.
P.S. Income from retirement accounts is not subject to NIIT while income from regular taxable investments will be.
I didn’t realize that retirement account income doesn’t count. Yet another great reason to max out retirement accounts.
just more work now for attorneys and cpas with 20 trillion in ret assets
guess the stretch ira is too good to be true and I was banking on it
Physicians have to work as triage nurses when it comes to assigning their dollars to the right treatment room. For those seeking advanced training, I recommend two documents from tax planning guru Michael Kitces:
https://www.kitces.com/wp-content/uploads/2014/02/Kitces-Report-January-February-2014-Exploring-The-Benefits-Of-Asset-Location.pdf
https://www.kitces.com/wp-content/uploads/2014/04/Kitces-Report-March-April-2014-Advanced-Asset-Location-Strategies1.pdf
lots of free digital books at james lange website
great important info if you want to leave more dollars to your family
For high net worth individuals, you will need to factor in the step-up in basis of assets. High return investments are generally capital gain assets and much of these are likely to be passed on to heirs.
Tax effecting allocations and withdrawals is worthwhile, and worth the effort IMO.
Always a good reminder about the math of post-tax vs pre-tax retirement accounts. More than once I’ve been on a forum where someone does voodoo to show Roth yields more post-tax money ceteris paribus – I always have to come back to your previous post where you break them down to get my head on straight.
according to james lange roth conversions are always better than traditional iras
suggests partial conversions when necessary and obviously converting non deductible iras to roth
I’ve read a lot of Lange’s work and I disagree that he says Roth is always better than traditional.
Just curious, in what situation would not converting an IRA to Roth be a better idea than converting? Are you referring to someone that has a large IRA balance that is not Roth that will be forced to pay taxes on a portion every time they convert, or rather to the fact that while converting to a Roth early in your career (when there is a long investing horizon to grow tax free) makes sense, it may be more intelligent to take the tax deduction as you get closer to retirement?
I have all of my IRA dollars in ROTH and do a back door conversion on the full amount (5500) every year along with maxing out my 401k and HSA… is this something that I should reconsider? Thanks!
If you can later get the money out at a lower effective rate than you are now paying to convert it, then converting now is a bad idea. If you have a tiny IRA and no other taxable source of income, paying at a high marginal rate to convert is dumb.
All my IRA dollars are Roth too because high income professionals with a 401(k) can’t deduct traditional IRA contributions. A backdoor Roth beats a non-deductible traditional every time. So you’re probably doing it right. But if you’re in your peak earnings years and doing Roth 401(k), there’s a good chance that’s a mistake.
As much as I love James Lange, many have questioned his math in regards to early Roth conversions done during peak earning years…..
Another article by Kitces on Asset Location; supports Pet Peeve #1:
https://www.kitces.com/blog/asset-location-for-stocks-in-a-brokerage-account-versus-ira-depends-on-time-horizon/
My pet peeve about this article is that he used the term “asset location” three times when he meant asset allocation.
Want to point out those errors and I’ll fix them?
Sure… See the article’s title, the first sentence, and the fourth sentence.
None of those uses of “asset location” is incorrect. Are you familiar with the concept of asset location?
Asset allocation is what mix of assets do you invest in. Asset location is how you place the various assets in your asset allocation into the investing accounts (such as tax-deferred, tax-free, and taxable) available to you.
Just read Delmuth’s “The Overtaxed Investor”. Nice book, but boy it is heavy on Pet Peave #1.
Another taboo topic people don’t mention much and seem to ignore when they endorse a global family portfolio, is the non-zero chance of divorce. Yet another reason to spread the bonds and high risk equities around a little even if their is a very small tax advantage to concentrating them all in certain accounts.
Why? It’s not like you get to keep your entire IRA and your spouse gets to keep their entire IRA and get none of yours. That’s all split up evenly in a divorce.
So if spouses have fairly equal 401ks (and perhaps similar incomes), a judge is going to go through the hassle of splitting up both accounts?
Let me first state I’m not an attorney, much less a divorce attorney, have never been to divorce court or been divorced.
But my understanding is that generally the pot is split. Now if you have a $500K IRA and she has a $600K IRA I would only expect you to get $50K to “even it up” not that you’d get a $250K IRA and a $300K IRA.
Good layout with numbered examples. One of the situations that I am in as well as many of my colleagues is that we are all W2 employees. The bulk of our investments end up in taxable accounts simply due to limited tax-protected space. One a handful of us can actually generate enough secondary income outside of our primary work to start a Solo 401k.
Again, not the worst problem in the world to have, but it makes a difference what 1099 contractors or self-employed can do!
In my taxable acct I own a tax-inefficient hedged mutual fund that is actually negatively correlated w/ a down S & P environment – it can have awesome gains in fact; it is not correlated much w/ up markets. It’s based on volatility. The acct has a margin interest rate presently approx 1.6% (good amount of assets, negotiated rate based on Libor). So for me it seems to make sense to have relatively high (long term) performance mutual funds in that taxable mix even if I don’t worry as much about the tax efficiency since with, say, 30-35% in margin, and a much lower overall standard deviation due to the hedged fund, I am not too concerned about the potential for a margin call, and this hedged fund has equity-like long term performance, so I feel this extra amount of equity mutual funds (and no bonds) more than offsets tax considerations; obviously no one can margin a tax-deferred or a tax-free Roth acct., both of which I have. So I guess rules were made to be broken for specific situations. Also, no financial guy seems to mention that in these tax-inefficient funds, 1 minor offset is that when you do sell, your basis is higher and you’ll pay less tax at that point at least (admittedly it far from makes up for the early higher taxation).
So you have a high-return, tax-inefficient asset that you think should be in taxable? I’m not convinced. I guess if that’s the only place it is available to you then you’re stuck with it, but if there’s another option it is likely better. You’re so vague on what the investment is I can’t quite tell.
see above Jim…
rather see below Jim…
I appreciate your response Jim. The fund is hfxix. It has a 10-year+ record, same mgr. Other things being equal, of course I would put this investment in tax-deferred or a Roth!! But my point is due to it’s negative correlation (only) when the S&P is down, it gives me the opportunity to, I feel, safely use a significant amount of strategic low rate interest margin precisely due to this inverse correlation; I buy ‘long’ funds – index or otherwise, in same acct. E.g., since beginning of 2012 (Morningstar) the S&P had 18 negative return months, 5 of those months between -6% and -3%; in those same 18 negative months this hedged fund had only 2 down months, and those 2 avg -0.27%. In the last 2 tough market years, 2008 the fund was UP 50% and in 2011 up 16 1/2%. It has a “below avg” Morningstar risk profile. It very recently hit a real tough patch in the last 3 trading days (volatility is extremely low w/ S&P running), but is still up for the year. Has very high expenses and is tax inefficient, but will certainly avg out much better than bonds, but more importantly is more inversely correlated w/ a down S&P than bonds. So due to the significant leverage I can apply because the fund more than smooths out down mkts, I feel this is an exception to the usual advise regarding margin, expense ratios and tax efficiency. Without the significant leverage, I would be an idiot to have this fund in a taxable acct (although I suspect you feel my actions are idiotic anyway Jim!).
Expensive fund. According to Morningstar, Catalyst Hedged Futures Strategy has an ER of 1.92%, a turnover of 177%, a 5 year annualized return of 5.05% and a 10 year annualized return of 10.74%. By way of comparison, a total stock market index fund has an ER of 0.05%, a turnover of 3%, a 5 year return of 14.90%, and a 10 year return of 7.38%. A total bond market index fund has an ER of 0.06%, a turnover of 11%, a 5 year return of 2.21%, and a 10 year return of 4.22%. It was a hedge fund prior to 2013, so I assume you didn’t invest it in until after that point. I’m not sure I would call the return after that point “equity-like” but if you think this is a worthwhile asset class to include in your portfolio, and limit it to a reasonable percentage of your portfolio (5-10% ish) I think that’s okay. I agree it belongs in a tax protected account, but if you want to use margin, that isn’t an option.
Let us know how it goes over the years.
Or this month
I admit I don’t understand Jeff’s strategy but HFXIX opened December a 12.02 at closed yesterday at 10.09.
I don’t think there is any other asset that has been up enough to cover that loss
Given he is also borrowing on margin to invest, I think I’ll steer clear.
Or the next month. I admit I don’t understand this strategy (Jeff’s) but HFXIX is down from 12.02 on 11/30 to 10.09 yesterday
I am sure I wouldn’t be comfortable with a strategy that involves this level of volatility AND borrowing on margin
(I’m 70% sure that I understand 70% of this post 😉 ……)
how do any of these recommendations and rules of thumb change for investors that plan to FIRE, so may live off of the taxable account for a 1-2 decades before they touch their tax advantaged/free accounts?
My plan so far has been to place more conservative investments in taxable because my timeline to withdrawal is much shorter, and I can afford to play the riskier long game in some of my tax-advantaged/free accounts.
Thoughts?
Great question. Yes, unfortunately tax location is complicated.
Basically, if you expect to spend all or most of your taxable account, then you would not assume a step-up in basis at death for equities, making them comparatively less tax-efficient. i.e. favor bonds in taxable more.
Not sure your strategy is the best as money is fungible. Sounds like you’re doing the “bucket” thing where you have two different asset allocations- one in taxable for the first few years of retirement and another totally separate one in tax-protected for later. Does it matter a lot? No. But I try to look at all accounts for a particular goal as one account.
I don’t think of this money as fungible at all, what am I missing Jim?
In about 7 years, age 45, I plan to be FIRE and will probably start living off of my portfolio. I cannot access any of the funds in my many various tax advantaged/free accounts without triggering SEPP (which isn’t terrible, but may not be ideal). I have a 15 year stretch until I can access those funds, so the money in those different are not fungible. A short to mid term risk (about 7-15 years) in my taxable account is much worse than in accounts that I’m unlikely to touch for more than 15 years.
Right?
I do look at everything as a single portfolio, but I don’t have the same access to all the money at the same time, and I can’t transfer funds between accounts to make up shortfalls due to risky investment downturns.
You’re missing the fact that there are many ways to access retirement account money, even without penalty, prior to age 59 1/2.
https://www.whitecoatinvestor.com/how-to-get-to-your-money-before-age-59-12/
Sure, SEPP is a little restricting, but given the tax and asset protection benefits of the retirement accounts I think it’s still worth it to use them.
Nope, I already knew all of those things you listed, wasn’t missing any of them. The only one that applies to me is SEPP which is totally not fungible with the liquidity of my assets in my taxable account (well, I *can* pull some money out for my health insurance, ). It’s completely possible that I will end up using SEPP, but it’s also completely possible I don’t. Either way, I do not have equal access to the two different buckets of money, and it would seem to me that means I need to treat each bucket’s timeline differently, and time lines are usually crucial to risk tolerance.
You can always use a bucket strategy if you like and just have two separate asset allocations. It’s not that big of a deal. But I’d SEPP before I skipped out on contributing.
I think there’s been some confusion. I’m definitely maxing out contributions in all available accounts. Your blog post is about how to allocate investments between all those locations with regard to taxes. My question was specifically about if/how that allocation may change if the locations have different timelines because your examples use the same timeline for all locations. Your blog post specifically mentions how some faux-tax-efficient strategies are really just increasing the risk profile. I’m wondering how differing timelines along with differing net taxes due alters the risk profiles.
I *think* I know the answer, but then so do the people who only pay attention to the tax-efficiency of the asset class, so….maybe I’ll ask again?
how do any of these recommendations and rules of thumb change for investors that plan to FIRE, so may live off of the taxable account for a 1-2 decades before they touch their tax advantaged/free accounts?
and, maybe I already have your answer, and that is “don’t. Use SEPP or any of the other methods to withdraw money from all accounts as needed, especially to “create your own tax bracket” by pulling from the various buckets.”
Either way, thanks for the time and all this info, it’s awesome.
I think you’ve got it. I think the answer is “don’t.” And if you “don’t” and you end up with a larger tax protected to taxable ratio than you otherwise would, then it’s that much sooner that you burn through the taxable account and have to SEPP a retirement account.
That said, if you decide to do a buckets strategy as you get close to the time when you’ll start burning that taxable account, then you may want to derisk the taxable accounts/pre 59 1/2 bucket. At that point though, asset location is a pretty minor issue. This is all pretty easy if you end up concluding that bonds (such as a muni bond fund) in taxable is right for you, then you’ve already derisked on the taxable side.
Dr. Dahle,
I am new to the site and am trying to learn, 74 yrs old, and do not understand the math notation. Sorry! Please explain?
My wife and I live in Texas, am working PT, have 1.7 million in managed funds (paying over 12,000/yr) and am anxious to make changes. I never had any confidence in financial matters, but you can see this 🙁
2019 will be a better year for us, with the freedom I anticipate CAN take place!
My sincere thanks,
Dr. K
Not sure what you’re asking exactly, but asset location has a relatively minor effect on investment returns so it’s not exactly the most important part of investing to understand. If you get it exactly right maybe it’s worth a few dozen basis points a year. At any rate, if you’re paying someone $12K a year for financial advice, they should not only be teaching you about proper asset location but doing it for you. Have you considered getting a second opinion from one of my recommended advisors? I’m sure you can cut your advisory fees in half and maybe get better advice at the same time.
https://www.whitecoatinvestor.com/financial-advisors/