Changes to my Income Fund Part One – Account Allocation

account allocation plans

I mentioned in my August Income Fund update that I was planning to make some changes to my Income Fund. Since the changes are quite significant, I’m going to describe them in two posts. Here’s the first change regarding my account allocation.

In the past I’ve written about my irrational behaviors. These include ignoring taxes and keeping my retirement and income fund accounts separate. Of course I think my reasons for these are entirely rational, but over time I’ve been questioning them more and more.

So I’m finally taking action to address some of behaviors which should reduce the taxable footprint of my Income Fund, increase its size and start bringing part of my retirement accounts into the picture.

For general advice on which accounts to place various assets in, I recommend this article as a starting point. There’s no single correct answer as it all depends on your individual situation. What accounts, tax rates, available funds, fees all affect the answer.

Income Fund

My Income Fund is held entirely in taxable accounts, the details are shown below as of the end of August.

The year to date income of the portfolio including the tax impact is shown below. The taxes won’t be paid until next year when 2017 taxes are filed so they tend to be invisible in a sense.

Symbol Asset Class Allocation Tax Rate YTD Income Taxes
Stocks  US Stocks 10% 15% $817
VHDYX US Stocks 50% 15% $2,193 $329
 VIHAX  International Stocks 20% 15% $1,354 $203
VWEAX HY Bonds 10% 28% $1,876 $525
VBILX  Intermediate Term Bonds 10% 28% $539 $151
Total    100% $6,778 $1,330

Not earth shattering tax numbers admittedly but the taxes will keep getting higher each year and the higher rate taxes can be eliminated entirely. So why keep them?

Retirement Fund

My Retirement Fund is held across three accounts: a 401(k), a Roth IRA and a Traditional IRA (T-IRA). It’s a fairly straightforward three-fund portfolio with 70% stocks & 30% bonds.

I don’t write about it much because I was focusing on reaching FI with my Income Fund in taxable accounts. I still am, since I can’t access the money in the tax-advantaged accounts until 59.5. But as time passes, I realize that I need to plan more on how I’ll use the accounts when I am able to access the funds.

Here’s the current value at the end of August.

Asset Class Allocation Value
  US Stocks 50% $190,297
  International Stocks 20% $84,063
  Bonds 30% $116,558
Total  100%  $401,268

I’m increasing contributions to my 401k this year and will start maximizing contributions by January. I’m not eligible to contribute to a Roth IRA, nor can I contribute pre-tax money to my T-IRA account. My 401k allows after-tax contributions which is another area I’m considering to use. After-tax contributions can be later rolled over into a Roth IRA.

First Steps

Since my main goal was to reduce taxes, I’ve decided the first step that I’ll take is to move all my Income Fund bond holdings into my T-IRA account. This account is also held at Vanguard and gives me access to the same funds available in my Taxable account.

I can’t actually add money to the account so I’m going to exchange some of the existing funds within the account into new bond funds. Working with the values above, this means I will

  1. Sell both VWEAX and VBILX for a total of around $90,000 in my Taxable account. This results in a small capital gain from VBILX and a larger capital loss from VWEAX.
  2. Use the $90,000 cash to buy more stocks in the Taxable account.
  3. Sell $90,000 of my T-IRA holdings and buy $90,000 worth of bonds within the same T-IRA account.

The result is that the monetary value of my Taxable Accounts and Retirement Accounts stay the same. However the value of the assets considered part of my Income Fund increase by $90,000 whereas my Retirement Fund will decrease by $90,000. At no time have I withdrawn any money from either account despite the sales. I’ve simply moved money into different funds with the same account.

Here’s how the Income Fund looks after the change (values are approximate)

Income Fund Allocation Account Account
 US Stocks 60% $281,499 Taxable
 International Stocks 20% $93,833 Taxable
 Bonds 20% $93,833 T-IRA
 Total  100%  469,165

I’m going to leave the rest of the Retirement Fund alone for now, although if I do need to increase the Bond holding in my Income Fund I will exchange some funds as needed.

How to access the money in the T-IRA account

In the evolution of my Emergency Fund, I reached the conclusion that I could tap into my Income Fund if I really needed funds in an emergency. I have sufficient Savings that I probably wouldn’t need to, but the option is there. Hence the move towards higher quality bonds in my Income Fund.

Now however the bonds are in my T-IRA. And it’s not possible to just withdraw money from a T-IRA before age 59.5 without paying a tax penalty (in addition to the taxes owed on the amount withdrawn). But accessing the money is simple using the Taxable and T-IRA accounts. Here’s how I might ‘withdraw’ $10,000 in an emergency.

  1. I sell $10,000 of stocks in my Taxable account, providing $10,000 in cash for the emergency.
  2. I sell $10,000 of bonds in my T-IRA account and buy the same $10,000 worth of stocks in my T-IRA account.

To ‘repay’ the withdrawal, it’s simply a case of doing this in reverse. So I’d buy stocks with cash in the Taxable account and sell the equivalent amount of stocks in the T-IRA account, buying bonds back with the proceeds.

What if the money is needed when the market crashes?

If the stock market crashed at the time when I needed to raise cash, then I’d be selling the stock in Taxable at a loss. But since I’m buying the same dollar amount of similar stocks in the T-IRA account at the same time, I’m not really selling anything.

The real risk of a market crash is that the stock value declines sufficiently that there wouldn’t be enough stocks to sell. However with an 80%:20% stocks to bonds, it’s a reasonable assumption that the stock value in Taxable will always be higher than the bond value in the T-IRA.

I might even chose to do this when there’s a big correction in order to tax loss harvest, although planning is needed to avoid a Wash Sale.

Why not just merge the portfolios now?

I suppose I could just treat everything as one big account. I still don’t want to do that however as most of the retirement account is inaccessible until after I’m 59. My general plan is to retire early before 65 and start converting the T-IRA account into my Roth account when I’m in a lower tax bracket, before the required distributions start

Metrics

There’s only a minor change to some of my tracking metrics as noted below. Most will remain the same.

Wet Worth

This will be unchanged. It consists of all the Taxable Accounts, Cash, Savings plus Debt. It ignores any holdings in tax-deferred (retirement) accounts or House value.

Dividends and Income

I’ll include the Bond distributions in the Income calculations and monthly Dividend tracking. However the Bond distributions will be re-invested immediately back into the fund in the T-IRA.

Security Ratio

My Security Ratio is the percent of living expenses paid for by my Income Fund. This metric remains unchanged since it’s the amount of sustainable income I can withdraw from the Income Fund (i.e. from the Taxable accounts).

Summary

Starting to use some of my retirement accounts like this is a pretty big change to my mental accounting for me. I think it’s the right thing to do however. There is space in my retirement accounts for bonds and I can still access the money via the methods above.

In Part Two I’ll describe some changes to the Asset Allocation itself, and the reasons behind them.


Quote of the Day

Plans are nothing; planning is everything.

12 thoughts on “Changes to my Income Fund Part One – Account Allocation”

  1. Recommend: Put REITS, MLPs, High Yield Bonds and International in your T-IRA. Use VWITX as your bond/emergency fund. VWITX yields 2.71% is fed and AMT tax free. Side note: At age 55 you can start using 72T to access the funds.

    1. Thanks Dave. Why would you put International (stocks) in the T-IRA? Wouldn’t you lose the foreign tax credit?
      The equal periodic withdrawals is something I’m considering if I’m able to reach early retirement at 55. Originally my targets were age 65 but I’m pulling ahead of those currently.
      Best wishes,
      -DL

      1. You are going to run into the same problem with a growing portfolio, the foreign tax limit is only $600 after that you will get whacked hard plus it is extra work at tax time. Better to put foreign stocks in the IRA now, so down the road you don’t have to sell to stay under the limit.

        P.S. Thank you Sophei. I appreciate your comment and will check out your blog.

  2. Opps, I see you are all ready over by more than double the limit. Your taxes are going to be a lot higher and a lot harder to figure out.

    1. Hi Dave,
      It should be similar to last year – per my 1099-DIV from Vanguard in 2016 which categorizes all the dividends: “US mutual funds that invest in foreign securities may elect to pass certain foreign taxes paid by the fund on to their shareholders; however because the funds are US Corporations, the dividends paid by the funds are US source dividends”.

      Last year I had $1,020.82 as qualified dividends from VIHAX of which $93 was counted as foreign tax paid.

      Best wishes,
      -DL

  3. Here is more info:

    The amount of your creditable taxes paid or accrued during the tax year is not more than $300 ($600 if married filing a joint return) as a result of the foreign tax redetermination.
    https://www.irs.gov/publications/p514/ar02.html

    Messing with foreign taxes is more trouble than it is worth. Better to construct your portfolio to stay under the limit. Good luck.

    1. Hi Dave,
      Thank you for the additional info and link – that’s very helpful!
      I have simplified all international into just one fund (previously I had some ADRs).
      So as I understand it, if the taxes are < $300 then form 1116 doesn't have to be filed, otherwise it's required. Judging from last year I'll likely come in under that limit this year, but I'll definitely check with my tax preparer about the impact in 2018. Appreciate your advice, thanks again! -DL

    1. Hi DFG,
      Yes that definitely makes sense and that’s a great book on investing. The reason I’ve treated mine separately thus far is that they have different objectives. E.g. I have my “retire early” portfolio with one allocation that’s a bit more income oriented, my “retirement backup plan” portfolio with another allocation that’s more total return oriented and a “save for big purchases in 10-20 years time” with a completely different allocation.
      But I can see the lines blurring between my two retirement portfolios and I think they’ll be one big portfolio sooner rather than later.
      Best wishes,
      -DL

  4. I think it makes sense to treat everything as one portfolio with the drive to put the most tax-inefficient assets into tax-advantaged accounts. Sometimes it can be hard to manage for high earners as you only have so much tax-advantaged space(401k, Roth, HSA for most people) but for most of us that’s enough and those accounts should be filled with bonds, REITs and any active stock funds that are likely to generated cap gains and/or ones that pay a high yield.

  5. I recently went through a restructuring of my own. It was somewhat similar to yours. I drastically changed my contributions to shift them from my taxable account into my 401(k) to make sure to max it out. Even if you plan to retire before the eligible retirement date for these accounts, there seem to be ways of accessing it early and avoiding penalties. There is also the option of simply paying the normal tax along with the 10% penalty, which could likely be better than investing in a taxable account over many years. Thanks for a well-written article.

Leave a Reply

Your email address will not be published. Required fields are marked *