Interesting behavior and wondering if there is a good explanation.. (add MORE bonds to tax deferred only and end up with MORE effective savings at the end)

@max12376

AI Overview:

The recommendation to hold bonds in tax-deferred accounts and stocks in taxable accounts is a common strategy called asset location because it can maximize after-tax returns. Bonds are less tax-efficient, as their earnings are primarily interest taxed as ordinary income, while stocks are more tax-efficient due to returns coming from capital gains, which are taxed at a lower rate upon sale. This strategy places the less tax-efficient assets (bonds) in a tax-sheltered account, and the more tax-efficient assets (stocks) in a taxable account.

Why this strategy works

• Bonds in tax-deferred accounts: Bonds generate income that is taxed as ordinary income, which is often at a higher rate than capital gains. Holding them in a tax-deferred account means you don't pay annual taxes on this income, letting it grow tax-free until you withdraw it in retirement.
• Stocks in taxable accounts: A large portion of a stock's return comes from price appreciation, which is not taxed until you sell the investment. By holding stock index funds in a taxable account, you can defer the tax on these gains until you sell, and when you do, they are often taxed at a lower long-term capital gains rate.
• Tax-efficient funds in taxable accounts: This strategy is particularly beneficial for index funds, which are designed to be more tax-efficient by minimizing capital gains distributions and holding a broad market.

Important considerations

• Individual circumstances: The optimal strategy depends on your specific tax bracket and overall asset allocation.
• Tax-free accounts: This strategy is different from Roth IRAs or Roth 401(k)s, which are tax-free accounts where the opposite placement may be beneficial for high-growth assets.
• Municipal bonds: Consider municipal bonds in taxable accounts, as their interest is often exempt from federal, and sometimes state and local, taxes.
• Long-term vs. short-term gains: The advantage of holding stocks in a taxable account is strongest for assets held for the long term, which qualify for lower long-term capital gains rates.

@max12376

Gaby has it right, you are seeing the impact of a tax efficient portfolio. The program will hold the allocation of the account at your input value until it needs to override it to maintain the overall asset allocation.

I want a pure tax efficient portfolio, where I preferentially keep bonds in tax deferred, then spillover to Roth if necessary. So I set the asset allocation for taxable and Roth at 100% stocks and the allocation for tax deferred at 100% bonds and put the accounts in the order of taxable, Roth, tax deferred. That way the program doesn't limit the bonds in tax deferred in any way, it just keeps the overall asset allocation constant.

Posted by: @ricke

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I want a pure tax efficient portfolio, where I preferentially keep bonds in tax deferred, then spillover to Roth if necessary. So I set the asset allocation for taxable and Roth at 100% stocks and the allocation for tax deferred at 100% bonds and put the accounts in the order of taxable, Roth, tax deferred. That way the program doesn't limit the bonds in tax deferred in any way, it just keeps the overall asset allocation constant

That's what I've done my whole investing life. But now as I want to lower my AA, I'm stuck with the inability to rebalance without a large capital gain! I wish I'd been a lot less black and white about what went into which account.

Interesting. I am familiar with tax efficient allocation. I just had never imagined how impactful it might be on the end result. In my case, it does lower my IRMAA brackets as I start to reach RMD age, which is nice. I started out with a 'pure' tax efficient portfolio, but I found it's harder to stomach my most valuable accounts (taxable and Roth) tanking during a downturn. So I have been using somewhere in between (mostly stocks in taxable, mostly stocks in Roth, mostly Bonds in tax deferred). What was striking was just by reducing the growth in the tax deferred (converting to bonds only) and doing nothing else (leaving the taxable and Roth as a mix of stocks/bonds), I ended up with more effective dollars. Paying less in taxes over a lifetime adds up!

Jonathan, I know where you are coming from. I do see a lot of Bogleheads run out of room in tax deferred for Bonds.

It's still weird though. I would literally be moving the tax deferred from 50/50 to 0/100 in my example scenario. And that tax deferred is not a small account relative to the others. I am not sure a 65/35 overall allocation would even be possible in that scenario, given the size of my tax deferred.

Does the #1 priority for the algorithm fixate on the "overall" 65/35 allocation and, if so, could it be adding more stocks to my other accounts (thus altering their allocations to be more stock heavy to do so) in order to achieve the overall AA objective? (I assume that is the rationale for the "prioritization") That would make sense to me. It would explain a greater effective dollar amount. I would still be adding risk because my most valuable accounts now have more stock.

I have to think about this some more... I wonder if I can see how the AA's for each account might change as the algorithm tries to keep my overall constant.

Chris

...and... I answered my own question. If you go to "review/tabular projections/portfolio/allocations", there it is in all its glory. Nice! I now better understand the prioritization. Since I put Roth first, it is keeping that constant. How cool.

@max12376

Yep, you just prioritize the accounts and the let the program figure out which assets go where to meet your asset allocation target.

Note that some of the improvement in final estate value is because Pralana is holding your overall asset allocation constant, but you only get to spend after-tax money and Pralana is not holding that constant. A way to visualize your tax deferred account is that you own a percentage of it and the government owns a percentage, based on the tax rate when you make withdrawals. When you do a tax efficient portfolio and jam your bonds into tax deferred, you are sticking the government with a larger share of your bonds and putting your stocks in Roth and taxable, where you own them outright. On an after-tax basis, you've actually increased your stock allocation and that is the source of some of the return. Purists would insist on keeping the after-tax allocation the same, but that is a really mushy concept as the tax bracket that the tax deferred balance will come out at often changes during your life, such as when RMDs rise in later years or when a spouse passes or when heirs inherit. To make it more confusing, the amount of stocks that are also in the tax deferred account (so the government has a claim to a share of them) also changes over time. I think Pralana's approach is a "good enough" treatment and going further down the rabbit hole would totally confuse everyone. Just recognize that after-tax, you hold a few percentage points higher stock allocation than it appears.

Note that the competitor programs in the market don't have a tax efficient option at all, if you were to use one of them and you tell it that you want to hold your bonds in tax deferred and stocks in Roth, those programs would see the low returns in tax deferred (because of the bonds) and high returns in Roth (because of the stocks) and recommend huge Roth Conversions. But they are really just getting rid of your bonds in favor of stocks as fast as possible and that unintended change in asset allocation is a much bigger effect than the tax savings of Roth Conversions. I've seen folks on retirement boards bragging about how they just converted everything at the top rate because their program told them it was a good idea, without understanding that they were fooled by a limitation of an inferior calculator tool.