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Author: DavidInTX Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 75596  
Subject: Allocations across 401(k), taxable accounts Date: 1/12/2005 12:31 PM
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Howdy fools -

This question is motivated by a column in the January, 2005 issue of Money magazine.

In the "Intelligent Investor" column (I think that's the one), Jason Zweig advocates favoring bonds over stocks in your 401(k) if you have investments in both a 401(k) and a traditional, taxable brokerage. The rationale is that interest income from bonds is taxable at up to 35%, depending on your tax bracket, while the maximum tax rate for capital gains is 15%.

By my reckoning, though, he's failing to factor in the fact that taxes are paid on the initial capital to be invested.

For example, assume that you have $1000 to invest, you're in the 35% tax bracket (both now and when you retire, for simplicity), you have 20 years until retirement, and your rate of return on the investment is 5% (i.e. you'll make the same investment either in your 401(k) or outside of it, the only question is where). My math looks something like this:

For the 401(k):
Available Investment $1000.00
Value at end $2653.30
Less income tax $928.65
Post-tax income $1724.64

For the non tax-advantaged account:
Available Investment $1000.00
Less income tax $350.00
Initial Contribution $650.00
Value at end $1724.64
Less initial contrib.
(already taxed) $650.00
Amount to be taxed $1074.64
Less cap gains tax $161.20
Cap gains retained $913.44
Plus initial principal $650.00
Post-tax income $1563.45

This analysis leads one to precisely the opposite conclusion advocated in the article.

So, my question is .... what am I missing?
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Author: IndecisiveFool Big funky green star, 20000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 43994 of 75596
Subject: Re: Allocations across 401(k), taxable accounts Date: 1/12/2005 1:24 PM
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So, my question is .... what am I missing?

One thing I think you are missing is that your analysis is based on 401k or taxable account. The author made the distinction that his article is based on 401k and taxable account. He states that when you have both accounts, you should place the bonds in the 401k, not taxable account.

IF


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Author: ziggy29 Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 43997 of 75596
Subject: Re: Allocations across 401(k), taxable accounts Date: 1/12/2005 1:40 PM
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You don't have more money at the end of the period in a taxable account, but IF you have both, and you have stocks and bonds, the stocks are clearly better to hold than bonds in the taxable account.

Keep in mind also that it may be wise to have a taxable account for some of your planned retirement savings anyway, for various reasons, not the least of which being that you don't have to wait until age 59 1/2 (or use SEPP) to start tapping the account. This is particularly important for anyone planning to retire before age 59 1/2.

#29


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Author: DavidInTX Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 44006 of 75596
Subject: Re: Allocations across 401(k), taxable accounts Date: 1/12/2005 5:51 PM
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"You don't have more money at the end of the period in a taxable account, but IF you have both, and you have stocks and bonds, the stocks are clearly better to hold than bonds in the taxable account."

That's what everyone says, I'm just having a hard time convincing myself of it.

I'm thinking of it this way: you have a marginal $1000 to invest, and it could go either place. In this case, it seems you're better off putting it your 401(k).

The other reply (from "IndecisiveFool") has got me thinking ... suppose you're in the fortunate scenario of maxing out your 401(k) *and* having an investment account. Then, your $1000 pre-tax capital will, by definition, be taxed. In that circumstance, you'd want to shift your bonds to the 401(k) as the Zweig suggested in his article.

So I suppose I just convinced myself.

Thanks, fools.

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