How to ideally rebalance a growing portfolio? Need advice!

[llmgwc]

I already posted this on bogleheads but would like to hear some opinions from here as well.

I'm going to try to keep this brief while also providing all the necessary information. If anyone needs more info, please let me know.

I'm having trouble deciding how to move forward with my asset LOCATION. I'm a relatively new self-advised investor. I've done the very best I can to keep my asset allocation as simple and as effective as possible, but as my investments grow I've found that rebalancing is not the simple few clicks I thought it would be and will take more forward-thinking than I had anticipated. I'll explain what I mean and hopefully some of you can help me with that.

Current Situation:

Demographics: 32 years old, wife is 31, infant child

Investable Assets: ~$100,000 of investable assets, tax-free and tax-deferred ONLY

Ideal Asset Allocation: 70% equities, 30% fixed income (I am okay with tilting towards equities as far as 75%, and am even further than that right at the moment which you'll see below). I like 30% of my equities to be International and a 10% tilt towards REITS. On paper, my written asset allocation goes like this:
42% US Stocks
21% International Stocks
7% REITS
30% Total Bond Market

Current Asset Allocation:
49% US Stocks
23% International Stocks
7% REITS
21% Bonds

Investment Vehicles:
My 401K: $49,000 - John Hancock
My Roth: $30,000 - Vanguard
Wife's Roth: $9,000 - Vanguard
Wife's SEP: $11,000 - Vanguard

Simple Enough, right? Well, not really, at least not to me. As you may have surmised, my 401K is invested 100% in US Stocks, hence the reason the asset allocation has hedged towards US stocks this year (not a bad problem to have, growing investments).

My 401k has poor options. I am 100% in an S&P 500 Index fund, and the expense ratio is 1.13 (the lowest of any option I have in the plan). I originally went all-in on the stocks in the 401k because I was trying to keep management fees as low as possible, and that fund had the lowest E.R. I figured I'd balance it through my funds at Vanguard. When I did a Roth conversion in my Roth or contributed to my wife's SEP, I would simply buy whatever I needed (bonds, REITS, or international) to rebalance the portfolio. Clearly, that will be untenable going forward.

My 401K will grow with contributions alone by $25,000 to $30,000 this year, depending on if my employer decides to make a profit-sharing contribution. The SEP will have ~$10,000 contributed to it this spring, and my Roth at least will probably have a conversion of $5500 added before the end of the year.

So the question is, what do I do from here? To me, the simplest fix is to bite the bullet and buy bonds and international in my 401k (E.R.'s of 1.35 and 1.6, respectively). Then rebalance my three Vanguard vehicles and treat each one as its own little portfolio, investing in all 4 of my preferred asset classes in each account. What are the pros and cons of doing it that way? These are what I've come up with:

Pros: 1) Eliminates the problem of my 401k stocks quickly outpacing the rest of my portfolio and throwing my asset allocation off
2) Simplifies rebalancing by eliminating the need to cross-check my accounts; just rebalance each one to my AA and I'm good

Cons: 1) Forces me to buy a crappy bond fund and a crappy international fund in my 401K
2) No options for REITS in my 401K, so I will have to account for this by purchasing more in my other accounts = confusing
3) Will be purchasing bonds in my tax-free Roths, which some people would say is a mistake.
4) Eliminates opportunity to buy Admiral Shares in pretty much all my Vanguard Accounts

As I said, I'm leaning towards treating each account as its own little portfolio. I think it will simplify things as a whole, although I'm still wondering what I'll do to account for no REITS in the 401K. To me, I'll be trading the headache of trying to account for excess stocks in my 401k to a deficit of REITS in my other accounts. Same problem, different asset classes. Any ideas on how to think that through and what to do?

If I were to go ahead and purchase the bonds and international in my 401k, I'd be looking at FEPIX for the bonds, a Fidelity fund. The international options are RERFX (Foreign Large Growth, 1.59) and DFIVX (Foreign Large Value, 1.53). The Large growth has the better historical returns, but I don't know quite enough about the difference between the Growth and the Value to make an educated decision on if I should do one over the other or split the two or what.

In my Vanguard accounts, I'll go with VBTLX (Vanguard Total Bond Market), VTIAX (Vanguard Total International Stock), VNQ (Vanguard REIT Index ETF), and the VTSAX (Vanguard Total Stock Market fund). I guess looking at things now I'll probably be forced to use ETF versions of most of the accounts above if I want to keep my expenses as low as possible. Either that or Investor Shares. What's everybody's thoughts on that? I like the low ER's of the ETFs, but I like being able to use all of my money to buy fractions of the mutual funds. Tough call.

Hope I gave you all enough info to help out here. I appreciate any insight and will check back in a little later tonight to see what people are saying.

Thanks!

[Hatton]

I think the problem is not your asset allocation but the options in your 401k.  They are horrible!!  Can you talk to the senior partner or practice manager about changing the plan.  It will be hard for you to get ahead with this.

[VagabondMD]

The real problem, in my opinion, is that your 401k has a 1% layer of fees, on top of the native mutual fund fees, that make the international and bond options only slight more untenable than the overpriced S&P 500 fund.

You gave little information about your job, employer, long term prospects, etc., but your 401k needs to be overhauled. The employer may not even know that it is a crappy plan, but employers are increasingly responsible for providing good, low cost retirement plan options. If your employer is a six employee office vs. a 5000 person health care company, the approach and outcome might be different, but I would start by trying to make the 401k plan better, especially if you hope to be there long term.

Short of that, I would be no less uncomfortable investing in the DFA international fund or Fidelity bond fund than the S&P 500 fund, recognizing that they are all decent options but just cost 1% or so more than they would if you were able to purchase them directly. Someone else, in all three examples, is getting that 1%!

[VagabondMD]

Worrying about the difference between expense ratios in Vanguard Investor shares vs. Admiral shares vs. ETFs is a waste of energy. They are all good enough. Worrying about these differences while you are paying an extra 1% on your 401k funds is like working up a 7mm thyroid nodule in a 95 year old in the hospice program for widely metastatic pancreatic carcinoma (to make a medical analogy).

[llmgwc]

I recognize that the 401(k) plan is awful.  I am a private practice associate dentist with one owning doc and 10 (or so) employees.  I do plan to be here long-term, preferably as a partner sooner than later.  I've broached the subject of the 401(k) gently in the past and plan to slowly show my owning doc how it is such a bad plan, but for now my major concern is that I need to know how to rebalance this portfolio in the most efficient manner, recognizing that this crappy 401(k) is going to grow at a much faster clip than the rest of my portfolio.

Options as I see them now (of which some ideas came from responses over at Bogleheads):

Option 1) Turn each account into its own little portfolio and rebalance each one individually, at the same time.  Moving forward the 401(K) contributions would be automated which would help with the simplicity of doing it this way.

Option 2) Use the following asset allocation:

My IRA:  100% International

My Wife's IRA:  100% REITs

SEP:  100% Bonds

My 401(k):  S&P 500 Index + Bonds

I would use my 401(K) as the "rebalancer" and as the US stocks began to outpace things again I would simply rebalance the 401(K) back into more bonds.  This idea was suggested by livesoft on Bogleheads and I like the simplicity of basically having 3 Vanguard funds that hold single funds and only the 401(K) that I am forced to rebalance a few times a year as the US stocks become a larger piece of the portfolio pie.  Biggest downside to this is that it makes me very international heavy, basically throughout the year.  With estimated contributions of approximately 40k throughout the year, it would basically take all of 2017 to get back to my preferred 21% international allocation.

Option 3) Use a simple algorithm (also suggested at bogleheads) to find the most efficient place to invest in each security based on the ER Delta of the different security options I have at Vanguard vs. my 401(k).  Spoiler alert, it ends up looking a lot like the example in my Option 2, with the exception of having international AND bonds in my Roth, as opposed to 100% international.  It's basically what I'm doing now, except that it also says I need to exchange some US for some bonds in the 401(k).

The more I type these things out and crunch the numbers, I think I lean towards Options 2/3 or a hybrid of them.  The only thing I get hung up on is the fact that with my contribution rate in the 401(k) growing so much faster than the rest of the accounts, I know it's going to give me more work because I'm going to have to rebalance more often than if I went with Option 1 and just had my 401(k) contributions automated to my ideal asset allocation that my other accounts were all set to.

Only other hang-up for me is the nagging feeling that I shouldn't have a large quantity of bonds in my Roth, but I think that's more psychological than anything.  The math says that based on my expense ratios, putting at least SOME bonds in the Roth makes sense.

Thoughts?

[pulmdoc]

Agree that the management fees in the 401k are the real problem and if that can br fixed your problems are much more minor. A few thoughts to add to what has already been said.

1) You didn't mention a taxable account. You could consider buying low cost bond funds in taxable instead of Depending on tax bracket, muni bonds vs TBM. The tax hit is likely to be less than paying a 1.35% ER going forward. This is what my wife and I do.

2) You should consider converting the SEP to a Roth so that your wife is eligible for future backdoor Roth contributions. There will be a tax hit, so run the numbers.

3) Roth IRA's are an ideal place for REIT funds IMO because of the stock-like growth potential and shielded from tax implications.

[llmgwc]

1) I like this idea.  I have no taxable account now and my plan has always been to not have a taxable account until my student loans are paid off (3.5 years from now).  Someone on bogleheads mentioned this tactic as well and I think it's worth exploring.

2) You may have missed this, but my wife already has a Roth.  As far as I've been able to discern, there is no limits on contributing to both a SEP and a non-deductible traditional IRA, so theoretically my wife can do Roth conversions right now.  Not sure converting to a SEP is necessary, or even really a good idea considering the SEP is her business retirement account and a tax advantage for us.

3) I like your thoughts on Roth/REIT situation.

[pulmdoc]

I did miss that your wife already has a ROTH account. Is she self-employed? Will you need to use backdoor ROTH to make ROTH contributions now or in the future? (2017 MAGI limits $196k for a couple) If your combined income is below the ROTH limit, by all means keep the SEP IRA and also contribute to ROTH for both of you. If self-employed and ineligible for regular ROTH contributions, will need to decide on lower MAGI this year vs tax free withdrawals later.

[llmgwc]

Yes she is self-employed and we will be ineligible for Roth contributions.  As far as I can tell though there is no restriction on her contributing to both her SEP and a non-deductible traditional IRA, so the door is still open for her to do Roth conversions as needed.

[pulmdoc]

Backdoor Roth conversions can be messed up easily because of the pro-rata rule. The pro-rata rule breaks down into a couple of components.

1) All IRA accounts count as one big IRA. So your wife's SEP-IRA, the traditional IRA you have to do a Roth conversion and the traditional IRA your wife has to do a Roth conversion all count as 1 big pot of money to the IRS. The corollary to this is that either both of you are in a position to use backdoor Roth, or neither of you are.

2) Only the % of the whole pot that are after tax contributions are deducted on the amount that is taxable during a Roth conversion. As an illustration, assume there is 89k in the SEP IRA (all pre tax) and both you and your wife want to contribute 5500 each to Roth via the backdoor, placing that money in traditional IRA and then converting it.
That means 11k after tax, 89k pre-tax. You pay taxes, at your marginal rate, on (89%x11,000)=$9790.

The nuts and bolts of whether it is a good idea to keep the SEP IRA or to roll it over and then use the backdoor Roth each year depends a lot on your wife's income. SEP IRA employer contribution limits 25% net self employment income up to 53k, pre-tax. The SEP IRA is obviously more valuable if she is making and saving close to the limit because contributions are pre-tax. You will need to sit down and run the numbers as well as make some educated guesses about future income to determine which route is more advantageous.

[llmgwc]

Hmmm.  You have me thinking now.  Especially here:

1) All IRA accounts count as one big IRA. So your wife’s SEP-IRA, the traditional IRA you have to do a Roth conversion and the traditional IRA your wife has to do a Roth conversion all count as 1 big pot of money to the IRS. The corollary to this is that either both of you are in a position to use backdoor Roth, or neither of you are.

Are you certain of the rules here?  Why would my wife's SEP-IRA and my traditional IRA have any link whatsoever?  They are IRAs, after all - emphasis on the "I".  Individual retirement accounts.

Form 8606 makes your point clear that all IRA's are treated as the same pot of money.  From Line 6:

"Enter the value of all your traditional, SEP, and SIMPLE IRA's as of December 31, 2016, plus any outstanding rollovers."

However, because IRAs are individual retirement accounts, held in each individual's name, each individual's assets are treated just that way... individually.  The IRS states that plainly at the top of Form 8606:

"If married, file a separate form for each spouse required to file Form 8606."

So, in our case, I contribute to my traditional IRA and make a Roth conversion to my Roth IRA.  I fill out the Form 8606.  It has nothing to do with my wife or with her SEP.  When Vanguard sends me my tax forms I will get statements for my IRA's, she will get statements for hers.  They will not be combined.

Now, if she were to make a Roth conversion from her traditional IRA or SEP, I could see how the pro-rata rule would come into play.  Otherwise, I don't think it applies here.  Am I wrong?

 

[pulmdoc]

Eesh, you are right. This is what I get for not proofreading before posting. Roth eligibility is determined jointly for a married couple. Your wife's SEP would effectively make Roth conversions undesirable due to pro rata rule. You are free to make Roth conversions assuming you have no other IRA's to bring pro rata rule into play.

[DMFA]

*Individual* retirement arrangements.  Her SEPs don't count toward your conversions vis-a-vis the pro rata rule.

Does she have to have a SEP?  Can she not do a solo-401k?  That'll solve any pro rate issues.

We are in a slightly similar situation with my wife's 403b, my TSP, and then our IRAs.  Fortunately for her, though, she actually has some decent options as hers is done through Fidelity: their institutional S&P index fund FXSIX is solid, but they don't have a total or good int'l option, so we make up for that with my TSP's C and I funds.  Likewise, the TSP doesn't have a total stock option, so we have to piece it together using large (C Fund) and mid-small/extended market (S Fund) components, so in order to simplify balancing (and since I prefer to favor mid-small caps anyway) we split between the two.

Your portfolio is one whole entity split across different accounts.  You've got to make the most out of the fund options you've got at employer accounts and factor that into the whole portfolio.  However, with your biggest chunk of existing assets and future contributions being in the account with the worst options, you've got to decide whether the allocation percentages are the most important thing, or if you would purposely slant away from what you'd like and just take the "least bad" option in the 401k (which hopefully is domestic equities, since that tends to be the largest chunk of portfolios) and piece together the rest of the portfolio from there.

[llmgwc]

She doesn't have to do a SEP, but it was the simplest option for us when we set it up last year because we had missed the deadline to start a 401k.  We've missed it again this year so a SEP contribution will happen again.  I probably need to look into options again for the 401k, though.

However, with your biggest chunk of existing assets and future contributions being in the account with the worst options, you’ve got to decide whether the allocation percentages are the most important thing, or if you would purposely slant away from what you’d like and just take the “least bad” option in the 401k (which hopefully is domestic equities, since that tends to be the largest chunk of portfolios) and piece together the rest of the portfolio from there.

A tough call for sure!  I think eventually I'm going to be forced to taking some bonds in the 401k.  One thought I had over the weekend was to not technically "rebalance" the 401k, but just start having 100% of my contributions go to the bond fund for now and readdress the situation in March after we find out how much we can contribute to my wife's SEP.  Take everything we contribute to hers and put it to bonds, then see where we sit as far as the allocations go.

Any advantage to going this way and simply buying more bonds in the 401k, as opposed to selling some of the equities I already have?

 

[TheGipper]

Many an article have been written on whether to invest in a crappy, high fee 401k.  I think the answer comes down to your marginal tax bracket.  If your are in one of the top tax brackets, I'd still max out the crappy 401k, especially is your profit sharing component comes from your employer and not "from yourself", with the understanding that most people will switch jobs many times in a career, and at that time you can roll into an IRA or a new better 401k.

Double check your plan rules and make sure that in-service rollovers to IRA or other qualified plans are not allowed.  Sometimes they are and then your problem is solved.  Every so often transfer money out of 401k.

If you are in a low to mid tax bracket, I'd skip the 401k entirely and use a Vanguard taxable account, UNLESS you also have the option of a Roth 401k, then I'd stick with the crappy Roth 401k with hopes of rolling of out to Roth IRA in the future.

Frustrating.