Bonds in taxable or tax advantaged?

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WalterMitty
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Bonds in taxable or tax advantaged?

Post by WalterMitty »

If I am using a 2 Fund Portfolio (VTSMX/VTI & VBMFX/BND), with ETFs for both, and given the relatively low Bond yields, does it really matter which account (taxable vs. tax advantaged) to use for either fund?

Thanks
Grt2bOutdoors
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Re: Bonds in taxable or tax advantaged?

Post by Grt2bOutdoors »

WalterMitty wrote:If I am using a 2 Fund Portfolio (VTSMX/VTI & VBMFX/BND), with ETFs for both, and given the relatively low Bond yields, does it really matter which account (taxable vs. tax advantaged) to use for either fund?

Thanks
What is your tax bracket and what is the dollar volume you are talking about?
Let me give you an example - you are in the 15% tax bracket and your net interest income is $1,000 - your tax liability may be ZERO.

Now here's another example - you are in the 39.6% or the 33% tax bracket, your income is over $250,000, your net taxable interest income is $15,000 - holding tax exempt bonds in taxable would be preferable in order to keep more than 1/3 of your interest in your pocket as opposed to the taxing authority's bank account. Also, you'd get dinged for the ACA bill of 3.8% on investment income and that additional contribution of 0.9% for Medicare. So, reducing taxable investment income would be a huge plus for these folks.

In both instances we have low bond yields, but totally different outcomes.
"One should invest based on their need, ability and willingness to take risk - Larry Swedroe" Asking Portfolio Questions
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Phineas J. Whoopee
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Re: Bonds in taxable or tax advantaged?

Post by Phineas J. Whoopee »

That's a subject which has come up several times over the past few low-bond-yield years.

One view has been to invert the traditional order, keep bonds in taxable, pay little in income tax because the interest is so low, then when intermediate-term interest rates go up Real Soon Now sell the bonds after their prices have gone down to harvest the tax loss, buy stocks in taxable with the proceeds, and make an offsetting transaction in tax-advantaged, being careful to steer well clear of the wash sale rule.

Another has been to just do what usually works best and try not to complicate one's life, especially since the tax loss harvesting strategy in the prior paragraph depends on doing several things right in an indeterminate timeframe and it's common for people to lose some of their cognitive abilities as they age.

Taylor, who seems to have lost little if any cognitive ability, is fond of writing "When experts disagree it's often because it makes little difference."

I go with that.

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rtw318
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Re: Bonds in taxable or tax advantaged?

Post by rtw318 »

The decision should be based on your federal + state tax bracket and the SEC yield of each bond fund.

Use this formula: TAXABLE_bond = TAXFREE_bond / (1 - Total_Tax_Rate)

If TAXABLE_bond is "significantly" larger (>0.4? 0.5? Others will chime in on this threshold...) than TAXFREE_bond then the after-tax returns you're making on the TAXABLE_bond fund are worth keeping in your taxable account. If the difference is smaller (<0.2), then you may steer more towards using the TAXFREE_bond fund.

For Total_Tax_Rate, combine your federal and state tax rate. If you are living in CA with 25% fed and 9.3% state taxes, then Total_Tax_Rate is .25+.093 = 0.343

If you're comparing the CA-Muni bond fund (VCADX) vs the Total Bond Market fund (VBTLX) at Vanguard, you can see:
TAXABLE_bond = 1.55 (SEC % yld of VCADX as of 10/20/2014) / (1 - 0.343) = 2.36 ...this is your minimum target SEC yld % for the TAXABLE_bond fund.

Currently, Total Bond only has a SEC % yld of 2.05...not really making the grade for it to be worth your while. There is, however, the intermediate-term bond fund (VBILX) which yields 2.47%. Better, but not stellar.

Ultimately, your individual tax situation should determine which bond fund to use.
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abuss368
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Re: Bonds in taxable or tax advantaged?

Post by abuss368 »

That is really a strategy question to your portfolio in general.

Essentially one strategy is based on "asset location" where stocks are in one account and bonds in another.

The other strategy is "equal location" where basically the same funds are in the same accounts. There may be minor differences and most often it is the bond allocation. An example is Total Stock and Total International in all accounts. The bond allocation may be Total Bond in tax advantaged accounts and Intermediate Tax Exempt in taxable accounts.

I employ an "equal location" strategy as Rick Ferri and his firm Portfolio Solutions recommend. Here is a link to Rick's excellent website with a very good article titled "Does Asset Location Make Sense?"

http://www.rickferri.com/blog/strategy/ ... ake-sense/

Also keep in mind that Treasury bonds and TIPS provide state and local tax benefits.

Best.
Last edited by abuss368 on Wed Oct 22, 2014 1:53 pm, edited 1 time in total.
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Phineas J. Whoopee
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Re: Bonds in taxable or tax advantaged?

Post by Phineas J. Whoopee »

^ Rick's recommendation assumes behavioral errors.
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inbox788
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Re: Bonds in taxable or tax advantaged?

Post by inbox788 »

Grt2bOutdoors wrote:
WalterMitty wrote:If I am using a 2 Fund Portfolio (VTSMX/VTI & VBMFX/BND), with ETFs for both, and given the relatively low Bond yields, does it really matter which account (taxable vs. tax advantaged) to use for either fund?

Thanks
What is your tax bracket and what is the dollar volume you are talking about?
Let me give you an example - you are in the 15% tax bracket and your net interest income is $1,000 - your tax liability may be ZERO.

Now here's another example - you are in the 39.6% or the 33% tax bracket, your income is over $250,000, your net taxable interest income is $15,000 - holding tax exempt bonds in taxable would be preferable in order to keep more than 1/3 of your interest in your pocket as opposed to the taxing authority's bank account. Also, you'd get dinged for the ACA bill of 3.8% on investment income and that additional contribution of 0.9% for Medicare. So, reducing taxable investment income would be a huge plus for these folks.

In both instances we have low bond yields, but totally different outcomes.
I asked similar question recently, but didn't get much attention. I had just read the article
Is Your Retirement Portfolio Ready to Do the 'Twist'?

which added a consideration I hadn't given too much though to. Basically, during accumulation, you want bonds in tax advantaged, but during withdrawal, it's probably better in taxable.

Don't forget the other side if the coin, which is the stocks, which will also be taxed at different rates, and are expected to yield higher returns. Changing and varying tax rates and returns is what makes the computation difficult, and if assumptions turn out different, can significantly change outcomes.
Iorek
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Re: Bonds in taxable or tax advantaged?

Post by Iorek »

I have seen enough debates about this (e.g. is tax advantaged space more valuable for stocks because of their greater growth potential or for bonds because they may spin off more income per year) that I generally aim for a balanced approach. That said I do look at ways to keep my taxable bonds to a reasonable amount (e.g. using ibonds).
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abuss368
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Re: Bonds in taxable or tax advantaged?

Post by abuss368 »

The best portfolio is the one that works for you and allows you to stay the course.
John C. Bogle: “Simplicity is the master key to financial success."
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Phineas J. Whoopee
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Re: Bonds in taxable or tax advantaged?

Post by Phineas J. Whoopee »

abuss368 wrote:The best portfolio is the one that works for you and allows you to stay the course.
And on that, the overriding value of staying the well-chosen course rather than trading in response to short- to medium-term market events, we fully agree.
:sharebeer
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