Time to rethink placing bonds in tax advantaged?

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Time to rethink placing bonds in tax advantaged?

Postby Clivus1 » Fri May 10, 2013 9:22 am

Is it time to revisit the conventional approach of placing bonds in tax advantaged accounts?

The yield on Vanguard Total Bond Market Admiral mutual fund shares is 1.56%.

The yield on Vanguard Total Stock Market Admiral mutual fund shares is 1.97%.

Past performance does not predict the future, but bond yields seem likely to remain low for the near term. Most rebalancing now involves selling equities and buying bonds.

Anyone have thoughts?
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Re: Time to rethink placing bonds in tax advantaged?

Postby livesoft » Fri May 10, 2013 9:27 am

viewtopic.php?f=1&t=104265
viewtopic.php?f=1&t=101897

I hope it is pretty clear that one would not sell all their equities in taxable, pay the cap gains taxes, then invest the proceeds into bond funds.
It's all about short-term opportunistic rebalancing due to a short-term change in one's asset allocation, uh, I mean opportunistic rebalancing, uh I mean rebalancing, uh I mean market timing.
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Re: Time to rethink placing bonds in tax advantaged?

Postby Leesbro63 » Fri May 10, 2013 9:44 am

I agree that it's too tax-costly to shift gears. But for new money/young investors or if we ever crash again and there are tax lost harvesting opportunities (heaven forbid! :) ) it might make sense to consider equities in sheltered accounts now.
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Re: Time to rethink placing bonds in tax advantaged?

Postby livesoft » Fri May 10, 2013 9:47 am

Furthermore, consider the tax rates on those TSM and TBM dividends. They are not the same, so one's after-tax yield is something to look at.
Last edited by livesoft on Fri May 10, 2013 9:50 am, edited 1 time in total.
It's all about short-term opportunistic rebalancing due to a short-term change in one's asset allocation, uh, I mean opportunistic rebalancing, uh I mean rebalancing, uh I mean market timing.
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Re: Time to rethink placing bonds in tax advantaged?

Postby PR101 » Fri May 10, 2013 9:50 am

Note that bond fund dividends are taxed as ordinary income, while most stock fund dividends are qualified dividends that are taxed at lower rates.
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Re: Time to rethink placing bonds in tax advantaged?

Postby grabiner » Fri May 10, 2013 10:48 pm

I looked at this in a previous thread: When to prefer low-rate bonds to stocks in taxable, but I believe my conclusion there is not quite correct.

If a municipal-bond fund yields less than a stock-index fund, it may make sense to hold the bond fund in a taxable account. The municipal-bond fund presumably loses 33% of its yield to taxes (assuming it is priced at the same after-tax return as a corporate fund in a 25% tax bracket). The stock fund loses 15% of its yield to taxes every year, and about 10% of its total return to capital-gains tax. If the yields are equal and the stock fund returns a normal 8%, this is close to break-even; the linked post has an example.

But the italicized phrase is important. In this example, the bond and stock funds have equal taxes if the stock fund returns 8%, but the stock fund has lower taxes if it returns 5% and higher taxes if it returns 11%. Thus, by putting the stock fund in your taxable account, you get the same expected return with lower risk, because the IRS will share some of your stock losses.

There is also the additional concern that you might not have to pay the capital-gains tax on the stock fund. If stock returns are high, you probably won't sell all your stock in your lifetime; you will leave some to your heirs, or give it away to charity.

But it may still make sense to hold bonds in taxable if there is a state tax issue. If you live in CA, for example, you have a 1.58% yield on CA Intermediate-Term Tax-Exempt Admiral shares with an effective tax of 0.52%, or a 1.97% yield on Total Stock Market Admiral Shares with an actual tax rate of 0.43% (0.30% federal + 0.18% state at 9.3% - 0.05% federal tax deduction from state taxes at 28%). And in any state, it's often a good idea to buy I-Bonds in taxable because they are exempt from state tax and have higher rates than TIPS held for less than twenty years.

If you do buy bonds in a taxable account, you'll want to switch to stocks in taxable if interest rates rise; this should not cause a tax problem, as rising interest rates will cause bond prices to fall and allow you to sell the bond fund for a capital loss.
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Re: Time to rethink placing bonds in tax advantaged?

Postby JimInIllinois » Sat May 11, 2013 3:25 am

There seems to be a life-cycle component to asset location that I do not recall seeing discussed.

When I retire I would prefer to have stocks in my taxable account for the usual reasons.

In my peak earning years immediately prior to retirement I will be shifting my asset allocation to be more conservative by selling stocks to buy bonds. If the stocks I own are all in my taxable account I will be paying taxes on decades of capital gains just when I am at my highest tax rate.

A good rule of thumb may be to not buy more stocks in taxable accounts than you plan to own on the day you retire. Your taxable investments in the years immediately preceding retirement should go into safe assets that you will spend during your first years of retirement while doing Roth conversions.
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Re: Time to rethink placing bonds in tax advantaged?

Postby Dandy » Sat May 11, 2013 8:19 am

Surely the current interest rate on fixed income vs Total Stock market yield would make you think of bonds in taxable. But, for the long term investor - do we expect this unusual difference to last? Or is this a short term strategy to buy bonds/bond funds in taxable, get higher yields (but maybe not after taxes), and when interest rates rise and the taxable bonds lose value - use that loss to offset gains?

If you are keeping your overall allocation the same but just varying the placement, or the placement of new money you have to consider the after tax return and the long term effect when interest rates resume a more normal relationship to stock yields.
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Re: Time to rethink placing bonds in tax advantaged?

Postby livesoft » Sat May 11, 2013 8:21 am

When interest rates rise, I suppose bond fund NAVs will go down, but guess what? -> So will the NAV of the Total Stock Market Index fund and probably by a higher percentage. Thus the TLH opportunities will still be better with TSM than with TBM. :twisted:
It's all about short-term opportunistic rebalancing due to a short-term change in one's asset allocation, uh, I mean opportunistic rebalancing, uh I mean rebalancing, uh I mean market timing.
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Re: Time to rethink placing bonds in tax advantaged?

Postby jeffyscott » Sat May 11, 2013 8:55 am

Interest rates rising would tend to mean an improving economy, an improving economy would tend to result in increasing stock prices. Of course the timing is in question, perhaps stocks have already risen in anticipation of further improvements in the economy, which are not yet resulting in rising interest rates?
press on, regardless - John C. Bogle
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Re: Time to rethink placing bonds in tax advantaged?

Postby jeffyscott » Sat May 11, 2013 9:05 am

livesoft wrote:Furthermore, consider the tax rates on those TSM and TBM dividends. They are not the same, so one's after-tax yield is something to look at.


Stocks with 1.97% yield means a tax bill of 0.3% at 15% tax rate, while bonds at 1.56% in the 25% tax bracket gives you a tax bill of about 0.4%.

Of course, the better option might be to first do I-bonds and perhaps EE bonds in "taxable".
press on, regardless - John C. Bogle
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Re: Time to rethink placing bonds in tax advantaged?

Postby Electron » Sat May 11, 2013 1:32 pm

I have been taking advantage of the 0% bracket for qualified dividends and capital gains, and try my best to avoid ordinary income in taxable accounts.

Everyone should review their tax situation very carefully and get a feel for the marginal tax rate for each income category.

In my case, additional ordinary income pushes qualified dividends out of the 0% bracket (actually the 15% bracket) resulting in a marginal tax rate much higher than expected. As an example, assume a 10% bracket for ordinary income. If qualified dividends are pushed out, the ordinary income is effectively taxed at 25%. The ordinary income is taxed at 10% and the qualified dividends see their tax rate change from 0% to 15%.
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Re: Time to rethink placing bonds in tax advantaged?

Postby linguini » Sat May 11, 2013 2:10 pm

jeffyscott wrote:
livesoft wrote:Furthermore, consider the tax rates on those TSM and TBM dividends. They are not the same, so one's after-tax yield is something to look at.


Stocks with 1.97% yield means a tax bill of 0.3% at 15% tax rate, while bonds at 1.56% in the 25% tax bracket gives you a tax bill of about 0.4%.

Of course, the better option might be to first do I-bonds and perhaps EE bonds in "taxable".


Wow, I somehow missed that they left the 15% capital gains for households with under $400k-$450k of ordinary income, and that 20% was only for the 39.6% bracket. Thanks for that! I guess I need to pay closer attention next time. The reporting at the time focused mostly on the fight over the top tax bracket rates, so I guess I stupidly assumed that the 15% was the "highest bracket" of capital gains taxes instead of realizing that they were referring to the top bracket of ordinary income. :oops:

Anyway, yeah, I bonds and EE bonds can act like traditional IRAs if you buy-and-hold. It satisfies the purpose of deferring taxes until one's income is lower in retirement, and it satisfies the purpose of deferring taxation on compounding interest. That said, you still end up taxing long term capital gains as ordinary income if you are holding stocks in a tax-deferred retirement account, so swapping them probably still puts you at some disadvantage relative to someone who weights tax-deferred accounts more toward bonds and taxable accounts more toward stocks. Long term capital gains are taxed incredibly lightly relative to ordinary income right now, so unless there are significant policy changes, it still seems to make a lot more sense to have stocks in taxable if what you care about is minimizing expected taxation. That is, unless I'm missing some details or making a logical flaw, which is entirely possible.
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Re: Time to rethink placing bonds in tax advantaged?

Postby jeffyscott » Sat May 11, 2013 6:01 pm

linguini wrote:That said, you still end up taxing long term capital gains as ordinary income if you are holding stocks in a tax-deferred retirement account, so swapping them probably still puts you at some disadvantage relative to someone who weights tax-deferred accounts more toward bonds and taxable accounts more toward stocks.


I don't think that is correct as I-bonds and EE bonds effectively expand your tax deferred space. So the comparison would be stocks in tax deferred with I and EE bonds vs. regular bonds in tax deferred and stocks in taxable.
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Re: Time to rethink placing bonds in tax advantaged?

Postby linguini » Sat May 11, 2013 9:02 pm

jeffyscott wrote:
linguini wrote:That said, you still end up taxing long term capital gains as ordinary income if you are holding stocks in a tax-deferred retirement account, so swapping them probably still puts you at some disadvantage relative to someone who weights tax-deferred accounts more toward bonds and taxable accounts more toward stocks.


I don't think that is correct as I-bonds and EE bonds effectively expand your tax deferred space. So the comparison would be stocks in tax deferred with I and EE bonds vs. regular bonds in tax deferred and stocks in taxable.


Yep! Logical error on my part. Good catch.
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Re: Time to rethink placing bonds in tax advantaged?

Postby grabiner » Sun May 12, 2013 10:50 am

jeffyscott wrote:
livesoft wrote:Furthermore, consider the tax rates on those TSM and TBM dividends. They are not the same, so one's after-tax yield is something to look at.


Stocks with 1.97% yield means a tax bill of 0.3% at 15% tax rate, while bonds at 1.56% in the 25% tax bracket gives you a tax bill of about 0.4%.


However, the stocks will lead to another tax bill if you have to sell them during your lifetime.

Dandy wrote:Surely the current interest rate on fixed income vs Total Stock market yield would make you think of bonds in taxable. But, for the long term investor - do we expect this unusual difference to last? Or is this a short term strategy to buy bonds/bond funds in taxable, get higher yields (but maybe not after taxes), and when interest rates rise and the taxable bonds lose value - use that loss to offset gains?


You have the point right. If it makes sense for you to hold bonds in taxable now because of the current rates (and other considerations such as the stock and bond options in your 401(k)), you can always switch later. Selling bonds in a taxable account doesn't cost much in taxes, and if the reason you are selling the bonds is that the bond yields have increased, then you will have a capital loss on the bonds.

(If you have Total Bond Market in your taxable account, use a different bond fund when you switch to bonds in your 401(k) to avoid wash sales. If you have a muni fund in your taxable account, wash sales should not be a problem because a muni fund should not be substantially identical to Total Bond Market.)
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