Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

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nycinvestor
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Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by nycinvestor » Thu May 05, 2016 10:32 am

First time poster but long time reader. Thank you to all of you as I learned a lot here over the years.

I am a little confused about when to start buying Municipal Bond funds in taxable accounts.
In my retirement accounts (tax deferred), bond funds comprise roughly 35% of tax advantaged holdings (so I still have space to add more bonds in place of stocks).
For the ease of discussion, Retirement accounts=Tax Advantaged=Tax Deferred.
My tax rate: 35% federal, 6.85% state, 3.65% city (these are approximate)
My overall allocation is 75% stocks and 25% bonds.
At this point, I max out all retirement accounts and put additional money into stocks in taxable.

My questions are: should I replace TSM with Vanguard TBF in tax deferred and then only when I run out of space in retirement accounts to start buying Munis in taxable? Or I should start buying Munis now and leave the tax deferred accounts the way they are? I am thinking that the last option will allow to achieve the max grows, as stocks in tax advantaged will greatly benefit from the tax deferral. In addition, with Munis in taxable instead of stocks, I would also save on yearly capital gains/dividends taxes.

Thank you in advance for your help.

Cheers.

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celia
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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by celia » Thu May 05, 2016 1:53 pm

I think the wiki page on Tax-efficient Fund Placement will help you. If not, come back here and re-state your question a little differently.
A dollar in Roth is worth more than a dollar in a taxable account. A dollar in taxable is worth more than a dollar in a tax-deferred account.

retiredjg
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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by retiredjg » Thu May 05, 2016 2:40 pm

The conventional Boglehead wisdom says to keep bonds in tax-advantaged accounts (such as a 401k or IRA). If the bond allocation is larger than can be held in tax-advantaged accounts, let bonds overflow into taxable, using tax-exempt bonds if in a higher tax bracket.

Not everyone agrees and part of that disagreement had to do with the poor bond returns during the very long low interest rate environment. Muni bonds are again starting to pay less than taxable bonds (after taxes) so I don't know what those folks think now.

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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by livesoft » Thu May 05, 2016 2:47 pm

I would definitely fill tax-deferred account(s) with taxable bonds before buying munis in a taxable account.

An oft-linked article from WhiteCoatInvestor aka EmergDoc about tax-exempt bonds in taxable compared that to taxable bonds in Roth which is not what you are writing about. You are not writing about Roth IRA nor Roth 401(k), Instead you are writing about tax-deferred accounts.

Tax-efficient equity funds in taxable should not have any capital gains nor non-qualified dividends. Plus they should allow tax-loss harvesting opportunities. All this makes them extremely tax-efficient with an annual tax-drag of less than 0.5%, plus many other benefits.
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House Blend
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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by House Blend » Thu May 05, 2016 2:52 pm

Welcome to the forum.

In your bracket, I don't think you need to completely fill tax-advantaged with bonds first. For one thing, it is useful to be able to do most of your rebalancing in tax-advantaged.

Second, in your bracket, you are likely paying 18.8% on qualified dividends. With that plus 10.5% state, minus a bit due to deductibility of state taxes, a dollar invested in TSM at a yield of 2% is losing 0.51%/year to taxes.

Replace that dollar with VG NY Long Term Tax-Exempt @ 1.64% and in some sense you are getting the benefit of a yield that is higher by 0.51%; i.e., 2.15%. This is comparable to Total Bond, but much riskier in at least three dimensions: duration, concentration, and quality. You are also reducing your exposure to future capital gains tax (good), and reducing your opportunities to TLH (bad).

I do think the case for adding munis would be more compelling if tax-advantaged were 75% bonds (or other tax-inefficient funds such as REIT), rather than the 35% you have now, but I don't see it as a major blunder either. If you go that route, you should probably set some limit on what fraction of your bonds you will allow to be in an NY muni fund.

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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by BigJohn » Thu May 05, 2016 6:21 pm

Not all agree but I personally liked to have at least some bonds in both taxable and tax deferred. Made my annual rebalancing all with tax deferred much more simple. A discussion here about this issue might be useful reading viewtopic.php?p=2020351

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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by grabiner » Thu May 05, 2016 8:44 pm

Another issue is that the 35% tax bracket isn't very large. If you are in that bracket, you are probably close to moving up to the 39.6% bracket. In that bracket, you pay 23.8% federal tax on your qualified dividends, but nothing extra on munis, and that makes NY munis much more attractive than taxable stocks. If you buy stocks in your taxable account, and then move into the 39.6% bracket, you will have to sell stock for a capital gain.
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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by inbox788 » Thu May 05, 2016 10:54 pm

It's a very complicated subject and there isn't a simple answer. A lot of variables impact your decision, some knowable today, some changing over time, and others based on unknowns in the future. Different assumptions about any can change your conclusions. A case can be made for either. Here's a good argument for bonds in taxable.

http://whitecoatinvestor.com/asset-loca ... n-taxable/

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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by retiredjg » Fri May 06, 2016 6:43 am

inbox788 wrote: Here's a good argument for bonds in taxable.

http://whitecoatinvestor.com/asset-loca ... n-taxable/
Is it? Or is it an argument to put bonds in taxable as opposed to Roth IRA?

Dandy
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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by Dandy » Fri May 06, 2016 8:04 am

I believe most investors should have some fixed income in both tax advantaged and taxable for stability and potential rebalancing. People generally should have some liquid assets in taxable - muni's are fine but don't let taxes be too much of a driver if you want to have some taxable fixed income.

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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by CommonCent$ » Fri May 06, 2016 8:27 am

Dandy wrote:I believe most investors should have some fixed income in both tax advantaged and taxable for stability and potential rebalancing. People generally should have some liquid assets in taxable - muni's are fine but don't let taxes be too much of a driver if you want to have some taxable fixed income.
+1 to the above.

However because the implications of the perceived advantages can lead to a slightly different AA of bonds to equities in taxable vs tax deferred accounts I too debate how much to slant the AA in each account. Looking forward to the discussion, and appreciate the input so far.

Finally, and I know this is against the BH approach, I for one am happy to remain with a significant cash position in accounts at least until the market in general seem to be more "on sale," and referring to both the low yields of bonds as well as the highish PE ratios.
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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by SuperDave » Fri May 06, 2016 8:50 am

Question:
livesoft wrote: Tax-efficient equity funds in taxable should not have any capital gains nor non-qualified dividends.
Many Bogleheads use a portfolio in part consisting of international in the form of VTIAX/VXUS. My understanding is that only ~75% of the dividends from this fund/etf are in the form of qualified dividends. Would it make sense for an investor who wants to be in international (though with the "controversy" regarding this and the tax-inefficiency compared to VTSAX perhaps a reason not to use international..) to place as much international in tax deferred space as possible (once bonds are taken care of or if the investor chooses CDs instead in current environment) and place domestic (US) in taxable?

-D

livesoft
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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by livesoft » Fri May 06, 2016 9:02 am

@SuperDave,

Where one puts international to be the most tax-efficient depends on one's personal circumstances and their tax brackets (marginal and effective). triceratop has some threads and spreadsheets which discuss the taxes. If you haven't read them, then I highly recommend that you do.

In reality, it is difficult for investors with substantial taxable assets to be super tax-efficient, but they can try. For instance, should one use muni-bonds in taxable instead of international if one is in the highest tax brackets?

I'd put international in a Roth IRA (I actually do that*). I have reduced international in my taxable and increased US large-cap index funds in taxable. Nevertheless, I still have some non-qualified dividends that poke through. I actually use VEA in taxable which used to be more tax-efficient than VTIAX (I don't know if that is still the case) and use VSS in tax-advantaged. I do not own any VTIAX nor VXUS nor other total international fund.

And one more thing, I do not want to have more than $20,000 of taxable dividends from international funds each year because that would make my Form 1116 Foreign Tax Credit more of a PITA.

*I use some of everything in a Roth. My only rule is no bonds in taxable since I can fit all my fixed income in tax-advantaged leaving room to spare for US and foreign funds. I can do all rebalancing in tax-advantaged without worries.
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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by abuss368 » Fri May 06, 2016 9:19 am

Hi nycinvestor,

There are two strategies that an investor can use. One is "Equal Location" which essentially places the same funds in each account. The other strategy is "Asset Location" which historically recommended equities in taxable accounts and bonds in tax advantaged accounts. In the day of Roth IRA's and very low interest rates, this strategy is debated more.

Personally, we moved to an "Equal Location" strategy many years ago upon the recommendation or Boglehead Rick Ferri. Rick had noted that his firm Portfolio Solutions follows this approach. In addition, I was talking with another advisor that used to post on this forum and he noted that his firm also uses the "Equal Location" strategy as it is the easiest. The tax code is always changing.

In my opinion, this topic is often to over debated and an investor should use what works best for their situation and allows them to sleep at night.

In stepping back and looking at the broad picture the Boglehead philosophy of low cost investing with no trading or active management is by far the most important part and also the best tax strategy. If an investor decides to place Total Stock Index in both types of accounts and also has Total Bond in tax advantage with Muni Bonds in taxable, that is a good option as well.

Best.
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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by Artsdoctor » Fri May 06, 2016 10:00 am

inbox788 wrote:It's a very complicated subject and there isn't a simple answer. A lot of variables impact your decision, some knowable today, some changing over time, and others based on unknowns in the future. Different assumptions about any can change your conclusions. A case can be made for either. Here's a good argument for bonds in taxable.

http://whitecoatinvestor.com/asset-loca ... n-taxable/
Agree with "a lot of variables impact your decision." NYC, you're going to have to realize that your tax situation is going to be very different than many others on the forum here, including the White Coat Investor. If you take a look at the article above, the tax percentages will not apply to you at all. You're going to have federal, net investment tax, PEP/Pease phase-outs, perhaps AMT but maybe not, state, and local. Munis will be far more beneficial to you than many others, especially if you're buying NYC bonds.

And just to be sure we're talking about tax-DEFERRED space and not Roth space. There's a bit of a difference. You might also want to take a stab at predicting your future domicile: if you really plan on living in NYC for the rest of your life, taking those highly appreciated assets out of your tax-deferred space later will be a very different experience than if you decide to move to Wyoming.

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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by abuss368 » Fri May 06, 2016 10:02 am

The Vanguard Intermediate Term Tax Exempt Fund is an excellent choice for a taxable account. We have invested in this fund for many years and are happy with the results.
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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by JW-Retired » Fri May 06, 2016 10:29 am

retiredjg wrote:
inbox788 wrote: Here's a good argument for bonds in taxable.

http://whitecoatinvestor.com/asset-loca ... n-taxable/
Is it? Or is it an argument to put bonds in taxable as opposed to Roth IRA?
"Bonds in taxable" might be quite misleading. The whole whitecoatinvestor argument was restricted to muni-bonds in taxable versus taxable bonds in a Roth. For a 33% bracket doctor munis win this easily.
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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by blevine » Fri May 06, 2016 12:47 pm

As I do the majority of my AA "rebalancing" via inflow/outflows, it is much easier to have some equity and bonds
in both taxable and tax deferred. Also if you review the wiki, you will see some types of equity funds are better off in
tax deferred, such as REIT. I keep the super tax efficient (Total Stock) in taxable, with some muni $, and I have a global REIT
fund in my tax def, along with global bonds. Total International (or FTSE) are borderline, I keep a core in taxable, but would buy
more in tax deferred if I needed more equity allocation in tax deferred accounts. After all, I will only hold so much REIT (as it
is a niche asset class) so once I surpass my target for REIT, any equity purchases would be Tot Int or FTSE equivalent.

I buy bonds or stocks as needed in both, maintaining my AA as I have cash to invest. I don't pay much in taxes on my investment income.

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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by Yesterdaysnews » Fri May 06, 2016 1:00 pm

What is someone has a 60/40 or 50/50 portfolio and the market tanks ala 2008 and the investor wants to re-balance into a 80/20 portfolio? A bit of timing u can say, but when the market is that cheap it makes sense. If you have a lot of bonds in taxable, you will have to sell and pay taxes on the cap gains. However, if u hold all ur bonds in tax-advantage accounts you can switch without any taxable event occurring.

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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by Artsdoctor » Fri May 06, 2016 1:10 pm

Yesterdaysnews wrote:What is someone has a 60/40 or 50/50 portfolio and the market tanks ala 2008 and the investor wants to re-balance into a 80/20 portfolio? A bit of timing u can say, but when the market is that cheap it makes sense. If you have a lot of bonds in taxable, you will have to sell and pay taxes on the cap gains. However, if u hold all ur bonds in tax-advantage accounts you can switch without any taxable event occurring.
This is true, but bond funds are unlikely to have the huge capital gains that equity funds can generate. The majority of "gain" from a bond fund is from the dividend. And during the 2008-2009 carnage, most of us were tax-loss harvesting like mad and had very large losses which handily offset the capital gains from bond funds.

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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by livesoft » Fri May 06, 2016 1:23 pm

abuss368 wrote:Personally, we moved to an "Equal Location" strategy many years ago upon the recommendation or Boglehead Rick Ferri. Rick had noted that his firm Portfolio Solutions follows this approach. In addition, I was talking with another advisor that used to post on this forum and he noted that his firm also uses the "Equal Location" strategy as it is the easiest.
I had read what Mr Ferri wrote. I think he said that it didn't matter for his clients AND that it was easier for his firm to do that for clients that were worried about having all risky equities in taxable. I don't think the firm did "Equal Location" for all their clients.

I did not read his words as a "recommendation", but that he was merely agnostic about it. I took his words that it was easier than trying to convince their clients otherwise and was the path of least resistance. You know, some clients will believe what they believe and to keep them as a customer you have to agree to what they believe.

For folks who switch funds because one fund has an expense ratio of 0.16% and another fund has an expense ratio of 0.07%, I would suggest that being very tax-efficient in taxable might be meaningful to them :twisted: so they would not want to follow an "Equal Location" strategy.

Related to all this is that any taxable turnover in a taxable account is pretty deadly for returns. To see more on this, read Michael Kitces: https://www.kitces.com/blog/are-the-tax ... verstated/ I conclude from that write-up that one should do everything in their power to not have any taxable turnover in a taxable account. Non-taxable turnover is fine though. If one can have non-taxable turnover by using muni tax-exempt bonds in taxable, then that would work.

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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by grabiner » Fri May 06, 2016 8:56 pm

SuperDave wrote:Question:
livesoft wrote: Tax-efficient equity funds in taxable should not have any capital gains nor non-qualified dividends.
Many Bogleheads use a portfolio in part consisting of international in the form of VTIAX/VXUS. My understanding is that only ~75% of the dividends from this fund/etf are in the form of qualified dividends0.
However, the foreign tax credit is greater than the extra tax on the non-qualified dividends, so this fund is about as good as a US index. (It is slightly less tax-efficient because international dividend yields have been higher since 2008.)
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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by namenloseblonde » Sun May 08, 2016 7:36 pm

Great discussion, and timely for me. I was just talking to my mother about the bonds they hold in taxable and discussing whether to keep them or sell them and rebalance that portion of their bond allocation in a tax-deferred account. Sounds like there are pros and cons either way - I'll just be happy to get them away from a Franklin Templeton fund with a .9+ ER into something at Vanguard!

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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by nycinvestor » Sun May 08, 2016 8:35 pm

Thank you to everyone for the discussion. I think I will increase my bond allocation in the tax deferred accounts to about 50% of the available space, and then start buying national and NY munis in taxable.

Thanks again
:sharebeer

inbox788
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Re: Should I completely fill the tax deferred space with taxable bonds before buying Munis in taxable account?

Post by inbox788 » Mon May 09, 2016 1:18 pm

JW-Retired wrote:
retiredjg wrote:
inbox788 wrote: Here's a good argument for bonds in taxable.

http://whitecoatinvestor.com/asset-loca ... n-taxable/
Is it? Or is it an argument to put bonds in taxable as opposed to Roth IRA?
"Bonds in taxable" might be quite misleading. The whole whitecoatinvestor argument was restricted to muni-bonds in taxable versus taxable bonds in a Roth. For a 33% bracket doctor munis win this easily.
JW
Yes, most of the article is about Roth, but there is mention about "The value of a 401K (AKA tax-deferred) account is a little more complicated." I don't think there is a clear or simple answer with either type of account.

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