Why is a Short-Term Bond Fund Okay in a Taxable Account?

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Shaoya
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Why is a Short-Term Bond Fund Okay in a Taxable Account?

Post by Shaoya » Mon Oct 19, 2009 10:51 am

I'm considering moving 1/2 of our Emerg. Fund (4-6 months living expenses) from VG Prime Money Market (VMMXX) (0.28%) to VG Short-Term Bond Index Fund (VIBSX) (0.22%) in order to get a better return relative to what is currently possible with VMMXX (7.88%-VIBSX vs 1.15%-VMMXX over the past year).

Several folks here have incorporated VIBSX or other ST-bonds into their E-funds or cash on hand.

I'd appreciate BH advice on this move, particularly about the following:

1) Why is doing this not contrary to the BH maxim "bonds should only be in tax-advantaged accounts"?

[My understanding is that bond income is taxed at one's marginal rate. Is there another reason?]

2) Won't an increase in the Fed Fund Rate (currently 0-0.25%) erode VIBSX's return? [FFR can't go any lower, and has to increase eventually.]

As always, your help is appreciated. - Shaoya

dbr
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Post by dbr » Mon Oct 19, 2009 10:59 am

With regard to the BH maxim a taxable MM fund is just as verboten as a taxable bond fund. The escape clause is the necessity for some mechanism to raise cash when needed in an emergency without having to do something you really don't want to do with your investments. A system has been suggested whereby one can raise money by selling stocks in taxable accompanied by exchanging bonds for stocks in tax deferred to maintain asset position and still not store lots of cash/bonds in taxable. This depends on having enough of everything to do it, however. If you are just starting out the prescription to have an emergency fund in cash/cash equivalent temporarily trumps tax location.

You are correct that the future return of VBISX cannot be predicted from the superior recent past return. The future return of VBISX cannot be predicted from any other view of the future either, certainly not in the short run.

Tramper Al
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Post by Tramper Al » Mon Oct 19, 2009 11:14 am

dbr wrote:With regard to the BH maxim a taxable MM fund is just as verboten as a taxable bond fund.
Ah, but what if my core tax-free MMF is yielding 0.01% at the moment? Not a hypothetical, my Fidelity core MMF in taxable (FMOXX) have for some time now had a yield of 0.01%. Yeah! I'm sure glad that's tax free, as I'd hate to pay tax on all that interest.

I reason that even if my tax bracket were 50%, I would be better off using any taxable cash instrument yielding 0.02% or more.

My observation is an aside, but I think it does serve as a reminder that when rates are so low, the gains from tax efficiency (or the losses from taxes) may be very small. The ultimate tax efficiency after all comes with an asset paying no interest.

For the time being, my best location for cash today seems to be last year's I-Bonds and last season's East Boston Savings Account. Even new money in an Ally No-Penalty CD earns a bit more than any of the typical MMFs on an after-tax basis.

That's right, I am keeping money in a bank. Strange times indeed.

And of course I agree that a bond fund, no matter how short, is not the same as cash. And if we reach for them as MMF substitutes mainly at times when they have recently outperformed cash, I would expect that might backfire >50% of the time.

dbr
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Post by dbr » Mon Oct 19, 2009 1:15 pm

What I should have added is that when it comes to taxes all advice is specific to the exact situation of the particular investor. Good tax planning means actually computing plausible individual tax scenarios to see what the best plan is.

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Taylor Larimore
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Tax-exempt (municipal) bonds ?

Post by Taylor Larimore » Mon Oct 19, 2009 1:32 pm

Hi Shaoya:
1) Why is doing this not contrary to the BH maxim "bonds should only be in tax-advantaged accounts"?
I believe you meant to say:
1) Why is doing this not contrary to the BH maxim "taxable bonds should only be in tax-advantaged accounts"?
Tax-exempt bonds are designed for use in taxable accounts by high-income taxpayers.
"Simplicity is the master key to financial success." -- Jack Bogle

RobG
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Re: Why is a Short-Term Bond Fund Okay in a Taxable Account?

Post by RobG » Mon Oct 19, 2009 1:37 pm

Shaoya wrote: [My understanding is that bond income is taxed at one's marginal rate. Is there another reason?]
Yes, there is more (actually, this is more important):
1)You are taxed before you can reinvest the interest so you do not reinvest the whole amount. Then the earnings on that reduced reinvestment are taxed and so on. In the end you wind up paying taxes on the earnings multiple times so you don't get the full compounded interest. With a tax deferred you only pay once.

2) At least for some of us, your retirement income will be less than your present income so you will be in a low bracket.

[edit: I should add that if you are spending the interest payments it doesn't matter if it came from the taxable account or not. In each case your earnings are just getting taxed once, and at the same rate.]

rg

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Shaoya
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Re: Why is a Short-Term Bond Fund Okay in a Taxable Account?

Post by Shaoya » Mon Oct 19, 2009 3:28 pm

First, thank you all for your ideas.

Yes, Taylor, I meant to specify "taxable bonds should only be in tax-advantaged accounts."
Taylor Larimore wrote:Tax-exempt bonds are designed for use in taxable accounts by high-income taxpayers.
Okay, does this also hold for 15% bracket-ers? Or is having VG Short-Term Bond Index Fund (VIBSX) in their taxable accounts less of a problem? I'm not understanding if my lower tax bracket is an advantage in this or not.
RobG wrote: You are taxed before you can reinvest the interest so you do not reinvest the whole amount. Then the earnings on that reduced reinvestment are taxed and so on. In the end you wind up paying taxes on the earnings multiple times so you don't get the full compounded interest. With a tax deferred you only pay once. rg
RobG, thanks for pointing this out about bond earnings and taxes; I didn't know that. Since this is Emergency Fund monies, I'm not moving money in/out willy-nilly.

Are you suggesting that I turn 50% into VG Short-term Tax Exempt (VWSTX) instead of VG Short-Term Bond Index Fund (VIBSX)?

[VMSTX returns less than VIBSX, but it's better than VMMXX.]

Thank you! - Shaoya

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Taylor Larimore
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Re: Why is a Short-Term Bond Fund Okay in a Taxable Account?

Post by Taylor Larimore » Mon Oct 19, 2009 3:50 pm

Shaoya wrote:
Taylor Larimore wrote:Tax-exempt bonds are designed for use in taxable accounts by high-income taxpayers.
Okay, does this also hold for 15% bracket-ers? Or is having VG Short-Term Bond Index Fund (VIBSX) in their taxable accounts less of a problem? I'm not understanding if my lower tax bracket is an advantage in this or not.
Hi Shaoya:

Tax-efficiency is less important for low-tax bracket investors--but it is significant in any tax bracket.

Use the link below to determine whether to use taxable or tax-exempt bond funds in your taxable account:

Morningstar Tax-Equivalent Bond Calculator
"Simplicity is the master key to financial success." -- Jack Bogle

RobG
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Re: Why is a Short-Term Bond Fund Okay in a Taxable Account?

Post by RobG » Mon Oct 19, 2009 10:30 pm

Shaoya wrote:
Are you suggesting that I turn 50% into VG Short-term Tax Exempt (VWSTX) instead of VG Short-Term Bond Index Fund (VIBSX)?

[VMSTX returns less than VIBSX, but it's better than VMMXX.]

Thank you! - Shaoya
I just checked: VIBSX is yielding more after taxes, but the reason is that it holds longer duration bonds so you are taking on more risk. VIBSX has ~2x the duration, meaning it will be twice as sensitive to interest rate changes. Same old story: more yield means more risk.

VIBSX (ST bond index) : 1.6% before taxes, 1.36% after taxes (duration: 2.6 yr)
VMSTX (ST Tax exempt): 0.84% before taxes. 0.84% after taxes (duration: 1.1 yr)

The Limited term tax exempt fund (VMLTX) would be a better comparison to VIBSX. Its yield is 1.46%, so it is about the same as VIBSX after taxes. But again it has 2x the duration of VMSTX.

Please get a second opinion... I may have misread the numbers.

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Shaoya
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Post by Shaoya » Mon Oct 19, 2009 11:37 pm

RobG & Taylor: Wow! Thank you both for educating me; it's much appreciated. - Shaoya

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jpsfranks
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Post by jpsfranks » Tue Oct 20, 2009 12:06 am

Why subject your emergency fund to any kind of risk at all when there are liquid FDIC insured accounts available with yields the same or higher than the short term bond funds you're considering?

A while back I helped some family members move some reserve money within a trust account into VBISX because they were unsatisfied with money market yields. We did this largely because purchasing a fund was very convenient within the trust and generally we found it was not easy or possible to open up high yield bank accounts in the name of the trust. But it sounds like your emergency fund is personal, taxable money, in which case an FDIC insured savings account seems like a better fit than jumping to a bond fund, particularly when the yields are comparable.

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Shaoya
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Post by Shaoya » Thu Oct 22, 2009 11:34 am

jpsfranks: thanks for this. Are you talking about a CD? I'm under the impression that your money is locked in for the duration of the CD (1-year, 2-year, etc.) and that getting it out (because of an emergency, per se) requires a fee.

Is this correct? Please give me some specific examples of the accounts you're talking about, ones that currently have similar returns to VIBSX (ST bond index). Thanks - Shaoya

denarius
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Post by denarius » Thu Oct 22, 2009 5:41 pm

Hi Shaoya,

Alliant Credit Union is paying 1.75% APY for checking and 2.00% APY for savings accounts.

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Doc
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Re: Why is a Short-Term Bond Fund Okay in a Taxable Account?

Post by Doc » Thu Oct 22, 2009 7:06 pm

Shaoya wrote: 1) Why is doing this not contrary to the BH maxim "bonds should only be in tax-advantaged accounts"?
I think you may be overstating the maxim. "Only" should probably be "usually". I don't think there are any BH's who would say "if you don't have a tax advantaged account, you should not hold bonds in your portfolio."
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

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Re: Why is a Short-Term Bond Fund Okay in a Taxable Account?

Post by retiredjg » Thu Oct 22, 2009 7:36 pm

Shaoya wrote:1) Why is doing this not contrary to the BH maxim "bonds should only be in tax-advantaged accounts"?
It is contrary, but there is a reason. With your retirement accounts, you can place things where they fit best. But where else can you hold your emergency fund? If you want the higher return of the bonds, you have to hold them wherever your emergency fund is - usually taxable.

Now...here is the work-around. If your accounts are large enough and flexible enough, you can hold your emergency fund in your retirement locations and hold your retirement stocks in taxable.

Please see Placing Cash Needs in a Tax-Advantaged Account on the Bogleheads Wiki.

If you must hold bonds in taxable, your tax brackets determine whether you do better using a taxable bond or a tax-exempt bond. In the 15% tax bracket, usually it is better to hold a taxable bond. Use the bond calculator provided by Taylor to figure that part out.

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jpsfranks
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Post by jpsfranks » Thu Oct 22, 2009 8:27 pm

Shaoya wrote:jpsfranks: thanks for this. Are you talking about a CD? I'm under the impression that your money is locked in for the duration of the CD (1-year, 2-year, etc.) and that getting it out (because of an emergency, per se) requires a fee.

Is this correct? Please give me some specific examples of the accounts you're talking about, ones that currently have similar returns to VIBSX (ST bond index). Thanks - Shaoya
Hi Shaoya.

There are a number of FDIC insured online savings and money market accounts with few or no withdrawal restrictions and yields currently comparable or greater than VBISX. A nice compiliation can be found here.

Of those listed I have used Ally and "SmartyPig" (don't laugh!).

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