Total bond vs intermediate tax exempt

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EnjoyIt
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Total bond vs intermediate tax exempt

Post by EnjoyIt » Sun Apr 20, 2014 2:24 pm

I am looking at the difference between the total bond fund vs the intermediate tax exempt fund. They both have very similar returns, slightly over 2%, but one is tax free. With that in mind, why would I want total bond when I can have the same return tax free?

Am I missing something?

I am 30% fixed income and currently split evenly between Total Bond in 401K and tax exempt in taxable account. I find this combination makes it easier to rebalance as I have fodder in each type of account but wonder if I should go all tax exempt. This would Make my 401k all equities and then buy tax exempt in taxable.

Basically what is the advantage of total bond over intermediate tax exempt?

-Beck
Last edited by EnjoyIt on Sun Apr 20, 2014 2:37 pm, edited 2 times in total.

Longdog
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Re: Total bond vs intermediate tax exempt

Post by Longdog » Sun Apr 20, 2014 2:33 pm

It wouldn't make sense to have tax free bonds in a 401k. Whatever you eventually withdraw from the 401k is going to be counted as ordinary income. Unless you were saying to get out of the bond fund in your 401k, and add the equivalent amount in tax free bonds in your taxable account. Is that what you were thinking?
Steve

Topic Author
EnjoyIt
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Re: Total bond vs intermediate tax exempt

Post by EnjoyIt » Sun Apr 20, 2014 2:36 pm

SteveM wrote:It wouldn't make sense to have tax free bonds in a 401k. Whatever you eventually withdraw from the 401k is going to be counted as ordinary income. Unless you were saying to get out of the bond fund I your 401k, and add the equivalent amount in tax free bonds in your taxable account. Is that what you were thinking?
I was hoping it would have made sense I would switch to only equites in my 401K but since it did not, I edited my OP to reflect that.

Thanks
Last edited by EnjoyIt on Sun Apr 20, 2014 10:20 pm, edited 1 time in total.

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kenyan
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Re: Total bond vs intermediate tax exempt

Post by kenyan » Sun Apr 20, 2014 2:46 pm

They are not equivalent. Don't you think that the bond market would not demand more compensation from taxable bonds than equivalent tax-free bonds?

Vanguard Total Bond Market Investor Shares: SEC yield 2.07%, Duration 5.6 years, 65% US Government Bonds.

Vanguard Intermediate Term Tax-Exempt Investor Shares: SEC yield 2.01%, Duration 5.0 years, 0% USG Bonds, 16.3% AAA-rated, 53.3% AA-rated, 26.2% A-rated. Some call risk.

The munis are riskier. This fund is still relatively safe and diversified, but that's the answer to your question. SEC yield, mind you, assumes no defaults or calls. Now, what you are proposing to do is within the bounds of 'perfectly reasonable,' and is a fairly common practice around here for those with taxable accounts, but don't assume that the risks are the same with these two bond funds.
Retirement investing is a marathon.

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EnjoyIt
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Re: Total bond vs intermediate tax exempt

Post by EnjoyIt » Sun Apr 20, 2014 10:39 pm

I wish I could quantify that risk to see if it is worth it. I am currently in the 39.6% tax bracket.
My accounts today are:

66% in taxable
Total stock market -26.5%
Total international - 30%
Intermediate term tax exempt - 15%
33% in tax advantaged
Total stock market - 13.5%
Total bond Market - 15%

My options are:
1)
66% in taxable
Total stock market -11.5%
Total international - 30%
Intermediate term tax exempt - 30%
33% in tax advantaged
Total stock market - 28.5%
Total bond Market - 0%

2) Stop wasting my time with it and do nothing


The math I find very complicated as having tax exempt funds in taxable and equites in tax advantaged can be a huge tax savings, but then there is the risk of Munis. How can I quantify that risk?

OutOfCyan
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Re: Total bond vs intermediate tax exempt

Post by OutOfCyan » Sun Apr 20, 2014 11:23 pm

Here's a Wikipedia page with some statistics on the historic default rate for municipal and corporate bonds.

Municipal bonds have a much lower rate of default than corporates of the same rating. In my mind, a fund of ~100% investment-grade munis is less risky than a fund that has 35% investment-grade corporates.

When the rates on taxable vs. non-taxable bond rates diverge in the future, you may wish to alter your strategy. For now, tax-exempt bonds are a fine solution to your problem.

tpm871
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Re: Total bond vs intermediate tax exempt

Post by tpm871 » Mon Apr 21, 2014 12:03 am

One other thing that you may want to think about: maybe move all of your total stock market holdings to taxable, and move as much of the total international to tax advantaged as you can.

For my holdings, I found that international equities generated more dividends (and had a higher ratio of ordinary dividends too) than domestic equities. I was better off shifting more of my international equities to tax advantaged space. However, I don't have the same funds as you, so you should probably look back on your 2013 account statements to see if that would have worked better for you.

I am also guessing that for you the AMT probably largely reduces or eliminates the foreign tax credit on total international taxes paid -- another reason to make the change.

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EnjoyIt
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Re: Total bond vs intermediate tax exempt

Post by EnjoyIt » Mon Apr 21, 2014 9:17 pm

OutofCyan: that wiki makes muni's much more attractive than 35% of total bond's corporate holding.

TPM: unfortunately I have no history in international up until a few months ago. I will see what turns up over the next few years regarding my international holdings.

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ogd
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Re: Total bond vs intermediate tax exempt

Post by ogd » Mon Apr 21, 2014 9:42 pm

Beckmaster: historically, the yields on municipal bonds have been much smaller than on taxable bonds, even Treasuries. Historically, they've been very safe. However, the current elevated yields, relatively speaking, should tell you that the market views them as significantly more risky, relatively speaking, than that long history of safety. It's not like the market forgot how to discount taxes all of a sudden.

It's not easy to quantify this risk, since it's forward looking. I suppose you could spend a lot of time becoming an expert on muni finances and legislation, and staying up to date with the latest. A better avenue of attack would be to simply trust the market and focus on the question of exactly what is the tax discount factored in, and just take it for granted that above that, you're getting a good deal in munis and below that you'd be better off in taxables. I've never seen a good study on this; my gut feeling is that it's somewhere between 25% and 30%, but this is just that, a gut feeling.

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wshang
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Re: Total bond vs intermediate tax exempt

Post by wshang » Mon Apr 21, 2014 10:05 pm

To the OP,
Up until I retired, I was in your tax bracket and had (still have) a large muni bond portfolio. In retrospect, I realize this might have been a mistake if for only this reason:

Bonds in general tend to have less volatility and less capital gains than stocks. Of course recent memory has been otherwise. If one puts bonds in the tax advantaged side of the portfolio, that tends to put the large capital gains into the taxable side . . . . exactly where you want them when retiring!

Capital gains are taxed as if in the lower tax bracket. So in other words, if I am in the 15% bracket by 401k/IRA distributions, the stock generated capital gains are taxed at 15% for the amounts exceeding the standard 15% cut off of say $72k up to the 28% limit. So the big gains are on the taxable side and the presumed stable side is in the side where capital losses are not taxable.

That doesn't even take into consideration we can designate lots when generating capital gains.

tpm871
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Re: Total bond vs intermediate tax exempt

Post by tpm871 » Tue Apr 22, 2014 12:20 am

Beckmaster wrote: TPM: unfortunately I have no history in international up until a few months ago. I will see what turns up over the next few years regarding my international holdings.
You can see the past tax cost ratios at the schwab site. For example, total stock market vs total international stock market:

http://www.schwab.com/public/schwab/inv ... axAnalysis

http://www.schwab.com/public/schwab/inv ... axAnalysis

The difference isn't as huge as other funds that I've seen, but it's definitely higher. For example, 0.90% vs 0.54% for the 3 year average. Unfortunately, that doesn't indicate the ratio of qualified vs ordinary dividends, but I think international tends to be less tax efficient in that regard as well.

dickenjb
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Re: Total bond vs intermediate tax exempt

Post by dickenjb » Tue Apr 22, 2014 6:46 am

OP, I have wondered the same as you. For what it is worth, my portfolio looks a lot like yours except I am 2/3 tax advantaged and 1/3 taxable. I hold a lot of total bond in my 401(k), we have the special share class at 7 bps. In taxable, I own Total International and VWIUX. Total Stock in my IRA's.

I figure split the difference and own both. Clearly the TB is more diversified, but I like the 2% tax free on the VWIUX.

Wagnerjb
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Re: Total bond vs intermediate tax exempt

Post by Wagnerjb » Tue Apr 22, 2014 11:03 am

dickenjb wrote:OP, I have wondered the same as you. For what it is worth, my portfolio looks a lot like yours except I am 2/3 tax advantaged and 1/3 taxable. I hold a lot of total bond in my 401(k), we have the special share class at 7 bps. In taxable, I own Total International and VWIUX. Total Stock in my IRA's.

I figure split the difference and own both. Clearly the TB is more diversified, but I like the 2% tax free on the VWIUX.
I do as DickenJB does, diversifying my fixed income portfolio. I have maybe 50% of my fixed income in an Inflation Protected Bond (TIPs) fund in my 401k. I have maybe 20% in a Short Term Treasury bond fund in my wife's IRA. I have maybe 20% in the Intermediate Tax Exempt bond fund in taxable. And the remaining 10% is in the Total Bond Market fund in a 529 account.

Granted, some of this diversification is driven by the limited choices I have in the 401k and the 529 account. But I also believe that diversifying is a wise move anyway. In your situation, I would only shift a portion of your fixed income to taxable (using the Intermediate TE fund) such that you also held fixed income in other instruments in other locations.

Best wishes.
Andy

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