How inefficient is it to hold Total Bond Index in a taxable account?

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S17C
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How inefficient is it to hold Total Bond Index in a taxable account?

Postby S17C » Thu Apr 20, 2017 4:39 pm

Say that young investor in the 28% Federal tax bracket with $100K in maturing CDs wants an AA of 60/40, but hypothetically has no retirement accounts. There is only room for $5500 to put that bond index into a new IRA account. The other $34,500 of VTBLX (Total Bond Index) would go into a taxable account. Approximately how much will be lost to taxes in that first year in the taxable account, as a consequence of not being able to place VTBLX in a retirement account?

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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby sport » Thu Apr 20, 2017 4:42 pm

Perhaps that young investor should consider a municipal bond fund(s) for taxable bond holdings.

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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby zuma » Thu Apr 20, 2017 4:46 pm

S17C wrote:Approximately how much will be lost to taxes in that first year in the taxable account, as a consequence of not being able to place VTBLX in a retirement account?

Do you have any ideas?

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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby willthrill81 » Thu Apr 20, 2017 4:47 pm

S17C wrote:Say that young investor in the 28% Federal tax bracket with $100K in maturing CDs wants an AA of 60/40, but hypothetically has no retirement accounts. There is only room for $5500 to put that bond index into a new IRA account. The other $34,500 of VTBLX (Total Bond Index) would go into a taxable account. Approximately how much will be lost to taxes in that first year in the taxable account, as a consequence of not being able to place VTBLX in a retirement account?


Go to Vanguard to find it the answer (approximately). On their site, click on the "Price & Performance" tab. You can find the after-tax returns on the fund, though your mileage may vary as each tax situation is different. Using the highest tax brackets, they estimate that taxes cut the five year return by about half, depending on whether you're talking about distributions only or in addition to sale of the fund as well.

https://personal.vanguard.com/us/funds/ ... 0584#tab=1

The moral of the story: taxable bonds in taxable account = bad.
Last edited by willthrill81 on Thu Apr 20, 2017 4:52 pm, edited 3 times in total.
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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby bloom2708 » Thu Apr 20, 2017 4:49 pm

Bond interest is ordinary income. 28% marginal tax bracket. It will cost you 28% of the interest earned each year.

We use Int-Term Tax-Exempt bond index in taxable.
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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby willthrill81 » Thu Apr 20, 2017 4:54 pm

Rather than putting money into bonds that are very likely to languish in a rising interest rate environment, have you considered a more productive way to use the capital? Paying down a mortgage would be a good alternative, for instance.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby somekevinguy » Thu Apr 20, 2017 5:01 pm

while I would agree that if you are in a very high marginal tax bracket, bonds (except for Munis) make less sense in taxable, it may still depend.

An alternative perspective from EmergDoc: http://whitecoatinvestor.com/asset-loca ... n-taxable/

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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby S17C » Thu Apr 20, 2017 5:26 pm

Thank you for the information.

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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby tractorguy » Thu Apr 20, 2017 5:34 pm

Just to make it more complicated, because municipal bonds generally have lower returns than their taxable equivalents, its not always a given that you should buy them in your taxable account. It depends on your marginal tax rate. If you are in a 35% tax rate, then almost certainly yes, you should focus on tax free bonds. If you are in the 0% or 15% tax rate, then no, you should not buy tax free bonds, but taxable ones of equivalent risk. And, if you are in the middle like most of us, it depends.

I addressed that problem by splitting the difference and buying some of each in my taxable space.

The math behind this is addressed here: https://www.aaii.com/journal/article/mu ... ield.touch
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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby Theoretical » Thu Apr 20, 2017 5:56 pm

Do you face state or local taxes? If so, consider a mix of short term treasury ETFs (VGSH comes to mind) and an intermediate municipal fund. For taxable bonds, ETFs have a major advantage over mutual funds because of how they deal with capital gains.

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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby Kevin M » Thu Apr 20, 2017 6:30 pm

I go by the assumption I learned from forum member grabiner, which is that muni bonds have about the same taxable-equivalent return as taxable bonds at a federal marginal tax rate of 25%. Going by this assumption, you are better off with muni bonds on a risk-adjusted basis in the 28% tax bracket.

If in a high-tax state with a good muni bond fund, then that state muni bond fund probably is the way to go in the 28% federal tax bracket, since your state tax rate probably is higher than that at which the taxable-equivalent returns of state muni bonds are equal to taxable bonds on a risk-adjusted basis.

If you go by this assumption, and ignore state taxes, then you're losing the difference between being taxed at 25% and 28%. Assuming a 2.3% return on VBMFX, you're looking at after tax returns of 1.73% at 25% and 1.66% at 28%, so you lose 7 basis points to taxes.

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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby kolea » Thu Apr 20, 2017 8:39 pm

tractorguy wrote:Just to make it more complicated, because municipal bonds generally have lower returns than their taxable equivalents,


I have often heard that said, but looking at today's yield curve for corporates and municipal bonds I see:
"A" rated, 5-year maturity. Corporate = 2.67%, Municipal = 3.57%

I suppose it is more complicated than just looking at a single point on the yield curve, so when I compare VWITX (Vanguard Intermediate Tax-Exempt bond fund) to VFICX (Vanguard Intermediate Corporate bond fund), both of which average in the high-end of investment grade, I see:
VWITX yield = 2.76%
VFICX yield = 2.79%

It looks to me like VWITX in a taxable account will be better than VFICX, at any tax bracket.
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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby Tamales » Thu Apr 20, 2017 8:45 pm

Theoretical wrote:For taxable bonds, ETFs have a major advantage over mutual funds because of how they deal with capital gains.


Has anyone ever run numbers to quantify the actual significance of this advantage of ETF bond funds over mutual funds?

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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby grabiner » Thu Apr 20, 2017 9:13 pm

willthrill81 wrote:Rather than putting money into bonds that are very likely to languish in a rising interest rate environment, have you considered a more productive way to use the capital? Paying down a mortgage would be a good alternative, for instance.


This works exactly the same. If you buy a 10-year bond yielding 3% for $1000, you are guaranteed to have $1344 in ten years. If you pay down your ten-year mortgage with a 3% rate, you will also have $1344 more in ten years.

The price of the bond will go up and down as rates change, but it will return to the old value at maturity.
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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby grabiner » Thu Apr 20, 2017 9:17 pm

Theoretical wrote:For taxable bonds, ETFs have a major advantage over mutual funds because of how they deal with capital gains.


This is an advantage for stock funds, but not for bond funds. When interest rates fall, all bonds have capital gains, and even bond ETFs will have to sell the bonds for a gain. Also, bond prices don't vary much, so bond ETFs cannot benefit as much from the creation-redemption process. You can see this in historical distributions; REIT Index is the only Vanguard stock ETF which has distributed capital gains other than just after getting started, but most of Vanguard's bond ETFs have distributed capital gains.

In any case, the tax distinction between mutual funds and ETFs irrelevant at Vanguard if you use index funds (for either bonds or stocks); the ETF BND is a share class of Total Bond Market Index, so both will have the same capital gains.
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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby Nicolas » Thu Apr 20, 2017 9:41 pm

kolea wrote:
tractorguy wrote:Just to make it more complicated, because municipal bonds generally have lower returns than their taxable equivalents,


I have often heard that said, but looking at today's yield curve for corporates and municipal bonds I see:
"A" rated, 5-year maturity. Corporate = 2.67%, Municipal = 3.57%

I suppose it is more complicated than just looking at a single point on the yield curve, so when I compare VWITX (Vanguard Intermediate Tax-Exempt bond fund) to VFICX (Vanguard Intermediate Corporate bond fund), both of which average in the high-end of investment grade, I see:
VWITX yield = 2.76%
VFICX yield = 2.79%

It looks to me like VWITX in a taxable account will be better than VFICX, at any tax bracket.


Those are the TTM (Trailing Twelve Months) yields.
If instead you compare the 30-Day SEC yields you have a different story.

VWITX 30-Day SEC yield: 1.95% (Vanguard Intermediate-Term Tax-Exempt Fund Investor Shares)
VFICX 30-Day SEC yield: 2.65% (Vanguard Intermediate-Term Investment-Grade Fund Investor Shares)

For someone in the 15% bracket the equivalent taxable SEC yield for VWITX is 2.29%. VFICX beats that.
But if the TTM yield continues into the future, then you're right. Which is more likely to occur?

Also note that VWITX's portfolio holdings are higher in credit quality than VFICX's.

Here's an explanation of the differences between the two types of yields:
https://www.thebalance.com/difference-b ... ld-2466432

By the way, I'm facing this same question myself, whether to invest in VWITX, or VFICX, or just the Total Bond Fund (though I would choose the Admiral shares, not the investor shares), thus my interest. I'm in the 15% federal tax bracket.
If anyone has any insights to share on this topic, please do.
Last edited by Nicolas on Thu Apr 20, 2017 10:51 pm, edited 1 time in total.
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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby willthrill81 » Thu Apr 20, 2017 10:50 pm

grabiner wrote:
willthrill81 wrote:Rather than putting money into bonds that are very likely to languish in a rising interest rate environment, have you considered a more productive way to use the capital? Paying down a mortgage would be a good alternative, for instance.


This works exactly the same. If you buy a 10-year bond yielding 3% for $1000, you are guaranteed to have $1344 in ten years. If you pay down your ten-year mortgage with a 3% rate, you will also have $1344 more in ten years.

The price of the bond will go up and down as rates change, but it will return to the old value at maturity.


These are very unlikely to be equivalent. His mortgage, if applicable, could easily have a rate above 3% (if it's a 30 year mortgage like most, it's probably closer to 4%), and if he doesn't itemize his taxes, his guaranteed after-tax rate of return will be equivalent to his mortgage rate. And as of today, 10 year treasury yields are 2.24%. It's no contest.
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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby grabiner » Thu Apr 20, 2017 11:04 pm

willthrill81 wrote:
grabiner wrote:
willthrill81 wrote:Rather than putting money into bonds that are very likely to languish in a rising interest rate environment, have you considered a more productive way to use the capital? Paying down a mortgage would be a good alternative, for instance.


This works exactly the same. If you buy a 10-year bond yielding 3% for $1000, you are guaranteed to have $1344 in ten years. If you pay down your ten-year mortgage with a 3% rate, you will also have $1344 more in ten years.

The price of the bond will go up and down as rates change, but it will return to the old value at maturity.


These are very unlikely to be equivalent. His mortgage, if applicable, could easily have a rate above 3% (if it's a 30 year mortgage like most, it's probably closer to 4%), and if he doesn't itemize his taxes, his guaranteed after-tax rate of return will be equivalent to his mortgage rate. And as of today, 10 year treasury yields are 2.24%. It's no contest.


Which one is better depends on yields, not on the fact that "bonds are likely to languish in a rising interest rate environment." Depending on your tax bracket, and on whether your mortgage is at a low fixed rate, it may be better to pay down the mortgage or to buy a municipal bond. Either one works the same way, giving you a guaranteed return for a fixed amount of time.

I don't pay down my own mortgage because municipal bonds are a better deal for me; my 2.625% mortgage rate is 1.89% after federal tax. With 12 years left on the mortgage, making a small additional payment would be equivalent to buying an 11-year or 12-year bond, and I can earn more than 1.89% even on 5-year bonds with Admiral shares of Intermediate-Term Tax-Exempt yielding 2.05%. (I don't hold this fund either; I hold bonds in my retirement account, and my taxable account is all stock.)
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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby inbox788 » Fri Apr 21, 2017 12:32 am

grabiner wrote:Which one is better depends on yields, not on the fact that "bonds are likely to languish in a rising interest rate environment." Depending on your tax bracket, and on whether your mortgage is at a low fixed rate, it may be better to pay down the mortgage or to buy a municipal bond. Either one works the same way, giving you a guaranteed return for a fixed amount of time.

I don't pay down my own mortgage because municipal bonds are a better deal for me; my 2.625% mortgage rate is 1.89% after federal tax. With 12 years left on the mortgage, making a small additional payment would be equivalent to buying an 11-year or 12-year bond, and I can earn more than 1.89% even on 5-year bonds with Admiral shares of Intermediate-Term Tax-Exempt yielding 2.05%. (I don't hold this fund either; I hold bonds in my retirement account, and my taxable account is all stock.)

The choice of taxable bonds vs tax-exempt bonds depends on tax bracket, no? All other things being equal, three investors one in low, middle and high tax bracket. Assume the one in the high tax bracket breaks even after taxes by investing in municipal bonds vs taxable. At the same rates, the investor in the low tax bracket would receive lower returns by investing in tax-exempt bonds, so he will avoid them. Similar with the middle tax bracket investor. If demand for municipal bonds is low, the rates may adjust so the middle tax bracket investor is the one that breaks even, so in this case, the high tax individual would do better in tax-exempt bonds.

So total bond isn't very inefficient for low tax brackets, but very inefficient for high tax brackets. For middle brackets, it depends on demand from higher tax bracket individuals.

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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby kolea » Fri Apr 21, 2017 2:40 am

Nicolas wrote:Those are the TTM (Trailing Twelve Months) yields.
If instead you compare the 30-Day SEC yields you have a different story.

VWITX 30-Day SEC yield: 1.95% (Vanguard Intermediate-Term Tax-Exempt Fund Investor Shares)
VFICX 30-Day SEC yield: 2.65% (Vanguard Intermediate-Term Investment-Grade Fund Investor Shares)


SEC yield includes changes in price which is more relevant to a short term investor who is banking on capital gains as part of his return. Distribution yield is just the return from interest payments. The latter dominates total return for long term investors. Most bogleheads are long-term investors, hence my focus on TTM distribution yield.

SEC yield vs. Distribution (or some other type of yield) is debated a lot around here. For me and my purposes, distribution yield seems to best fit the need. And based on distribution yield, and comparing credit risk between VFICX and VWITX, the latter looks more compelling to me in a taxable account.
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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby sschoe2 » Fri Apr 21, 2017 10:33 am

I am in the 25% bracket. I currently hold only short term bonds as my emergency fund and until interest rates stabilize.

corporate VFSUX=2.02%
Muni VMLUX=1.40%

0.75*2.02=1.515 VFSUX wins

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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby John Laurens » Fri Apr 21, 2017 11:02 am

Paying down mortgage is better in almost all close yield scenarios. In a mortgage the lender (the bank) assumes risk. Holding municipal bonds the lender (YOU) assume risk. One can't simply quote a yield spread and not also account for risk.

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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby Theoretical » Fri Apr 21, 2017 11:13 am

We are at 25% and for our bond holdings we use a mix of BMBIX, some prerefunded bonds all maturing in the next quarter or two, one 15 year legacy muni bond, and brokered CDs in about a 5 year ladder (I say about because it's odd lots), and a small TVA 20 year zero coupon agency bond.

We'll probably be at 28% in a few years.

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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby teacher » Fri Apr 21, 2017 11:20 am

Excellent thread. I'm here to learn, so my post will alert me of further comments the next few days.

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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby willthrill81 » Fri Apr 21, 2017 11:26 am

John Laurens wrote:Paying down mortgage is better in almost all close yield scenarios. In a mortgage the lender (the bank) assumes risk. Holding municipal bonds the lender (YOU) assume risk. One can't simply quote a yield spread and not also account for risk.

Regards,
John


My thoughts are the same. Most mortgages have a rate greater than 3.5%, and even 10 year Treasuries are only yielding about 2.25%. You maintain liquidity with the Treasuries but at the opportunity cost of returns.

That's partly why I don't mind being close to 100% equities with my invested portfolio; I'm aggressively paying off my mortgage (negative bond) at the same time.
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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby The Wizard » Fri Apr 21, 2017 11:38 am

Answer to OP depends on the situation.
Most folks are looking at a long term 30+ year timeframe.
Recently, I put $$ aside over a two year period to buy a new truck with.
I put part of my savings in Ally Bank at 1% which was taxed at 28% + 5% combined
I put another part in VBILX Int Bond fund. The dividends were taxed at 33% combined but were higher than the 1% of Ally Bank. I also had a small capital loss on the principal in VBILX which got subtracted from my income for the year.

Overall, I preferred VBILX over Ally Bank, but next time, I'll use a stock index fund to accumulate my funds...
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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby Kevin M » Fri Apr 21, 2017 11:43 am

kolea wrote:SEC yield includes changes in price which is more relevant to a short term investor who is banking on capital gains as part of his return. Distribution yield is just the return from interest payments. The latter dominates total return for long term investors. Most bogleheads are long-term investors, hence my focus on TTM distribution yield.

You have this backwards--kind of.

You're right that distribution yield is the return from interest payments (actually dividend payments, which is bond interest plus or minus the effects of accounting for premiums or discounts at time of purchase), but it's backward-looking, and does not account for the return due to price change of the bonds looking forward. Vanguard's distribution yield is a trailing one-month yield, so it gives you a pretty good idea about what your income will be next month. It's a good short-term indicator for income, but not for total return.

SEC yield is a form of yield to maturity, which factors in the price change of the bonds as they approach maturity, as well as the coupon payments (interest). Yield to maturity (YTM) is well understood to be a good estimate of total return for a bond held to maturity. SEC yield isn't as good for a fund, since bonds may not be held to maturity, and because the fund itself doesn't mature, but most people accept it as the best we have for estimating expected return.

This is easier to understand if you think about an individual bond. The price of a 5-year bond with a yield (to maturity) of 2.3% and a coupon rate of 3% is 103.27. The current yield, which is analogous to distribution yield for a fund, is 2.90% (=3/103.27). So current yield is higher than yield to maturity, but you won't earn the current yield if you hold the bond to maturity, because the value will fall from 103.27 to 100 at maturity. The yield to maturity of 2.3% factors in this price decline, and is a good estimate of your total return for the bond held to maturity (with the reinvestment rate adding some uncertainty).

So current yield of a bond is a decent indicator of income return over the short term, but yield to maturity is a much better indicator of total return over the "long" term. Substitute distribution yield for current yield and SEC yield for yield to maturity, and you have the closest analogy we have for a bond fund.

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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby kolea » Fri Apr 21, 2017 3:07 pm

Kevin M wrote:This is easier to understand if you think about an individual bond. The price of a 5-year bond with a yield (to maturity) of 2.3% and a coupon rate of 3% is 103.27. The current yield, which is analogous to distribution yield for a fund, is 2.90% (=3/103.27). So current yield is higher than yield to maturity, but you won't earn the current yield if you hold the bond to maturity, because the value will fall from 103.27 to 100 at maturity. The yield to maturity of 2.3% factors in this price decline, and is a good estimate of your total return for the bond held to maturity (with the reinvestment rate adding some uncertainty).

So current yield of a bond is a decent indicator of income return over the short term, but yield to maturity is a much better indicator of total return over the "long" term. Substitute distribution yield for current yield and SEC yield for yield to maturity, and you have the closest analogy we have for a bond fund.

Kevin


To be perfectly honest, I am not 100% sold on using distribution yield either. The mental model I have for a bond fund is to ignore capital gains/losses. Reasons why are: (a) changes in price are limited because the underling bonds' intrinsic values are limited by their par values, (b) changes in price are driven by interest rate changes which are unpredictable and can go up or down, so bond price tends to mean revert as interest rates wobble around some mean value. Since I want to ignore capital changes, and in fact would be perfectly happy if a bond price never changed, all I am left with are dividends. So that is why I pay the most attention to distributions.

Where my mental model breaks down is that while bond price should mean revert, it can take a long time to do so.

In any event, this is a little academic as I mostly pick bond funds based on maturity, quality, risk, and duration. I will peek at yield but it is not top of list. Heck I just bought some TIPS yielding 0% (actually slightly negative!).
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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby printer » Sun Apr 23, 2017 1:22 am

This is what I do too, not only because of tax, but also because of some possibility of diversification. Historically, for example, VWITX (Vanguard Intermediate-Term Tax-Exempt Fund) behaved at times differently than a total bond market fund such as VBMFX (Vanguard Total Bond Market Index). Although I am not sure whether they're different enough to justify to me the complexity of having two bond funds instead of only one, that is what I do. I actually have three - a total bond fund in my 401k, VWIUX (the admiral shares version of VWITX) in a taxable account, and IEI in a taxable account. So I diversify not only across total bond market / munis, but also across having some bonds in taxable and some in non-taxable (see WhiteCoat investor's article "Bonds Belong in Taxable").

tractorguy wrote:Just to make it more complicated, because municipal bonds generally have lower returns than their taxable equivalents, its not always a given that you should buy them in your taxable account. It depends on your marginal tax rate. If you are in a 35% tax rate, then almost certainly yes, you should focus on tax free bonds. If you are in the 0% or 15% tax rate, then no, you should not buy tax free bonds, but taxable ones of equivalent risk. And, if you are in the middle like most of us, it depends.

I addressed that problem by splitting the difference and buying some of each in my taxable space.

The math behind this is addressed here: https://www.aaii.com/journal/article/mu ... ield.touch

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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby whodidntante » Sun Apr 23, 2017 2:30 am

The bond fund dividend distributions would be taxable at the marginal rate, and you would need to adjust for any realized or distributed cap gains. It's probably not as much tax as you think, but paying tax you didn't need to pay is burned money from the perspective of the investor.

If taxes are a primary consideration, I would suggest that the investor:
Proceed to open an IRA, HSA, and if possible a 401k or other tax advantaged account. Max them every year, burning down the taxable accounts to fund it if necessary. Burn down the taxable bonds first.
Keep only the amount of bonds needed in taxable after the above is taken care of. Taxable bonds will usually yield more, even after tax.
Hold fixed income in a tax advantaged account.
Buy equity index ETFs in taxable.
May need to take more risk than 60/40, depending on the situation.
When trading in taxable, consider taxes and place the most efficient trades possible.
Keep an eye out for TLH opportunities and execute them.

If money is needed today:
Sell equity index ETFs in taxable to raise cash.
Trade in tax advantaged accounts as needed to maintain the desired asset allocation. Meaning sell bonds and buy stock there so your overall asset allocation stays where you want it.

But to be honest, asset allocation decisions matter more when there is a larger amount of money involved, so don't spend too much time trying to implement things "perfectly." One hundred grand is worth planning, but just rough it in and don't get stuck on minor details.

selters
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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby selters » Sun Apr 23, 2017 3:33 am

S17C wrote:Say that young investor in the 28% Federal tax bracket with $100K in maturing CDs wants an AA of 60/40, but hypothetically has no retirement accounts. There is only room for $5500 to put that bond index into a new IRA account. The other $34,500 of VTBLX (Total Bond Index) would go into a taxable account. Approximately how much will be lost to taxes in that first year in the taxable account, as a consequence of not being able to place VTBLX in a retirement account?


My answer here is not specific to the US tax system. But everything else being equal, $10,000 in a taxable account growing at 2% a year for 30 years where gains are taxed at 28% annually turns into 15,356 after taxes. In a tax deferred account $10,000 grows into 15,842 after taxes. For $34,500 the numbers are $52,978 and $54,655.

If the bonds had returned 2.15% annually instead of 2% in the taxable account, you'd be ahead of the tax deferred account.

So the value of tax deferral for a low returning investment such as bonds is really quite overhyped by Bogleheads, in my opinion.

livesoft
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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby livesoft » Sun Apr 23, 2017 4:31 am

Tamales wrote:
Theoretical wrote:For taxable bonds, ETFs have a major advantage over mutual funds because of how they deal with capital gains.


Has anyone ever run numbers to quantify the actual significance of this advantage of ETF bond funds over mutual funds?

There is no major advantage between ETF bond funds over bond mutual funds wrt capital gains. For instance, VCSH and VSCSX both paid capital gains in 2015. And all share classes of Vanguard Total Bond Market (BND, VBMFX, VBTLX) paid capital gains in 2015 and 2016. Maybe @Theoretical can explain what they mean?
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House Blend
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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby House Blend » Sun Apr 23, 2017 7:15 am

selters wrote:
S17C wrote:Say that young investor in the 28% Federal tax bracket with $100K in maturing CDs wants an AA of 60/40, but hypothetically has no retirement accounts. There is only room for $5500 to put that bond index into a new IRA account. The other $34,500 of VTBLX (Total Bond Index) would go into a taxable account. Approximately how much will be lost to taxes in that first year in the taxable account, as a consequence of not being able to place VTBLX in a retirement account?


My answer here is not specific to the US tax system. But everything else being equal, $10,000 in a taxable account growing at 2% a year for 30 years where gains are taxed at 28% annually turns into 15,356 after taxes. In a tax deferred account $10,000 grows into 15,842 after taxes. For $34,500 the numbers are $52,978 and $54,655.

If the bonds had returned 2.15% annually instead of 2% in the taxable account, you'd be ahead of the tax deferred account.

So the value of tax deferral for a low returning investment such as bonds is really quite overhyped by Bogleheads, in my opinion.

That's not the right comparison, because $10K of post-tax and pre-tax money are not equivalent. And even allowing for that, your calculation is wrong: $10,000 growing at 2% for 30 years in tax-deferred is $18,114 before tax, and worth $13,042 after 28% tax. It is far worse than the $15,536 produced by the taxable account.

The proper choice is (say) $10,000 in tax-deferred or $7,200 in taxable, given that the tax rate is 28%.

As noted, the $10,000 after 30 years in tax-deferred is worth $13,042, whereas the $7,200 in taxable would be worth 7200*(1+0.72*0.02)^30 = $11,056. The tax sheltered approach produced 18% more.

If you know that the tax avoided by deferring dollars, and the tax paid by withdrawing dollars is always a single constant rate [*], you can regard tax-deferred dollars as a foreign currency that is tied to the US dollar at fixed rate of exchange. Once viewed that way, you realize that all bonds in tax-deferred behave as if they were tax-exempt bonds [**].

[*] Generally false in the real world.
[**] We are ignoring price fluctuations and assuming they average out to 0.

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StevieG72
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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby StevieG72 » Sun Apr 23, 2017 7:26 am

I had the same issue and purchased Vangaurd High Yield Tax Exempt bond fund.
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Kevin M
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Re: How inefficient is it to hold Total Bond Index in a taxable account?

Postby Kevin M » Sun Apr 23, 2017 12:17 pm

House Blend wrote:
selters wrote:
S17C wrote:Say that young investor in the 28% Federal tax bracket with $100K in maturing CDs wants an AA of 60/40, but hypothetically has no retirement accounts. There is only room for $5500 to put that bond index into a new IRA account. The other $34,500 of VTBLX (Total Bond Index) would go into a taxable account. Approximately how much will be lost to taxes in that first year in the taxable account, as a consequence of not being able to place VTBLX in a retirement account?

My answer here is not specific to the US tax system. But everything else being equal, $10,000 in a taxable account growing at 2% a year for 30 years where gains are taxed at 28% annually turns into 15,356 after taxes. In a tax deferred account $10,000 grows into 15,842 after taxes. For $34,500 the numbers are $52,978 and $54,655.
<snip>

That's not the right comparison, because $10K of post-tax and pre-tax money are not equivalent. And even allowing for that, your calculation is wrong: $10,000 growing at 2% for 30 years in tax-deferred is $18,114 before tax, and worth $13,042 after 28% tax. It is far worse than the $15,536 produced by the taxable account.

The proper choice is (say) $10,000 in tax-deferred or $7,200 in taxable, given that the tax rate is 28%.

A problem with this line of discussion is that the question in the OP is not sufficiently well formed to really provide an answer. The OP referenced "IRA" and "retirement account", either of which could refer to either traditional or Roth accounts. Either way, if a 401k/403b were available, then House Blend is more on the right track.

Assuming a typical 401k/403b, and assuming no pre-existing balance, one would only be able to "place" $18K (after tax) into it, so we can't compare to "placing" $34.5K in it. If there were an existing 401k/403b, then we'd want to ask more questions, since we'd be interested in the entire portfolio, not just the $100K from maturing CDs (why does a young investor have this much in CDs anyway?).

So, I'm wondering what the OP is really asking. Is this a real situation that the OP is looking for advice on, or is the OP just interested in the math of tax-advantaged vs. taxable investing? If it's the latter, then House Blend's comments are relevant, but we can make it even simpler.

Using the $10K example (not the OP's example, for which we would need more information to really address), assuming a constant 28% marginal tax rate, and assuming that $7,200 out of pocket is all that one can afford to contribute to an account for retirement, then as House Blend says, contributing $10K to a tax-deferred account is equivalent to contributing $7,200 to a taxable account. But, it's also equivalent to contributing $7,200 to a Roth 401k, and this is what makes it simpler to think about.

It should be obvious that it's better to contribute $7,200 to an account which will never be taxed than to a taxable account. This way we don't even have to do any math to at least say that all distributions will be taxed compared to none being taxed in the tax-advantaged account.

So let's assume that somehow OP could "place" the entire $34,500 into a Roth "retirement account" (which would be equivalent to placing $47,917 into a traditional retirement account, since we're ignoring the contribution limits). Then, the answer to the OP's question is that 28% of all dividend and short-term capital gain distributions and 15% of all long-term capital gains distributions will be lost to tax.

LTCG distributions for VBTLX (not VTBLX) have been tiny over the last 18 months, so I'll guess we can pretty much ignore them as a significant factor over the next year. Distribution yield is the most relevant number to use in considering taxes on distributions over the next year. The most recent distribution yield was 2.57%, and the lowest distribution yield over the last 18 months was 2.31% (distribution yield changes slowly), so I'd use 2.5% as an estimate of distribution yield over the next year.

So that's $863 of dividend income (2.5% * 34,500), and 28% of that, or $242 will be "lost to taxes", leaving $621 after tax.

If we assume that distribution yield will average closer to 2.7%, due to increasing coupon rates for new bonds, then pre-tax dividends would be $932, $261 will be lost to tax, leaving $671 after tax.

Another factor in how much is lost to taxes is the tax on any capital gain or loss. Guessing what that will be over the next year is a crapshoot, but whatever it is, you will lose 15% of any gains, and gain 15% of any losses (i.e., the government shares 15% of the risk and return on this part in a taxable account, and shares none of the risk or return in a Roth or your 72% share of a traditional account), assuming you were to sell at the end of the year. If you don't sell at the end of the year, then this part is irrelevant for a one-year holding period.

Kevin
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