When to prefer low-rate bonds to stocks in taxable

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grabiner
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When to prefer low-rate bonds to stocks in taxable

Post by grabiner » Sun Jun 03, 2012 6:00 pm

The Boglehead conventional wisdom, as reflected in Principles of Tax-Efficient Fund Placement
is to place stock index funds in your taxable account if you don't have enough room to hold your whole portfolio in a tax-deferred account. However, given how low bond fund yields are, that may no longer be correct, as I realized in this discussion. Thus, here is a proposed rule of thumb, and two variants:

If a municipal-bond fund yields less than a stock index fund, then it probably saves you in taxes to hold the municipal-bond fund in taxable until the yield rises. When the yield rises, the fund will presumably have a capital loss, so you can sell it and switch to stocks in taxable at no tax cost, and possibly even save a bit in taxes.

The assumption I will make for the tax cost of munis is that munis are priced to break even in a 25% tax bracket; that is, a muni fund will have 75% of the yield of a taxable bond fund in the same tax bracket.

Suppose you have a muni fund with a 2% yield; the effective tax cost is 0.67% because a taxable bond fund with the same risk would have a 2.67% yield. (For comparison, Admiral shares of Intermediate-Term Tax-Exempt currently yield 1.88%, while Admiral shares of Intermediate-Term Investment-Grade yield 2.78% with a little more risk.)

Suppose, instead, that you buy a stock index fund with a 2% yield, all qualified dividends. You will lose 0.30% to taxes this year. In addition, the stock index fund is expected to gain 8% total, so you will have a 6% unrealized gain, say $600 on a $10,000 investment. When you sell the fund (either when you withdraw the money, or earlier if you harvest a loss), you will pay 0.9% taxes on that 6%, which is $90 if the gain is $600.

However, the taxes are paid in dollars in the year of sale, which are of less value than current dollars. Thus, if you buy stocks this year, you effectively own a negative bond which will cost you $90 on the day you sell the stock; the current cost of that future payment is equal to the value of a zero-coupon bond which will mature on that day. The current yield on long-term zero-coupon Treasuries is about 3%, so $90 thirty years from now is worth $37 today, and the net cost comes out to 0.67%; the cost of the stocks is slightly higher if your time horizon is less than 30 years.

The exact agreement of the two numbers is an accident, and isn't the main point, because there are many other considerations. The most important consideration is that you might not have to pay those capital-gains taxes; you may donate some of the stock to charity, or leave it to your heirs. Working the other way is the expectation that your tax-deferred account will grow faster because stocks usually return more than bonds; however, if stocks do have high returns, you probably won't need all the stocks in retirement and are more likely to leave them to your heirs.

Another consideration is the possibility of harvesting, but that is pretty much a wash. Whenever you do buy the stocks, you can harvest any losses, but primarily in the first few years after you have bought them. If you buy stocks after three years and hold them for 27 more, you give up any chance to harvest 28-year-old losses, but it is unlikely that you will have any losses that old.

International funds in a taxable account may reduce the tax bill because of the foreign tax credit; however, with the exception of Tax-Managed International, they do not have 100% qualified dividends, and thus the tax savings isn't that great. In addition, in recent years, international yields have been higher than US yields, negating the tax benefit.

The final consideration is not a tax consideration at all; if you have a 401(k), your options may be constrained by what is in the 401(k). If the only low-cost option in your 401(k) is an S&P 500 index fund (a common situation), then you should hold stocks in your 401(k), bonds in your IRA, and if you need to hold more bonds, hold them in taxable. Conversely, if you have an unusually good bond option in the 401(k) such as the TSP G fund, then you should hold your bonds there. (The TSP G fund currently yields about 2% with the same risk as a money-market fund, so the effective tax cost for a government employee to hold bonds in taxable is 2%.)
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Re: When to prefer low-rate bonds to stocks in taxable

Post by stlutz » Sun Jun 03, 2012 6:06 pm

Wow--great post. Thanks for quantifying all in the ins and outs of that!

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Re: When to prefer low-rate bonds to stocks in taxable

Post by grabiner » Sun Jun 03, 2012 6:12 pm

My first post ignored the issue of state taxes. If you pay state taxes, then a fund which is exempt from state taxes is even more attractive. For example, if you are in a 25% federal and 8% state tax bracket, then your effective tax cost on qualified dividends and capital gains is 21% if you itemize deductions and 23% if you don't. However, there is a diversification issue; if all of your bonds are in one state, and something happens to that state, all of your bonds will lose money.

Therefore, I would recommend holding a single-state fund in taxable in a high-tax state even if its yield is a bit higher than the yield on a stock index fund, but not for any more than half your bond allocation. You could hold half your bonds in taxable in a state tax-exempt fund, and the other half in your IRA in Total Bond Market.

Similarly, if you hold Treasury bonds in a taxable account, you get a state tax advantage. If you are in a 25% federal and 8% state tax bracket, a non-Treasury bond of comparable risk (GNMA, corporate of lower duration to compensate for the credit risk) would be taxed at 31% rather than 25%. Thus the effective tax cost of the Treasury bond for federal tax comparison is 19% rather than 25%, so Treasuries yielding slightly more than a stock index can be held in taxable. TIPS look particularly good in a taxable account as long as inflation expectations are low.

(edited to make a minor correction of numbers)
Last edited by grabiner on Wed Jun 11, 2014 9:38 am, edited 1 time in total.
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Re: When to prefer low-rate bonds to stocks in taxable

Post by Bob's not my name » Sun Jun 03, 2012 6:17 pm

grabiner wrote:The most important consideration is that you might not have to pay those capital-gains taxes; you may donate some of the stock to charity, or leave it to your heirs.
Or you may be able to realize the gains when you're in the 0% bracket. As I've posted before, an elderly person in assisted living can have six figures of income but be in the 0% bracket -- and I don't mean 0% LTCG rate in the 15% bracket, I mean actually in the 0% bracket. The elderly person whose finances I manage is in the 0% bracket with tens of thousands of dollars of headroom, so I'm liquidating individual stocks with fifty years of gains and paying no taxes on the sales. Another opportunity may occur in early retirement before SS and RMD's start -- 60-70 today, presumably 70-80 in the future for current twentysomethings.

As I've also posted, it's also possible to realize LTCG at 0% tax by gifting appreciated stock to your kids, but you have to manage this within kiddie tax limits, which are pretty, uh, limiting.

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Re: When to prefer low-rate bonds to stocks in taxable

Post by Bob's not my name » Sun Jun 03, 2012 6:19 pm

grabiner wrote:My first post ignored the issue of state taxes
States and localities may also tax investment income differently, e.g., Philadelphia taxes interest, dividends, and STCG only, and Massachusetts taxes STCG at 12%.
Last edited by Bob's not my name on Sun Jun 03, 2012 6:22 pm, edited 1 time in total.

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Re: When to prefer low-rate bonds to stocks in taxable

Post by grabiner » Sun Jun 03, 2012 6:21 pm

Bob's not my name wrote:
grabiner wrote:My first post ignored the issue of state taxes
States and localities may also tax investment income differently, e.g., Philadelphia taxes interest, dividends, and STCG only, and I believe Massachusetts murders these.
Check with your state tax advisor for all the details.

Another example: NJ does not tax Treasuries even in IRAs, so the recommendation about holding Treasuries in taxable doesn't apply there; TIPS are ideal in a non-roth IRA for a NJ investor.
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Re: When to prefer low-rate bonds to stocks in taxable

Post by bdpb » Sun Jun 03, 2012 8:45 pm

More excellent discussion by grabiner.
grabiner wrote: Similarly, if you hold Treasury bonds in a taxable account, you get a state tax advantage. If you are in a 25% federal and 8% state tax bracket, a non-Treasury bond of comparable risk (GNMA, corporate of lower duration to compensate for the credit risk) would be taxed at 31% rather than 25%. Thus the effective tax cost of the Treasury bond for federal tax comparison is 19% rather than 25%, so Treasuries yielding slightly more than a stock index can be held in taxable. TIPS look particularly good in a taxable account as long as inflation expectations are low.
It's definitely a mistake to ignore state taxes. In a high state tax (think CA at 10%), before discussing tax exempt funds
to match TBM, one should definitely consider moving Treasuries to taxable. Since 15% fed + 10% CA on QD = 25%, and
25% fed + 0% CA on Treasury interest = 25%, then any Treasuries yielding less than stocks should be in taxable.
That pretty much handles Treasuries past 10 years right now. If you hold only Treasuries, then it's easy. If
you hold TBM, then you would have to break it into it's components and would have less Treasuries to move around.
You don't have to compare the risks between the tax exempt fund and TBM this way.

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Re: When to prefer low-rate bonds to stocks in taxable

Post by grabiner » Sun Jun 03, 2012 9:07 pm

bdpb wrote:It's definitely a mistake to ignore state taxes. In a high state tax (think CA at 10%), before discussing tax exempt funds to match TBM, one should definitely consider moving Treasuries to taxable. Since 15% fed + 10% CA on QD = 25%, and 25% fed + 0% CA on Treasury interest = 25%, then any Treasuries yielding less than stocks should be in taxable.
The effective tax rate on stocks is 22.5% in this situation; presumably, if you live in CA and have taxable investments, you pay enough state taxes to itemize your deductions.

It's still true that Treasuries yielding equal to stocks should be in taxable, because you pay only a bit more in state taxes now, and you won't pay capital-gains tax on the Treasuries. (If Treasury yields rise to exceed stock yields, then Treasury prices will fall and you can sell the Treasuries for a capital loss.)

(edited to correct second paragraph)
Last edited by grabiner on Fri May 27, 2016 7:57 pm, edited 1 time in total.
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Re: When to prefer low-rate bonds to stocks in taxable

Post by dyangu » Mon Jun 04, 2012 12:52 am

There was another thread about this recently. Basically, because of historically low interest rate, the equity risk premium over bonds is likely higher than the entire bond yield, so it would make sense to put the much higher yielding investment in a tax shelter.

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