When to prefer low-rate bonds to stocks in taxable

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When to prefer low-rate bonds to stocks in taxable

Post by grabiner »

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 »

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

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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 »

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 »

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 »

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 »

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

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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 »

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

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grabiner wrote: 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.
Since I refer to this thread frequently, I should mention that this no longer applies, and the effective tax rate is now 25%. If you live in a high-tax state and are considering buying munis, you probably hit the $10K SALT limit, so the additional state tax on state-taxable investments no longer increases your federal itemized deductions.
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Re: When to prefer low-rate bonds to stocks in taxable

Post by OSUperu »

grabiner wrote: Mon Feb 18, 2019 10:05 pm
Since I refer to this thread frequently, I should mention that this no longer applies, and the effective tax rate is now 25%. If you live in a high-tax state and are considering buying munis, you probably hit the $10K SALT limit, so the additional state tax on state-taxable investments no longer increases your federal itemized deductions.
Can you expound upon this a bit more? Trying to understand tax liability vs general return/risk. We live in Oregon and surprisingly had to use standard ded. for Federal, but itemize for State. We are in the 24% marginal tax rate. We are now maxing our 401ks and are unable to utilize a tax deduction for our IRAs, thus Taxable is our next route.

Originally I was thinking a more conservative approach than my current 95/5 allocation in my tax deferred accounts (I want to pull from this account early that 59.5 as a way to bridge the gap and retire in the early 50s), and so looking at 50% tax efficient VSTAX or VTCLX, with 50% VBTLX or VWITX.

Thanks for any input
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Re: When to prefer low-rate bonds to stocks in taxable

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OSUperu wrote: Tue Apr 16, 2019 4:43 pm
grabiner wrote: Mon Feb 18, 2019 10:05 pm
Since I refer to this thread frequently, I should mention that this no longer applies, and the effective tax rate is now 25%. If you live in a high-tax state and are considering buying munis, you probably hit the $10K SALT limit, so the additional state tax on state-taxable investments no longer increases your federal itemized deductions.
Can you expound upon this a bit more?
In order to compare two investments in a taxable account, you need to look at the tax cost of both.

When I first posted this thread, most muni investors deducted all of their state income tax from federal tax (except for those affected by the AMT). Therefore, the tax cost of an out-of-state muni fund was lower than your actual state tax, because some of that tax was deducted.

With the changes to the tax law in 2018, most muni investors either use the standard deduction or are already paying $10K in state tax. In either case, paying more state tax results in no change in your federal tax.
Trying to understand tax liability vs general return/risk. We live in Oregon and surprisingly had to use standard ded. for Federal, but itemize for State. We are in the 24% marginal tax rate. We are now maxing our 401ks and are unable to utilize a tax deduction for our IRAs, thus Taxable is our next route.
Look into the backdoor Roth IRA if you don't already have a deductible IRA (or are willing to convert it or roll it into a 401(k)).

Given these tax numbers, your OR tax rate is presumably 9%. Thus, if you hold bonds in your taxable account, you pay 9% tax on non-OR munis, 24% on Treasuries, and 33% on corporate bonds. If you hold stocks in your taxable account, you pay 24% on qualified dividends and long-term capital gains, and 33% on non-qualified dividends.
Originally I was thinking a more conservative approach than my current 95/5 allocation in my tax deferred accounts (I want to pull from this account early that 59.5 as a way to bridge the gap and retire in the early 50s), and so looking at 50% tax efficient VSTAX or VTCLX, with 50% VBTLX or VWITX.
I don't think Tax-Managed Capital Appreciation (VTCLX) is worth it in your tax bracket; you pay more in higher expenses than you save in taxes. And given the 9% state tax, you might well be better off using Treasuries for your taxable bond allocation. TIPS maturing around the time you plan to retire early could be a particularly good deal.

You should also use I-Bonds. The interest on I-bonds is exempt from state tax, and the federal tax is deferred until you cash them in; if this is in early retirement, you will probably be in a low tax bracket.
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Re: When to prefer low-rate bonds to stocks in taxable

Post by sambb »

in highest tax bracket, it is more pronouncrd
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Re: When to prefer low-rate bonds to stocks in taxable

Post by OSUperu »

grabiner; thanks for the quick and concise response...
grabiner wrote: Tue Apr 16, 2019 8:47 pm
Look into the backdoor Roth IRA if you don't already have a deductible IRA (or are willing to convert it or roll it into a 401(k)).
...What about the "pro rate" rules? I have a few tIRAs (ESOP distributions) at $105k and $60k. Doesn't that mean I will be taxed on a portion of those if I say, fund $20,000 post tax to a tIRA, to then move to a Roth?
grabiner wrote: Tue Apr 16, 2019 8:47 pm I don't think Tax-Managed Capital Appreciation (VTCLX) is worth it in your tax bracket; you pay more in higher expenses than you save in taxes. And given the 9% state tax, you might well be better off using Treasuries for your taxable bond allocation. TIPS maturing around the time you plan to retire early could be a particularly good deal.

You should also use I-Bonds. The interest on I-bonds is exempt from state tax, and the federal tax is deferred until you cash them in; if this is in early retirement, you will probably be in a low tax bracket.
I need to present my whole portfolio plan in the other forum, (ESOP distributions occured/occuring and funds to be sent to a few accounts...etc), but suffice to say; the premise of this taxable account (if I don't do the backdoor roth) is to create a less aggressive fund ($30k to start w/$1500 monthly), that I want to pull from, say by early 50's during a "moderate" retirement phase, without touching the tax deffered funds until 59.5 (and maybe around 55, start the back door roth for my tIRAs?). So I would be using this fund in ~15 years or so.

How would that affect the the type of bond (TIPS, I bonds, long term, treasuries vs muni vs corp...etc) portion of this 'less aggressive' portfolio?

And the better word might be less 'volatile', in that, say we want to be somewhat retired at 51, I don't want have to keeping working full time just because the market is in a down cycle. So maybe what I'm looking for is a taxable that is less volatile, beats inflation and any tax liability. In my very novice thoughts, I was thinking 50% VTSAX and 50% VBTLX. I also don't want to get caught up on minor differences in tax liabilities -if- the difference in average returns well outweighs the tax.
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Re: When to prefer low-rate bonds to stocks in taxable

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grabiner wrote: Sun Jun 03, 2012 6:00 pm
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.
grabiner,

I disagreed with that assumption:

A) I could be buying stock regularly.

B) I could harvest the gain at 0% and generate the loss to offset gain and income later.

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

Post by DB2 »

grabiner wrote: Tue Apr 16, 2019 8:47 pm
OSUperu wrote: Tue Apr 16, 2019 4:43 pm
grabiner wrote: Mon Feb 18, 2019 10:05 pm
Since I refer to this thread frequently, I should mention that this no longer applies, and the effective tax rate is now 25%. If you live in a high-tax state and are considering buying munis, you probably hit the $10K SALT limit, so the additional state tax on state-taxable investments no longer increases your federal itemized deductions.
Can you expound upon this a bit more?
In order to compare two investments in a taxable account, you need to look at the tax cost of both.

When I first posted this thread, most muni investors deducted all of their state income tax from federal tax (except for those affected by the AMT). Therefore, the tax cost of an out-of-state muni fund was lower than your actual state tax, because some of that tax was deducted.

With the changes to the tax law in 2018, most muni investors either use the standard deduction or are already paying $10K in state tax. In either case, paying more state tax results in no change in your federal tax.
Trying to understand tax liability vs general return/risk. We live in Oregon and surprisingly had to use standard ded. for Federal, but itemize for State. We are in the 24% marginal tax rate. We are now maxing our 401ks and are unable to utilize a tax deduction for our IRAs, thus Taxable is our next route.
Look into the backdoor Roth IRA if you don't already have a deductible IRA (or are willing to convert it or roll it into a 401(k)).

Given these tax numbers, your OR tax rate is presumably 9%. Thus, if you hold bonds in your taxable account, you pay 9% tax on non-OR munis, 24% on Treasuries, and 33% on corporate bonds. If you hold stocks in your taxable account, you pay 24% on qualified dividends and long-term capital gains, and 33% on non-qualified dividends.
Originally I was thinking a more conservative approach than my current 95/5 allocation in my tax deferred accounts (I want to pull from this account early that 59.5 as a way to bridge the gap and retire in the early 50s), and so looking at 50% tax efficient VSTAX or VTCLX, with 50% VBTLX or VWITX.
I don't think Tax-Managed Capital Appreciation (VTCLX) is worth it in your tax bracket; you pay more in higher expenses than you save in taxes. And given the 9% state tax, you might well be better off using Treasuries for your taxable bond allocation. TIPS maturing around the time you plan to retire early could be a particularly good deal.

You should also use I-Bonds. The interest on I-bonds is exempt from state tax, and the federal tax is deferred until you cash them in; if this is in early retirement, you will probably be in a low tax bracket.
Hi Grabiner,

Are you sure about VTCLX not being worth it in the 24% bracket? I'm in that bracket (although my effective tax rate will probably be a few percent below that for 2019). I compared the after tax between VTCLX and VSTAX over the last 10 years and the after-tax distributions leans in VTCLX's favor more so than several basis points.

https://personal.vanguard.com/us/funds/ ... tingFrom=6
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Re: When to prefer low-rate bonds to stocks in taxable

Post by grabiner »

DB2 wrote: Wed Apr 17, 2019 10:09 am Are you sure about VTCLX not being worth it in the 24% bracket? I'm in that bracket (although my effective tax rate will probably be a few percent below that for 2019). I compared the after tax between VTCLX and VSTAX over the last 10 years and the after-tax distributions leans in VTCLX's favor more so than several basis points.

https://personal.vanguard.com/us/funds/ ... tingFrom=6
The funds track different indexes, which can lead to a difference in returns. In particular, Tax-Managed Capital Appreciation has no small-caps.

To compare expected after-tax returns, you need to take two similar funds or fund combinations, and assume that they will have the same return before expenses and taxes. Tax-managed fund comparison has Tax-Managed Capital Appreciation one basis point behind 500 Index in a 24% tax bracket, and a combination of 90% Tax-Managed Capital Appreciation and 10% Tax-Managed Small-Cap three basis points behind Total Stock Market Index in a 24% tax bracket.
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Re: When to prefer low-rate bonds to stocks in taxable

Post by DB2 »

grabiner wrote: Wed Apr 17, 2019 8:58 pm
DB2 wrote: Wed Apr 17, 2019 10:09 am Are you sure about VTCLX not being worth it in the 24% bracket? I'm in that bracket (although my effective tax rate will probably be a few percent below that for 2019). I compared the after tax between VTCLX and VSTAX over the last 10 years and the after-tax distributions leans in VTCLX's favor more so than several basis points.

https://personal.vanguard.com/us/funds/ ... tingFrom=6
The funds track different indexes, which can lead to a difference in returns. In particular, Tax-Managed Capital Appreciation has no small-caps.

To compare expected after-tax returns, you need to take two similar funds or fund combinations, and assume that they will have the same return before expenses and taxes. Tax-managed fund comparison has Tax-Managed Capital Appreciation one basis point behind 500 Index in a 24% tax bracket, and a combination of 90% Tax-Managed Capital Appreciation and 10% Tax-Managed Small-Cap three basis points behind Total Stock Market Index in a 24% tax bracket.
Thanks for the info.
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Re: When to prefer low-rate bonds to stocks in taxable

Post by OSUperu »

grabiner wrote: Tue Apr 16, 2019 8:47 pm And given the 9% state tax, you might well be better off using Treasuries for your taxable bond allocation. TIPS maturing around the time you plan to retire early could be a particularly good deal.
How is that? Maybe I missed something but I thought treasuries are federally taxed but not state taxed. So I'd be paying 24%, rather than a muni at 9% right?
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Re: When to prefer low-rate bonds to stocks in taxable

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OSUperu wrote: Wed Apr 17, 2019 11:59 pm
grabiner wrote: Tue Apr 16, 2019 8:47 pm And given the 9% state tax, you might well be better off using Treasuries for your taxable bond allocation. TIPS maturing around the time you plan to retire early could be a particularly good deal.
How is that? Maybe I missed something but I thought treasuries are federally taxed but not state taxed. So I'd be paying 24%, rather than a muni at 9% right?
This is correct. My comment should be interpreted as, "Because you pay 9% state tax, I recommend you use Treasuries for your taxable bond allocation."
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Re: When to prefer low-rate bonds to stocks in taxable

Post by OSUperu »

Ok... so I'd save the 9% of state taxes, but not the 24% of federal to keep teasuries in my taxable. Why not have the munis at the opposite scenario? Save 24%, but pay 9%?
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Re: When to prefer low-rate bonds to stocks in taxable

Post by ivk5 »

OSUperu wrote: Thu Apr 18, 2019 12:22 am Ok... so I'd save the 9% of state taxes, but not the 24% of federal to keep teasuries in my taxable. Why not have the munis at the opposite scenario? Save 24%, but pay 9%?
Goal is after-tax yield, not minimizing tax.

Pre-tax yields are not the same.
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Re: When to prefer low-rate bonds to stocks in taxable

Post by OSUperu »

ivk5 wrote: Thu Apr 18, 2019 1:01 am
Goal is after-tax yield, not minimizing tax.

Pre-tax yields are not the same.
Ok, so are you saying that treasuries (intermediate term treasuries I assume, so as to compare with VWITX) will provide a better after tax yield, than Munis?
VSIGX shows a 2.3 yield and VWITX shows a 2.02 yield. That doesn't like a large enough spread. Or are you talking long term treasury VLGSX at 2.83?
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Re: When to prefer low-rate bonds to stocks in taxable

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OSUperu wrote: Thu Apr 18, 2019 1:18 am
ivk5 wrote: Thu Apr 18, 2019 1:01 am
Goal is after-tax yield, not minimizing tax.

Pre-tax yields are not the same.
Ok, so are you saying that treasuries (intermediate term treasuries I assume, so as to compare with VWITX) will provide a better after tax yield, than Munis?
VSIGX shows a 2.3 yield and VWITX shows a 2.02 yield. That doesn't like a large enough spread.
The Treasury fund is significantly less risky, which likely makes it a better deal with a high state tax and moderate federal tax despite the lower after-tax yield. (Besides the credit risk of munis, the muni fund also has call risk.)
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Re: When to prefer low-rate bonds to stocks in taxable

Post by Bongleur »

grabiner wrote: 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
When you said this in 2012 you were speaking specifically about Munis.
Now in 2019 how does this question play out with other types of bonds & bond funds?
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Re: When to prefer low-rate bonds to stocks in taxable

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Bongleur wrote: Fri Apr 19, 2019 1:32 am
grabiner wrote: 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
When you said this in 2012 you were speaking specifically about Munis.
Now in 2019 how does this question play out with other types of bonds & bond funds?
In a moderate tax bracket, munis and taxable bonds of comparable risk have comparable returns, so it does not matter much for purposes of tax-efficient fund placement whether you use munis or taxable bonds. One exception: in a high-tax state, Treasury bonds in a taxable account may give a more tax-efficient portfolio.

In the bottom tax brackets (12% now, historically 15%), the tax on qualified dividends and long-term gains is zero. This makes the tax cost of a stock index fund also close to zero, and the cost of rebalancing out of that fund is zero unless it pushes you into the 22% tax bracket. Therefore, if your tax bracket is so low that munis do not make sense, stocks in taxable are clearly better.
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international001
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Re: When to prefer low-rate bonds to stocks in taxable

Post by international001 »

Anybody has as spreadsheet to calculate all this?
sharx
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Re: When to prefer low-rate bonds to stocks in taxable

Post by sharx »

grabiner wrote: Sun Jun 03, 2012 6:00 pm
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.)
I'm going through this exercise for myself (high tax bracket in a high tax state). How do you go about comparing risk between an in-state muni fund and others (either out-of-state muni or corporate)?

So far I've compared VNYTX (New York long term, 1.55% yield) to VWLTX (national muni long term, 1.73% yield). Seems like the latter is better for a 6.85% state marginal tax bracket by doing the TEY calculations and also national rather than single state diversification.

But how do I go about finding a non-muni fund of comparable risk? Do you eyeball the credit quality composition chart? For instance VWESX yields 2.85%, however it's hard to compare credit quality because it has some federal bonds but also more A and less AA than the muni fund.

edit: I just realized that the very paragraph I quoted compares intermediate-term tax-exempt to intermediate-term investment-grade. Seems like you came to the conclusion the latter is a little more risky.
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Re: When to prefer low-rate bonds to stocks in taxable

Post by sharx »

Adding to my last post, it seems like the difference in yield between investment grade and tax-exempt bond funds (even for shorter terms) is wide enough that it's unlikely for the tax cost to be lower than a stock fund. Given that yields are very low right now and I'm looking at the 35% tax bracket which is high I have a hard time believing that bonds in taxable ever make sense.

edit: ah I was overlooking the capital gains part of the stock fund's tax cost, and was solely looking at dividends.
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Re: When to prefer low-rate bonds to stocks in taxable

Post by grabiner »

sharx wrote: Mon Sep 09, 2019 1:37 pm Adding to my last post, it seems like the difference in yield between investment grade and tax-exempt bond funds (even for shorter terms) is wide enough that it's unlikely for the tax cost to be lower than a stock fund. Given that yields are very low right now and I'm looking at the 35% tax bracket which is high I have a hard time believing that bonds in taxable ever make sense.

edit: ah I was overlooking the capital gains part of the stock fund's tax cost, and was solely looking at dividends.
While you caught that error, there is also another issue: make sure you compare taxable and muni funds of comparable risk. At the moment, Vanguard Intermediate-Term Tax-Exempt has a duration of 4.5 years, while Total Bond Market has a duration of 6.0 years. Thus, while the Admiral yields of 1.43% and 2.19% would be break-even at a 35% tax rate, the muni fund is less risky. A mixture of Intermediate-Term and Long-Term with a 6-year duration would have a 1.77% yield, break-even at a 20% tax rate; here, I believe the muni fund is slightly riskier, as Long-Term Tax-Exempt has a lot more interest-rate risk from a duration which will increase if rates rise.

My rule of thumb is that the break-even is a 25% tax rate, so a muni fund with the same risk as Total Bond Market Index would have a 1.64% yield.
Wiki David Grabiner
sharx
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Re: When to prefer low-rate bonds to stocks in taxable

Post by sharx »

Great, thanks for the reply! There is a lot of great information in there for how to judge the risk of a bond fund.

Sounds like I should consider breaking apart my TBM in my Roth IRA and putting some combination of treasuries, NY muni and shorter-term national muni in my taxable and use the roth space for more stock funds.
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Re: When to prefer low-rate bonds to stocks in taxable

Post by Northern Flicker »

At current yields of non-US stock index funds and percent of dividends that are qualified, the main benefit of holding non-US stock in a taxable account is (current or future) liquidity. The foreign tax credit enables the income to be realized in a tax-efficient manner when the liquidity is desirable, and the higher yield means there is more income/liquidity available.
Risk is not a guarantor of return.
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