Muni Bonds in Taxable Account - Good, Bad, or Ugly?

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amiller7x7
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Muni Bonds in Taxable Account - Good, Bad, or Ugly?

Post by amiller7x7 » Fri Aug 10, 2018 12:50 pm

Following our earlier post from July, we are moving quickly toward a self managed approach of our retirement assets based largely on a three fund portfolio approach. Most of the consolidations of funds in the accounts are proceeding smoothly but like all real problems there are quirks. This post is looking for guidance and perspectives on our current position (left over from an external advisor’s actions) which is holding 10.5% of our total funds in our one taxable account in the form of 9 pretty highly rated municipal bonds (details available if needed) -they each generate 4% returns Federal income tax free (we are in a 24% income tax bracket in 2018).

My unease is about their illiquidity in the face of possible (?) increasing interest rates and potentially increasing inflation factors. They are part of our long term asset allocation of 50% equities / 50% bonds(fixed income items) so if we didn’t hold them here we would need to create equivalent space in our tax deferred accounts for a more traditional bond fund (which of course has both potential interest rate and inflation rate issues as well).

So the two questions are:

1) what are the pro’s and con’s of holding such specific municipal bonds long term in our taxable account? Note: we are using the muni bonds as part of the overall asset allocation and we are not trying to generate current consumable income from them. Illiquidity, interest rate pressures, and potential inflationary forces are causing me to wonder about the wisdom of this position right now as a long term position. Conversely they do throw off some cash ($18K per year Federal Income tax free...but not free for other tax issues such as Medicare etc.)

2) Given the current discussions about interest rate pressures, and potential inflationary forces right now, which assets or funds are folks here using to establish their portfolio bond positions? Since we are now entering the RMD phase of our portfolio, I would be most interested in the perspectives appropriate for folks of our age & stage of life - other perspectives which are appropriate for younger investors will be shared with my son & daughter!

Our status:

Emergency Funds – Have 6+ months of expenses in readily available cash not represented below.
Debt - None
Tax Filing Status – Married Filing Jointly
Tax Rate: No state income tax; Marginal Federal Income Tax Rate of 24%
State of Residence: Washington
Age – He is 69 – She is 71
Target Asset Allocation – 50% Stocks / 50% Bonds (including RMD positions as noted below)
Target Allocation of Stocks – 25% International; 75% US
Stated Financial Objective – Preserve Purchasing Power over what is hoped to be a very, very long retirement. It is okay to have monies at the end but not okay to run out early! :>)
Stable Gross Monthly Income of Social Security and a Defined Benefit Retirement Plan (the latter is not COLA’d and it seems like the former is not very well COLA’d!) have covered our living and recreation expenses up to date. After 7 years of retirement, we have never needed to withdraw any funds from the Current Retirement Accounts listed below.

Our current Portfolio (all percentage positions are % of the total portfolio which is in the several million range) - this is the "to be" portfolio as noted as we are still consolidating accounts but are well over half way there

Our taxable account - 33.3%
Municipal Bonds (9 of them) - 10.5%. [4% yield Federal income tax free]
ISHARES CORE S&P TOTAL US STOCK MARKET* (ITOT - ER=0.03%)) - 17.4%
ISHARES TRUST CORE MSCI EAFE ETF* (IEFA - ER= 0.08%) - 4.9%
[* this is a story in motion as we how soon we can get to the indicated equity ishares fund allocation is about how soon and by what means we end up addressing the 6 figure taxable gains we have for the current existing other 6 ishares funds which will migrate to the targeted funds shown]

His IRA - 55.9% of total
FIDELITY U.S. BOND INDEX PREMIUM CLASS (FSITX ER=0.025%) - 31.9%
FIDELITY ZERO TOTAL MARKET INDEX (FZROX ER=0.0%) - 11.2%
FIDELITY ZERO INTERNATIONAL INDEX (FZILX ER=0.0%) - 4.6%
3 year CD Ladder to cover RMD’s for 2019, 2020, 2021 - 6.8%

His ROTH IRA. - 3% of total
FIDELITY ZERO TOTAL MARKET INDEX (FZROX ER=0.0%) - 1.3%
FIDELITY ZERO INTERNATIONAL INDEX (FZILX ER=0.0%) - 1.7%

Her IRA - 6.1% of total
FIDELITY ZERO TOTAL MARKET INDEX (FZROX ER=0.0%) - 4.5%
FIDELITY ZERO INTERNATIONAL INDEX (FZILX ER=0.0%) - 0.7%
3 year CD Ladder to cover RMD’s for 2019, 2020, 2021 - .7%
2018 RMD in cash MM - 0.3%

Her Roth - 1.54 % of total
FIDELITY ZERO TOTAL MARKET INDEX (FZROX ER=0.0%) - 1.33%
FIDELITY ZERO INTERNATIONAL INDEX (FZILX ER=0.0%) - 0.21%

Thank you in advance for your insights and perspectives! This has been an eye opening but fun journey so far for both my wife and myself. And she is starting to get pretty conversant in Boglehead-speak!

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triceratop
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Re: Muni Bonds in Taxable Account - Good, Bad, or Ugly?

Post by triceratop » Fri Aug 10, 2018 12:56 pm

I may be misunderstanding your post but could you clarify so I can help you better? I think you might have it backwards: you typically don't set an allocation to Munis and then decide where to best put them. Instead, you find an asset allocation and if it is needed to put bonds in your taxable account then you may find it useful to fill that space in your asset allocation with Munis for tax reasons. Are you thinking about this differently?
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."

amiller7x7
Posts: 16
Joined: Mon Feb 02, 2015 7:58 pm

Re: Muni Bonds in Taxable Account - Good, Bad, or Ugly?

Post by amiller7x7 » Fri Aug 10, 2018 1:21 pm

Triceratop

" Instead, you find an asset allocation and if it is needed to put bonds in your taxable account then you may find it useful to fill that space in your asset allocation with Munis for tax reasons. Are you thinking about this differently?"

Thanks for the quick response! For clarification, we have an asset allocation of 50/50 equities/bonds(& cd's) - but we ended up with having this relatively large specific set of muni bonds in our taxable account from the activities of our previous account advisor and they do currently comprise part of the 50/50 portfolio target. We have the option to move that amount of bond type resources to an IRA account (which would not be muni bonds per se) or the option of leaving them alone. I was uncomfortable with my lack of understanding of all of the issues associated with holding the specific muni bonds in our taxable account which is a long term position for us and was looking for people's guidance on the advisability of continuing with the current position of the 9 municipal bonds in the taxable account versus liquidating them and moving the funds to an equivalent bond position in the tax deferred IRA accounts (which keeps the 50/50 asset allocation percentages intact)

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triceratop
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Re: Muni Bonds in Taxable Account - Good, Bad, or Ugly?

Post by triceratop » Fri Aug 10, 2018 1:35 pm

I see, thank you for the clarification. If there are no transactional (tax or market impact) consequences and you can easily hold your bonds in your retirement account then sure. However, have you looked into the transaction costs of selling Muni bonds? What if you instead reinvested proceeds into bond funds in your IRA gradually as the munis mature? Do be aware that your risk profile may change by putting bonds in retirement accounts -- a useful forum/google search is "Bonds in taxable".
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."

amiller7x7
Posts: 16
Joined: Mon Feb 02, 2015 7:58 pm

Re: Muni Bonds in Taxable Account - Good, Bad, or Ugly?

Post by amiller7x7 » Fri Aug 10, 2018 2:48 pm

Triceratops

Thanks for the advice! - will check the reference to earlier threads on bonds in taxable accounts. The bonds are fairly young and maturity dates for the 9 bonds are 2040, 2044, 2045 (4), 2046, 2047, and 2049 - so there doesn't appear to be any near term roll them over when mature option readily available.

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