Vanguard's 2020 capital gains estimates

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
palanzo
Posts: 1608
Joined: Thu Oct 10, 2019 4:28 pm

Re: Vanguard's 2020 capital gains estimates

Post by palanzo »

grabiner wrote: Fri Nov 20, 2020 10:34 am
palanzo wrote: Fri Nov 20, 2020 2:45 am
grabiner wrote: Mon Nov 16, 2020 8:38 pm With recent declines in bond yields, almost all the bond funds are distributing capital gains. Capital gains in a bond fund are normally advantageous, as you pay capital-gains tax when the fund replaces a high-coupon bond with a lower-coupon bond after rates fall, so the capital gain replaces non-qualified future dividends.

However, there are small capital gains in most of the muni funds, where the taxable gain is a total loss (although it will be recovered as a reduced gain when you sell the fund). VTEB, the muni ETF, is not projected to distribute a capital gain, but I don't know whether the ETF structure helped with that; Intermediate-Term Tax-Exempt, with a similar portfolio, also is not projected to distribute a gain,
Can you explain why muni funds like California Long-Term Tax-Exempt Admiral are declaring capital gains? And why the taxable gain is a total loss?
If a fund buys a bond for $1000, and then rates fall, the bond price might rise to $1050. If the fund holds the bond to maturity, the price drops back to $1000 at maturity. If it sells the bond to buy a new bond, the fund has a $50 capital gain, and the new bond which is worth $1050 at maturity has smaller distributions. The pre-tax return for the investor is the same either way.

However, long-term bond funds must sell bonds before maturity, as the bonds are no longer long-term. So the investor in the fund gets a $50 capital gain, but $50 less in future dividends, because the fund has sold the bond. In a muni fund, the capital gain is taxed, while the dividends are not, so it is a loss to the investor. In a taxable bond fund, the capital gain is taxed at a lower rate than the dividends, so it may be a benefit to the investor.
Thank you grabiner. That was really helpful and clear. Do you think these levels of capital gains will repeat next year? Presumably this would require rates to go down further. I need to use TurboTax to decide whether to keep using California Long-Term Tax-Exempt and Limited-Term Tax-Exempt or rather switch to Total Bond in taxable.
User avatar
grabiner
Advisory Board
Posts: 28207
Joined: Tue Feb 20, 2007 11:58 pm
Location: Columbia, MD

Re: Vanguard's 2020 capital gains estimates

Post by grabiner »

palanzo wrote: Fri Nov 20, 2020 3:53 pm
grabiner wrote: Fri Nov 20, 2020 10:34 am
palanzo wrote: Fri Nov 20, 2020 2:45 am Can you explain why muni funds like California Long-Term Tax-Exempt Admiral are declaring capital gains? And why the taxable gain is a total loss?
If a fund buys a bond for $1000, and then rates fall, the bond price might rise to $1050. If the fund holds the bond to maturity, the price drops back to $1000 at maturity. If it sells the bond to buy a new bond, the fund has a $50 capital gain, and the new bond which is worth $1050 at maturity has smaller distributions. The pre-tax return for the investor is the same either way.

However, long-term bond funds must sell bonds before maturity, as the bonds are no longer long-term. So the investor in the fund gets a $50 capital gain, but $50 less in future dividends, because the fund has sold the bond. In a muni fund, the capital gain is taxed, while the dividends are not, so it is a loss to the investor. In a taxable bond fund, the capital gain is taxed at a lower rate than the dividends, so it may be a benefit to the investor.
Thank you grabiner. That was really helpful and clear. Do you think these levels of capital gains will repeat next year? Presumably this would require rates to go down further. I need to use TurboTax to decide whether to keep using California Long-Term Tax-Exempt and Limited-Term Tax-Exempt or rather switch to Total Bond in taxable.
Bond funds will distribute capital gains for several years after interest rates decline. For example, if an intermediate-term bond fund holds bonds maturing in 5-10 years, then it will distribute capital gains in any year in which 5-year rates are lower than 10-year rates were five years earlier.

My rule of thumb is that munis are priced to break even with bonds of comparable risk at a 25% tax rate. Therefore, if your federal tax rate is over 25%, all your taxable bonds should be munis. If your federal tax rate is 22% or 24%, your CA bonds should be munis, but if you don't want to hold all your bonds in CA, the non-CA bonds should be taxable. (TIPS are particularly good for the taxable bond investments, since they are exempt from state tax, and the low risk leads to low yields and low federal tax. Max out I-Bonds before buying any TIPS, as I-Bonds are an even better deal.)
Wiki David Grabiner
palanzo
Posts: 1608
Joined: Thu Oct 10, 2019 4:28 pm

Re: Vanguard's 2020 capital gains estimates

Post by palanzo »

grabiner wrote: Sat Nov 21, 2020 4:58 pm
palanzo wrote: Fri Nov 20, 2020 3:53 pm
grabiner wrote: Fri Nov 20, 2020 10:34 am
palanzo wrote: Fri Nov 20, 2020 2:45 am Can you explain why muni funds like California Long-Term Tax-Exempt Admiral are declaring capital gains? And why the taxable gain is a total loss?
If a fund buys a bond for $1000, and then rates fall, the bond price might rise to $1050. If the fund holds the bond to maturity, the price drops back to $1000 at maturity. If it sells the bond to buy a new bond, the fund has a $50 capital gain, and the new bond which is worth $1050 at maturity has smaller distributions. The pre-tax return for the investor is the same either way.

However, long-term bond funds must sell bonds before maturity, as the bonds are no longer long-term. So the investor in the fund gets a $50 capital gain, but $50 less in future dividends, because the fund has sold the bond. In a muni fund, the capital gain is taxed, while the dividends are not, so it is a loss to the investor. In a taxable bond fund, the capital gain is taxed at a lower rate than the dividends, so it may be a benefit to the investor.
Thank you grabiner. That was really helpful and clear. Do you think these levels of capital gains will repeat next year? Presumably this would require rates to go down further. I need to use TurboTax to decide whether to keep using California Long-Term Tax-Exempt and Limited-Term Tax-Exempt or rather switch to Total Bond in taxable.
Bond funds will distribute capital gains for several years after interest rates decline. For example, if an intermediate-term bond fund holds bonds maturing in 5-10 years, then it will distribute capital gains in any year in which 5-year rates are lower than 10-year rates were five years earlier.

My rule of thumb is that munis are priced to break even with bonds of comparable risk at a 25% tax rate. Therefore, if your federal tax rate is over 25%, all your taxable bonds should be munis. If your federal tax rate is 22% or 24%, your CA bonds should be munis, but if you don't want to hold all your bonds in CA, the non-CA bonds should be taxable. (TIPS are particularly good for the taxable bond investments, since they are exempt from state tax, and the low risk leads to low yields and low federal tax. Max out I-Bonds before buying any TIPS, as I-Bonds are an even better deal.)
Thank you for explaining. It makes sense that bond funds will continue to distribute capital gains.

At the moment I hold California Long-Term Tax-Exempt and Limited-Term Tax-Exempt in equal amounts in taxable. Why do you suggest the non-CA bonds should be taxable? The non-CA bonds would then be taxed both Federal and CA.

I am beginning to think an alternative given that rates have declined would be to hold several years of expenses in savings account/CD and the rest in California Intermediate-Term Tax-Exempt. Or perhaps just go use Total Bond in taxable instead? I am 22% Federal and 8% CA and expect that to continue.

Can you help me figure out how to think about this? It was easier when rates were higher and bond funds were not distributing capital gains.
User avatar
grabiner
Advisory Board
Posts: 28207
Joined: Tue Feb 20, 2007 11:58 pm
Location: Columbia, MD

Re: Vanguard's 2020 capital gains estimates

Post by grabiner »

palanzo wrote: Mon Nov 23, 2020 4:14 pm
grabiner wrote: Sat Nov 21, 2020 4:58 pm
My rule of thumb is that munis are priced to break even with bonds of comparable risk at a 25% tax rate. Therefore, if your federal tax rate is over 25%, all your taxable bonds should be munis. If your federal tax rate is 22% or 24%, your CA bonds should be munis, but if you don't want to hold all your bonds in CA, the non-CA bonds should be taxable. (TIPS are particularly good for the taxable bond investments, since they are exempt from state tax, and the low risk leads to low yields and low federal tax. Max out I-Bonds before buying any TIPS, as I-Bonds are an even better deal.)
At the moment I hold California Long-Term Tax-Exempt and Limited-Term Tax-Exempt in equal amounts in taxable. Why do you suggest the non-CA bonds should be taxable? The non-CA bonds would then be taxed both Federal and CA.
Given my rule of thumb, it makes sense to use taxable bonds rather than munis if the tax difference is less than 25%. Thus you should use CA munis in preference to taxable bonds (30.3% tax difference) but taxable bonds in preference to non-CA munis (22% tax difference).
I am beginning to think an alternative given that rates have declined would be to hold several years of expenses in savings account/CD and the rest in California Intermediate-Term Tax-Exempt. Or perhaps just go use Total Bond in taxable instead? I am 22% Federal and 8% CA and expect that to continue.
This is a very reasonable strategy. CDs, like taxable bonds, are subject to both CA and federal tax, but they are risk-free as long as you stay under the FDIC limit, which makes them a good alternative to Treasury bonds.
Wiki David Grabiner
Post Reply