Rethinking Bonds In Taxable

For some time those “in the know” have been recommending that if you have both taxable and tax-protected accounts, that you preferentially place stocks into the taxable account and more tax-inefficient bonds into the tax-protected accounts (like IRAs and 401Ks.)  This makes sense because stocks are inherently more tax-efficient than bonds, since much of their growth is deferred, and even distributed capital gains and dividends are only taxed at the lower tax rate.  I wasn’t initially convinced, so I did the math once, and sure enough, it made sense to put stocks in taxable.  This is actually the main argument I used against using municipal bonds– because most investors are better off using fully taxable bonds in their tax-protected accounts.

Current Market Environment Changes Assumptions

Since I’ve done that math, however, two very significant things have happened in the market.  The most important is that interest rates have come way down.  Less important, but still significant, the spread between municipal bond yields and similarly risky taxable bond yields has narrowed a great deal.  These changes mean that the assumptions plugged into the equations now have to change.  In this case, when you change the assumptions, you also change the conclusions.

TFB Gets It Right

Harry Sit, over at The Finance Buff, recently pointed this out.  His argument was that it’s important to consider the ABSOLUTE tax cost of an investment, not necessarily the RELATIVE tax cost. His example changes the assumptions used in previous calculations.  He asks which should be put in a taxable account first, a stock fund returning 7% taxed at 20%, or a bond fund returning 2% taxed at 40%?  The stock fund loses 1.4% a year to taxes, whereas the bond fund loses 0.8% a year to taxes.  [See comments section for a criticism of the methodology used by TFB.] Although the stock fund is relatively more tax-efficient, on an absolute basis, the bond fund is more tax-efficient.  I think he’s absolutely correct.

Forget Putting Your E- Fund Into Tax-Protected

A few years ago investing math nerds were figuring out ways to put their emergency fund into their tax protected accounts (basically when you needed money you’d sell the exact amount of stocks you needed in taxable and buy those same stocks in the tax-protected account so you never had to sell stocks low.)  Now this approach doesn’t make any sense at all, since any investment that is reasonably safe enough to be an emergency fund has a yield of 1% or less.  It’s really all about the expected returns.

Importance of Being Financially Sophisticated

Many investors (and I’m sure I’m somewhat guilty too) simply learn a handful of rules of thumb rather than reading the primary literature from which they come, such as these articles by investment authorities recommending “stocks in taxable”: Journal of Finance, TIAA-CREF, and Vanguard.   But if you don’t understand the assumptions and methods used to derive those rules of thumb, you won’t realize when it is time to ditch them.  Lowered expected returns not only affects the “bonds in taxable” rule, but it also affects other well-known rules such as the 4% withdrawal rule.  Your financial education must be ongoing throughout your life, just like your continuing medical education.

What should you do?

So what should you do now that you’ve realized stocks in taxable is no longer right?  Probably nothing, but it depends.  I won’t be making any changes because nearly my entire portfolio is in tax-protected accounts.  The question is simply irrelevant to my current portfolio, and perhaps yours as well.  If you have no taxable account, you don’t need either stocks or bonds in it.

Even if you do have a taxable account, you still may not want to do anything dramatic, especially if your stocks or stock funds have a low relative cost basis.  They may still be highly tax-efficient if you plan on either dying (your heirs get a step up in basis) or donating the shares to charity (no tax cost) any time soon. Even if you don’t anticipate either of these occurring in the near future, the small advantage in increased tax efficiency each year isn’t worth paying a big tax bill (plus possible fees and commissions) this year in order to reorganize the portfolio.

So if you do want to make this change, it would behoove you to do it gradually, mostly with new money.  The advantage is quite small (1.4% vs 0.8% currently with The Finance Buff’s assumptions), and will shrink as interest rates rise.  It just doesn’t matter as much as it did with higher interest rates.

Don’t worry about getting burned if interest rates rise and you need to switch back.  As The Finance Buff rightly points out, if interest rates rise your bond funds will likely have a capital loss so selling them in taxable isn’t going to hurt your tax situation any (and might even help!)

Muni Bonds Back On The Menu

Since holding bonds in taxable is reasonable again, you’ll need to choose between taxable and municipal bonds.  Most high income professionals who do the calculation (if Taxable yield * (1-marginal tax rate) < Municipal Yield means use munis) will find a municipal bond fund to be a great option.

Asset location matters, but how much it matters (as well as where optimal asset location may be for stocks and bonds) varies with changes in interest rates.


Rethinking Bonds In Taxable — 10 Comments

  1. I agree asset location is far less critical with today’s interest rates and muni rates, but I think there is a major flaw in the methodology described.

    “The stock fund loses 1.4% a year to taxed, whereas the bond fund loses 0.8% a year to taxes.”

    This is only true if you turnover your stocks every year. If you have a fund with 5% turnover, 7% return, and 20% cap gain your annual taxes lost is .05*.2*.07 = 0.07%. Having stocks in the taxable allows you to defer the capital gains; whereas, the yield from bonds is taxable in that year. This is overly simplistic given many equities yield as much as bonds do in this environment…

  2. Dwolf-

    You can run the numbers without that simplification if you like. Let’s assume a bond yield of 2% and a bond return of 2%. Let’s also assume a stock yield of 2% (Vanguard TSM is 2.04% right now) and a stock return of 7% per year. Let’s assume also that you cash out of all investments after 30 years including withdrawing your entire IRA at a 25% tax rate. Let’s assume an accumulation marginal tax rate of 33% and an accumulation dividend tax rate of 15%. Let’s say you put $100K into the taxable account and $100K into the IRA.

    Stocks in taxable

    Growth rate for stocks is 7%-(2%*0.15)=6.7% per year
    After 30 years the taxable account is worth $699,733. Subtract out the capital gains taxes and you end up with $609,773.
    Meanwhile the bonds grow at 2% a year, so the IRA is worth $181,136, or $135,852 after taxes.
    Total value is $745,625.

    Bonds in taxable

    Growth rate for bonds is 2%-(2%*0.33)=1.34% per year
    After 30 years the taxable account is worth $149,083.
    Meanwhile the stocks grow at 7%, so the IRA is worth $761,226 before taxes and
    $595,920 after taxes.
    Total value is $745,002.

    It’s basically a wash under these assumptions. Run those numbers with 5% yields/returns on the bond portion and you’ll see significantly different results. Run them with lower yields (the Vanguard Short Term Treasury fund has a yield of 0.12%) and you’ll see a small advantage for the stocks in taxable option.

  3. I think having your calculations in the comments will help readers. I’ve ran the numbers with similar results, but I was concerned someone would run the numbers making the assumption 1.4% of the 7% annual return is lost to taxes – which is what the article says. If you assume you only have a 5.6% return annually in the stocks taxable account the results will be skewed. I still think you might want to look at modifying the sentence I quoted above, but just my opinion:)

    On a side note I really liked this comment: “Your financial education must be ongoing throughout your life, just like your continuing medical education.” Although I don’t think finances need to be made overly complicated, in the past I’ve seen bloggers saying you can do it all yourself in only a few hours a year. I think this is a recipe for disaster and I appreciate you reminding everyone to continue learning.

  4. i have two comments actually. For those living in a state with state income tax or with a federal tax rate of 28 percent or higher, then after comparing the this weeks weekly yields that are released every monday tax free muni bonds will likely have a higher after tax return than similar maturity taxable bonds. Comment two. In retirement most people want/need steady income every month to pay their bills. If you have all of your bonds in IRAs / 401ks and all of your stocks in taxable accounts then the returns of the stock market will dictate where you pull your income from instead of you deciding if you pull money from taxable account or IRAs/401k. My initial thought is to keep a majority of stocks in taxable account and majority of bonds inside 401k. I have a related post on my site that calls today’s low interest rates essentially a tax on the wealthy.

  5. WEB-

    I agree that muni yields are relatively attractive right now (mostly because treasury yields are so low.)

    I don’t understand why you think asset location matters so much as far as withdrawing money. It would be very unusual for someone not to have some overlap, i.e. stocks and bonds in tax-deferred or stocks and bonds in taxable. Rebalancing can often be done within the tax-protected account, and if it has to be done within the taxable account, can often be done in a way that minimizes taxes- using distributions first, then tax-loss harvesting, then selling assets with minimal gains etc.

  6. My biggest criticism of the tax efficient placement of funds as proposed on Bogleheads for example is that current tax efficiency and future tax efficiency may be at odds with each other, especially for younger investors. By placing higher (expected) yielding securities (e.g. equities) in a tax deferred plan while you are younger, you can expect a lot more room for your bonds when you are older, when hopefully interest rates would be higher and you would want to tax shelter the bond income. By putting bonds in tax-deferred accounts now, you may be forced to purchase bonds in taxable later because you run out of room in your IRAs and 401ks as you adjust your bond holdings to reflect your age and correspondingly reduced risk tolerance.

    Additionally there is the option to purchase certain bonds in taxable that allow for tax deferral of interest for up to 30 years (e.g. series I savings bonds or EE bonds) which makes equities in taxable even less compelling.

    The counterargument to equities in tax deferred or Roth accounts would be reduced ability to take advantage of tax-loss harvesting if equities decline which will offset some of your income if in taxable accounts but has no such benefit in tax protected accounts.

    I also COMPLETELY disagree with your criticism about putting your E-fund in protected accounts. I think you are missing the point about the rationale for doing this. For residents especially, putting money in the Roth that is safe money serves a dual purpose. It is available in an emergency as contributions can be removed without penalty, but it also reserves space for later as an attending (when you can afford to invest more) that you otherwise would not have available to you if you had instead put your E-fund in taxable during residency and failed to fund your Roth. As your income grows, you then bring your E-fund into taxable.

  7. Mark-

    On the other hand, maybe risk will actually show up and stock returns will suck for 20 years and bond returns will outpace stock returns, causing those who put stocks in tax-protected accounts to have tiny tax-protected accounts. Perhaps not likely, but possible. Maybe worry about current tax efficiency and then work on future tax efficiency later. Tax laws are likely to change in the next 30 years anyway.

    I agree that putting at least some bonds in taxable allows you to take advantage of some of the advantages of I, EE, muni, and even treasuries (no state tax).

    Another counterargument aside from tax loss harvesting is the step up in basis and the option to donate the shares.

    I understand the importance of funding a Roth as a resident. I wasn’t criticizing that. I was criticizing the idea of holding a money market fund in a tax-protected account (your emergency fund) and holding stocks in taxable. A resident trying to reserve Roth space isn’t holding stocks in taxable. He has no taxable.

    • WCI — I’ve tried to duplicate your calcs as well as the advice of the Finance Buff but I can’t seem to get it to work with a real world example (money in taxable and tax advantaged).

      I’m not sure I follow completely. For the tax advantaged money, it looks like you took 25% off the bonds (135,582/181,136) = 0.75.

      However, for the stocks we have (595,920/761,226)= 0.78 Did you intentionally treat those differently? If you take the full 25% off, then Stocks in taxable comes out ahead.

      In fact, stocks in taxable comes out ahead even with bonds at 0% which doesn’t make sense.

      I suspect this analysis misses the fact that the tax-advantaged money is partly owed by the government and not you. As a result, it skews your real stock/bond split. If that is the case, then determining your preferred asset allocation is really challenging!

      I am growing my after tax account since 401K, Stealth and Backdoor are full. This is a real dilemma for me.

      Does that make sense? What am I missing?

      • First, don’t sweat this too much. The truth is at our current interest rates where you put your bonds doesn’t matter much. It’s probably slightly better on one side than the other, but it’s a pretty minor issue.

        You’re right that to be totally accurate in your AA, you have to tax-adjust all of your accounts because the government owns a portion of your pre-tax accounts. In fact, not accounting for this is one reason why many people mistakenly conclude that stocks in taxable is right for them.

        I’m not sure I understand exactly what question you’re asking about the math. Perhaps if we start over using your numbers, I can help you arrive at the right conclusion for you.

  8. Thanks for the offer — I’ll send you an e-mail with the particulars. Your site has been very helpful and has gotten me thinking about the finer details — and I’m not not in the medical field.

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