When an investor invests in value stock funds and bonds in both a tax deferred account and a taxable account, there are basically two choices:
(A) Put taxable bonds in the tax deferred account and put value stock funds in the taxable account; OR
(B) Put value stock funds in the tax deferred account and buy tax-exempt muni bond funds in the taxable account.
With approach A, you earn more from the taxable bonds but you must also pay taxes on the dividends from the value stock funds. With approach B, you pay less in taxes but you also earn less because the yield on muni bonds is typically less than that on taxable bonds.
Right now I’m using approach A but I’m moving toward approach B. I’m selling taxable bond funds in my tax deferred accounts to buy value stock funds and I’m selling value stock funds in my taxable accounts to buy muni bond funds.
I’m making this move because the tax on dividends is going up, especially for someone already in or will cross into the magic $250,000 married, $200,000 single target line.
Dividends increase your Adjusted Gross Income (AGI). If they push you over to the target line, all kinds of interesting things start happening. You don’t want to go there if you have a choice.
If you are subject to the AMT, the tax rate on qualified dividends is higher than you think when you are in the AMT phaseout zone. If your AGI is above $200k single, $250k married filing jointly, you are also subject to the 3.8% Medicare surtax.
Dividends are seen as unearned. Taxing dividends is more politically acceptable than taxing wages. Taxing muni bonds, however, is not as acceptable because it will increase the funding cost for the states.
Not that there’s anything wrong with increasing taxes to cover budget deficits and reduce the growth of the national debt, as a practical matter, I will favor muni bond interest over dividends in a taxable account. I will go help my state government.