Dividend Tax Going Up, Moving to Munis

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.

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  1. Random Poster says

    A few thoughts:

    1) For those in upper incomes, is the increased taxation on dividends a flat “across the board” ordinary-income tax rate, or is the tax rate increased only on that portion of the dividend income that is above the income threshold amounts?

    2) I’m curious how an ordinary-income tax rate on dividends dovetails into the additional Medicare payroll tax (3.8% on investment income for individuals with an AGI above $200K/$250K) that is coming due in 2013. I believe that you did a post on this a while back, and the 3.8% tax rate only applied to that portion of the unearned income above the income threshold levels.

    3) I’m not saying that it is impossible or inconceivable, but I would be shocked if dividends do not continue to receive preferential tax treatment. I think that the investment community has too loud of a voice to be ignored.

    4) It really is hard to plan for the future and be a buy-and-hold investor when Congress is continually tinkering with the tax code and changing the rules of the game as they play.

  2. KD says

    I have funds in all four places in your very nice figure because I could not anticipate my future income or future tax liability. It is rather inefficient, but oh well, I have my options đŸ˜€

  3. Evan says

    “Taxing muni bonds, however, is not as acceptable because it will increase the funding cost for the states.”

    It also has to do with an old Supreme Court Case about th duality of our system (just like a State can’t tax income from T-Bills).

  4. Harry Sit says

    Random Poster – My comments to your thoughts:

    (1) Without the actual law or even a bill that spells it out, it’s impossible to know exactly how it’s going to work.

    (2) The 3.8% surtax would be on top of the regular tax, regardless how the regular tax is figured out. Previous post is here.

    (3) The preferential treatment on dividends only existed in the last ten years. I would say it’s more of an exception than a rule. One can reasonably argue that such preferential treatment benefits the rich more than the middle class and the poor and therefore must be reversed. Especially if it’s taken away from only the upper income taxpayers, it only affects a small % of investors. The majority will go for it in a heartbeat.

    (4) I agree. When you have value stock funds in a taxable account with sizable unrealized capital gains, you will find yourself in a bind — either pay a high tax rate on dividends or sell and pay the capital gains tax. That’s why I’m making the changes now before capital gains build up.

    Finally, AMT might absorb some of the additional tax, depending on how exactly it’s implemented.

  5. Random Poster says

    TFB, thanks for the reply.

    If you did not hold any value stock funds in your taxable account, but rather only, say, a total stock market index fund, would you still make the investment changes?

    I ask because, at some point, most people only have so much space in their tax deferred accounts, and legally avoiding all taxation on their investments while maintaining their desired asset allocation is–as far as I can tell–pretty close to an impossible task.

  6. enonymous says

    1.) What are you planning to do about TIPS/ TIPS funds? These are highly tax inefficient, so I assume you will either drop them as an asset class (I doubt this) or you wll leave them in tax deferred space. It seems it would be pennywise poud foolish to move TIPS out into the taxable space.

    2.) I only hold US Treasury instruments in my bond/fixed income portfolio (cash/cd’s money markets are not part of my portfolio, just part of my emergency/daily needs funds). I do so because of their presumed safety. I switched to all US Nominals and US TIPS in 2006. It treated me very well during the recent financial meltdown, and allowed me to rebalance when needed and benefit strongly from keeping a proper asset allocation due to the negative correlation that was expected, and ocurred (I hold intwermediate term US Treasuries through the Spartan INt Term US Treasury fund). MUNI funds, depending on their duration, did not fare as well. Fixed income should be for volatility reduction, safety, and as a source from which rebalancing funds can be taken. I like your premise but it would force me to abandon my core belief as stated in this paragraph.
    What are your thoughts on this matter?
    Full disclosure – I purchased 1% of my net worh in CA GO bonds when they were yielding 5.75% in 2009. I don’t count that in my fixed incme allocation – it was the only ‘play money’ I’ve ever ‘gambled’ with since I went strictly passive low cost index/broad asset class ETF in 2005-6.

    I’m 75% equities/25% bonds. About 35% of my equity portfolio is in small and/or value (incl international via VSS).

    Appreciate your thoughts on this mater

    (I am a MFJ wage slave with >250K income).

  7. Harry Sit says

    enonymous – (1) TIPS: I sold the short-term ones and I’m keeping the long-term TIPS in tax deferred. (2) Nominal Treasury: While you do get a “flight-to-quality” bonus when there is turmoil, in quieter times you earn less. Over the long term, the flight-to-quality bonus and the lower yield balance out. It’s great nominal Treasury worked out well in 2008-2009, but a financial crisis like that doesn’t happen often. If you have good income, your ongoing savings are a source for rebalancing as well.

  8. enonymous says

    TFB – thanks for the clarification on the TIPS – I have done the same (back in late 2008).

    I hold nominal UST b/c I value their modern portfolio benefit. Muni funds likely, but not always, will yield more on a tax equivalent basis than UST, though at current levels, depending on your state and duration, that may not be the case. Regardless, 2008-9 thankfully does not happen often. The point is simply that it can, and it did. My fixed income functions like portfolio insurance. I won’t chase the yield, but I will chase the quality. When I need the quality, I want it to be there. If I lose a few basis points yearly, or even in the long run, perhaps it will balance out with the flight to quality bonus, perhaps it won’t, but at all times, my fixed income will be not be subject to any credit risk. I’ll take my term risk and inflation risks at the level that I choose them. I don’t want the other risks. That’s hat my Equities, REITs, and CCFs are for.

  9. Mike says

    I might be missing something, but even if dividends were taxed as ordinary income, I don’t see how it makes sense to hold value stocks in tax deferred and munis in taxable. Value stocks do have a relatively high yield, but dividends are only part of the total return. By holding value stocks in tax deferred, the capital gains will be taxed as ordinary income rather than long-term capital gains, which really hurts after-tax return.

    Do you have any data showing that holding value stocks in tax-deferred generates better after-tax return, even under the proposed higher tax rates?

  10. Harry Sit says

    Mike – You are missing the tax deduction when the money was originally contributed to a tax deferred account. When you take into account the original tax deduction, it has been shown that a tax deferred account is exactly the same as a Roth account when the marginal tax rate remains the same. A Roth account strictly dominates a taxable account because there is no tax on dividends or capital gains. So the choices really come down to (a) pay tax on dividends and capital gains and pay no tax on the bond interest; or (b) take a hit on the bond yield and pay no tax on capital gains or dividends, as I outlined in the beginning of the post.

  11. J says

    I have a newbie question. I am 34 years old. Right now I’m maxing out my Roth IRA, my spouse’s Roth IRA, my SEP-IRA and (when I have one) my 401(k) to the best of my ability. However, I am considering taxable investing for those years I cannot contribute to these accounts.

    I’m looking at purchasing one fund in my taxable account and never selling until I retire. For this purpose, I was wondering if Vanguard’s Tax-Managed Balanced Fund (VTMFX) could work as a one-stop-shop for a taxable account. I do not see myself tax-loss harvesting or redeeming shares within five years. The simplicity of this balanced fund appeals to me, and I think I could rebalance within my current retirement accounts to achieve my bond/domestic/foreign allocation.

    The only downside I see is possibly losing some domestic returns. VTMFX is not a pure index fund, and it has a slight growth tilt. However, I’m wondering if its tax management might be worth it.

  12. Harry Sit says

    J – Vanguard’s Tax-Managed Balanced Fund (VTMFX) is about 50% large US stocks with low dividend yield, 50% muni bonds. If you use that fund in your taxable account, it’s basically the same as I wrote in this post: munis in taxable, value stocks in tax deferred (assuming you will put a value stock fund in your IRAs to keep the value/growth balance). I like it.

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