I usually include a spreadsheet when I post something about numbers and calculation. That way you can play with your own assumptions. I didn’t do one in my post last week Dividend Tax Going Up, Moving to Munis. My bad.
Reader Random Poster asked:
“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 also exchanged emails with another reader Mike on calculating the tradeoff. I made this spreadsheet to help do the calculation:
I start with this set of assumptions:
|Tax rate on dividends (including state income tax)||21.0%|
|Tax rate on capital gains (including state income tax)||21.0%|
|Amortize capital gains over||30 years|
|Taxable bond yield||6.0%|
|Muni yield as a % of taxable bond yield||80%|
|Tax on bond interest||31.0%|
The 21% tax rate on dividends and capital gains consists of 15% federal income tax and 6% state income tax. The calculator shows the tax cost for holding stocks in a taxable account under these assumptions is 0.93% a year. Doing the opposite — holding muni bonds in a taxable account and holding stocks in a tax advantaged account — costs 1.15% a year. An investor is better off with holding bonds in a tax advantaged account. That’s the conventional wisdom, which is correct under the set of assumptions above.
However, the answer will change under a different set of assumptions. If you are in the AMT phaseout zone, you will have to add another 6.5% or 7% to the tax rate on dividends. For someone in a high tax state, the total tax on dividends can be over 30% after you add the state income tax and AMT phaseout.
If we change the tax rate on dividends from 21% to 30%, the tax cost for holding stocks in a taxable account goes up from 0.93% a year to 1.37% a year. The tax cost for holding munis in a taxable account stays the same at 1.15% a year. And that’s with a tax efficient fund that only distributes 2% dividends. What if we change the dividend yield from 2.0% to 2.5%? The tax cost for holding stocks in a taxable account goes up to 1.45% versus the same 1.15% for holding munis in a taxable account.
So there you have it. Enter your own assumptions in the tax cost calculator and see which way is better for you.
See All Your Accounts In One Place
Track your net worth, asset allocation, and portfolio performance with free financial tools from Personal Capital.