Tax Cost Calculator

By Harry Sit

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:

Tax Cost Calculator

I start with this set of assumptions:

Stocks  
Total return 8.0%
Dividend yield 2.0%
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
   
Bonds  
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.

2.2% Rewards Card $444 Bonus

Earn 2.2% toward travel on all purchases with Barclaycard Arrival World MasterCard. No caps and no foreign transaction fees. 40,000 bonus points if you make $1,000 or more in purchases in the first 90 days. $89 annual fee waived in the first year (40,000 bonus miles pay for 5 more years after that). Learn More

Software picked, likely related posts:

Posted on May 19, 2010 under Investing. Keywords: .

Leave a comment

Comments

2 Comments on Tax Cost Calculator

  1. Random Poster on May 19, 2010
     

    Thanks. Your calculator is very helpful.

  2. Ted on May 21, 2010
     

    Thanks for the calculator and the analysis.

    One thing I’ll note: In your second example, municipal bond yields (as a percentage of taxable bond yields) don’t need to go down very much in order to make bonds-in-tax-advantaged-equities-in-taxable look good again.

    I wouldn’t be surprised if, when the market incorporates the effects of the tax changes into municipal bond prices, we’ll have a new equilibrium in which most of us are back to the same point as we were before.

Tell me what you're thinking, but please don't spam. See comments moderation policy.