Tax Efficiency: Relative or Absolute?

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Tax efficiency becomes a factor when you have investments in regular taxable accounts (versus a tax advantaged accounts such as a 401k or IRAs). Because you have to pay taxes on interest, dividends, and realized gains, an investment that loses less of its returns to taxes is said to be more tax efficient.

Tax efficiency is a non-issue if you only have tax advantaged accounts.

Which one of these two investments is more tax efficient?

  • A stock mutual fund is expected to earn 7% a year; its returns are taxed at a 12% rate.
  • A bond mutual fund is expected to earn 2% a year; its returns are taxed at a 30% rate.

For simplicity’s sake, I spread the eventual capital gains tax when you finally sell the stock mutual fund into a constant tax rate per year.

The blue dots represent the actual pattern of taxes on a stock mutual fund: smaller when you hold, larger when you sell. The red dots represent a normalized pattern: same amount every year.

The stock mutual fund gets the preferential tax treatment. Qualified dividends and long-term capital gains are currently taxed at a lower rate than ordinary income. In this example, the stock mutual fund loses 12% of its returns to taxes instead of 30% lost by the bond mutual fund.

That makes the stock mutual fund more tax efficient relatively. But on an absolute basis, the stock mutual fund loses 7% * 12% = 0.84% to taxes each year whereas the bond mutual fund only loses 2% * 30% = 0.6%.

Which number is more important? The relative, 12% vs 30%, or the absolute, 0.84% vs 0.6%?

If you want both investments and you can’t put both of them into tax advantaged accounts because there is a limit on how much you can contribute to tax advantaged accounts, you will have to prioritize. You should focus on the absolute number: 0.84% for stocks and 0.6% for bonds in our example, because that’s how much you will lose to taxes if you hold that investment in a regular taxable account.

In other words, the investment with a larger absolute tax cost should be sheltered in tax advantaged accounts. In this case, the stock fund should go into the shelter first, leaving the bond fund outside if there isn’t enough room.

The expected return plays a big role here. Back when bond funds were yielding 6%, 8%, the correct asset placement strategy was to shelter the bond funds. Now bond funds are only yielding 2%. The low bond yield changed the picture. The strategy must follow.

The new strategy will be very obvious if our bond fund is actually a money market fund paying 0.05%. Although the income from the money market fund is fully taxable, there is no point in sheltering it because it’s too small. It’s not worth worrying about. It would be a mistake if you waste precious space in tax advantaged accounts on sheltering 0.05% yield while leaving stock mutual funds paying 2% dividends out in the cold unsheltered.

Trade Spaces

What if you are still operating under the old rules and you already have your bond funds in tax advantaged accounts and your stock funds in taxable accounts? Chances are you don’t want to trade your stock funds for bond funds because doing so would trigger capital gains tax.

You can swap gradually with new cash. Next time when you are about to buy more shares of stock funds in your taxable account, sell some bond fund shares in your tax advantaged account and buy stock fund shares there. Use your available new cash to buy bond fund shares in your taxable account. This way over time you will build up more money in stock funds inside your tax advantaged accounts and more money in bond funds outside.

Step-Up In Basis At Death

Don’t do the swap if you have more money than you can spend in your lifetime and you will leave your vast fortune behind to your heirs very soon. Assets left behind in a regular taxable account receive a step-up in basis at death. Unrealized capital gains are forgiven when you die. In such case you will want to have stock funds in taxable accounts in order to maximize tax free unrealized capital gains.

I’m assuming most people will need and use the money themselves.

What If Interest Rates Go Up

What if interest rates go up and change the picture again? Lose that fantasy. Have you not got the message from the Fed? Bond yields are not going back up to 6%, 8% any time soon. I quote this from Vanguard senior economist Roger Aliaga-Díaz (emphasis added by me):

“Our outlook for bonds is tame and really depressed,” [Aliaga-Díaz] said. “Forget about the years that bond returns were 6% to 8%. We’re talking about 1% to 2% for 10 years. If rates don’t rise, you have those yields. If rates do rise, you have capital loss (in bond value). All of this is tilted to the downside. That’s a reality, even for a long-term investor.”

* Source: With investors still focused on bonds, more talk of a bubble, Vanguard.com, September 28, 2012

If rates do go back up, no problem. Your bond funds in taxable accounts will have a capital loss. Remember bond values go down when interest rates go up. You can reverse the trade and take the capital loss. No harm is done.

Having fixed income money in taxable accounts is the more tax efficient strategy in the current low interest rate environment. Doing so also affords us many opportunities not available in tax advantaged accounts (for example buying I Bonds at 1.5% higher yield than 5-year TIPS). If the environment changes, switching back is not a problem because it won’t trigger capital gains tax.

[Photo credit: Flickr user adafruit]

[Updated on Dec. 1, 2012. Changed numbers in the example to avoid confusion.]

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Comments

  1. Charlie says

    This is very interesting stuff. I would be taking a long look at this kind of strategy, but I use the G Fund as my primary fixed income holding.

    I did have a thought about another situation. The absolute advantage of holding bonds in taxable right now seems to depend on the fact that capital gains will be realized at some point. What about investors who are young and don’t expect to realize capital gains for a very long time? Over the 10 years we expect to see low bond yields, they would lose more to taxes if they hold bonds in taxable. They also might sacrifice a lot of opportunities for tax loss harvesting, where they can save taxes at their top marginal rate. When they eventually do realize gains, they might be able to offset capital gains with prior losses, or depending on future tax law may be in a lower income bracket at the 0% capital gains rate. They may decide to give appreciated shares to charity. There seems to be a lot of assumptions one has to make to decide which course is best, and a lot of ways to avoid paying capital gains taxes on stocks for a very long time.

  2. Lynne says

    This post makes a great point about an important way our thinking needs to change in a sadly long-term low-return environment for bonds.
    But it seems to assume we have as good choices in our retirement accounts as we do in the taxable accounts where we can hold anything.
    In reality, my company’s 401K plan has few index funds. Our only international stock fund option, for instance, is a very expensive actively managed fund, so I’d hate to buy that rather than one of the international stock index funds I can buy in my taxable account.
    Of course, there’s always my ROTH IRA, but I can only contribute $6,000/yr to that account, and that’s where I keep REIT and high yield bond funds, which I think still belong in a tax-advantaged account.

  3. Harry says

    Charlie – Yes, I did say this is assuming that you will need and use most of the money yourself as opposed to accumulating a pile for the step-up in basis at death or donating to charity. As long as you will use the money yourself, longer time only means the investment will build up more unrealized capital gains. It does not reduce the tax rate on the gains. Stocks pay dividends. Right now the dividend yield is about the same and sometimes higher than the bond yield. The preferential treatment of dividends over interest and wages is scheduled to go away. At best the preference will shrink. You are not paying that much less in taxes on dividends even before amortizing the eventual capital gains tax.

  4. Harry says

    Lynne – I hope you are contributing the max to your 401k before investing in a taxable account although your 401k has more expensive investment options. You still come out better off that way in most cases. See my previous post Alternatives to a High Cost 401k Or 403b Plan. Most plans have relatively better options for stocks than for bonds. Usually they at least have a S&P 500 index fund. It’s one more reason for putting stock funds in tax advantaged accounts. As I will post in the coming weeks, there are many opportunities to earn more than bonds in taxable accounts.

  5. joe says

    Great article. I’ve given this idea a lot of thought myself. Looking at an index s and p 500 fund from vanguard, since 2000 it has returned with dividend on average 2.25% or so. The vanguad TIPS fund which is not tax efficient has returned 7% per year. Using these numbers I would want to shield the TIPS bond fund.

    Using your strategy you need to be able to guess what the returns will be. Since bond yields are very low right now it may be better to shield stock mutual funds in tax sheltered accounts. But if inflation rears its ugly head, maybe you want to shield your TIPS funds?

  6. Harry says

    joe – Buying I Bonds in taxable account will help with that dilemma. Existing TIPS can stay in tax advantaged accounts.

  7. Harry @ PF Pro says

    I never thought about in relative vs. absolute terms. But that would seem to make sense to put your low yielding bonds in an after-tax account.

    Is this not a similar concept to your last article(guest post)? Wouldn’t you want to hold stocks in your Roth and bonds in your 401k for the same reason or am I missing something?

  8. Harry says

    Harry @ PF Pro – No, this is different. The guest post talks about two tax advantaged accounts: Roth and Traditional. The conclusion is that it doesn’t matter. Here I’m talking about taxable accounts versus tax advantaged accounts (whether Roth or Traditional).

  9. White Coat Investor says

    Great post. In fact a great month worth of posts. Love the circle graphic.

    I just wanted to add one thing. While nominal yields may not rise any time soon (at least if the Fed gets its way), the total yield on inflation-indexed securities may very well go up quite high if inflation spikes. Say you have a TIPS with a real yield of 0%. But then we get unexpected 5% inflation. You’ll be wishing you had those stocks in taxable then, especially when you have to pay the taxes on the phantom income.

    Otherwise, great article turning the conventional wisdom on its head. It’s getting pretty old to not only have low dividend yields on stocks but also low yields on bonds. Perhaps it’s time to be investing in real estate- low prices and low interest rates. If only it wasn’t such a hassle.

  10. CoderDude says

    My first question is whether it’s realistic to assume stocks will have significantly higher returns than bonds. The example provided was stocks returning 7% and bonds 2%. As a counterpoint, in 2002 William Bernstein predicted Large US Stocks would return 3.5%, while investment-grade corporate bonds would also return 3.5%.

    Next, consider the range of outcomes for stock returns. If stock returns are equal to or less than bond returns, it’s better to hold stocks in taxable. Since stocks didn’t do very well, you will really appreciate the tax savings. If stock returns are sufficiently larger than bond returns, then in hindsight, it would have been better to hold stocks in tax-advantaged. However, since stocks did very well, you can afford to pay more in taxes without compromising your lifestyle. Stocks in taxable is a win-win. Either they have low return and you play low taxes, or they have high return and you can afford to pay the higher taxes.

    Finally, holding stocks in taxable allows you to tax-loss harvest. I have heard that tax-loss harvesting can increase after-tax returns by as much as 1% per year (though I don’t know the validity of this claim). Anecdotally, I was happy to be holding stocks in taxable in 2008 since I was able to bank large losses.

  11. Harry says

    Your first question has no answer. No one knows what returns will be in the future. The numbers given in the article are an example to show that the absolute tax loss is the more important number to consider, not the relative number. They are not a prediction of future returns.

    Second, even if stocks end up having similar returns to bonds, you are still not saving much taxes by holding bonds in tax advantaged accounts because you can buy muni bonds in taxable account for not much loss in income.

    Finally, you can only harvest losses from recent purchases. If a crash comes in year 24, there is not much loss to harvest. The 1%-per-year number is greatly exaggerated.

  12. theo says

    Nice analysis, turns conventional wisdom on its head.
    You don’t seem to emphasize the fact that stocks’ capital gains are eventually taxed at the higher marginal income tax rate if held in pretax retirement accounts instead of the lower (thus far) long term capital gains in regular taxable accounts.
    Is that because you assume that the gap in taxation will disappear or become smaller in the future?

  13. CoderDude says

    What is the formula for determining whether it’s better to hold stocks or bonds in taxable at a particular time? Is it based on things like taxable bond yield, municipal bond yield, stock yield, dividend and capital gains tax rates, etc?

    If I do switch to holding bonds in taxable, when would I know the right time to switch back?

  14. theo says

    @Coder It would be interesting to see TFB do some real-life calculations according to current tax rates but it is obviously difficult to project future rates…

    I don’t think TFB suggested switching existing holdings in taxable accounts since that would trigger capital gains. His suggestion is to redirect new contributions :)

    Come to think of it though leaving aside anyone’s particular case, as a general rule capital gain tax rates are at historic lows and assuming (as most do) that these rates will go up, this could represent a golden opportunity to lock in the current rates by realizing those capital gains this year :)
    Of course in particular cases one could have lower income in the future which could lead to potential lower capital gain tax rates, though IMHO that would be an exception rather than the rule…

  15. Harry says

    @theo – The tax on withdrawal from a tax deferred account is taken care of by the tax deduction when you made the contribution. From that point on, the governments (federal and state) own a portion of your account. The remainder you own is tax free. The actual percentage owned by the governments depend on tax laws in the future but it doesn’t depend on what you hold in the account. Whatever you hold in the remainder is tax free regardless. Therefore the often cited “convert capital gains into ordinary income” argument is not valid.

    @CoderDude – Yes it’s based on those things. You know it’s the right time to switch when those things change. I updated my Tax Cost Calculator which uses those factors as inputs.

  16. theo says

    The total porfolio after all taxes are paid in the end does depend on the capital gain tax rate and where stocks are held …There are 2 opposing forces: deferring taxes on the higher yielding asset (- i.e. stocks) will allow for compounding to work its magic. OTOH it is only in a taxable account that you can benefit from lower capital gains taxes on stocks – this benefit disappears when stocks are held in a tax deferred account where everything is taxed as regular income in the end.

    I had difficulties wrapping my head around the theoretical stuff and had to go for an example :)
    Sorry for the wall of text, I hope nobody gets a heart attack :)

    In each case the tax deferred account starts from a higher amount (57.15k) which after 25% tax ~ equals the taxable account amount (42.85).
    I assumed a marginal income tax rate of 25%, annual bond yield of 4%, annual stock capital gain of 7% (ignoring stock dividends and bond capital gains for simplicity).

    The only difference between the 2 cases is the capital gain tax which is 25% in the first example and 15% in the second.

    Case #1: capital gain and income tax both are 25%, 30 years horizon.

    Stocks in Tax Deferred.
    57.15*(1.07^30)*0.75= 326.28
    Bonds in taxable:
    42.85*(1.03^30)= 104.01
    total after 30 years=
    430.29

    Bonds in TD.
    57.15*(1.04^30)*0.75= 139.02
    Stocks in taxable:
    42.85*((1.07^30-1)*0.75+1)= 255.35
    total portfolio after 30 years=
    394.37
    This portfolio total is ~10% lower than the former scenario.

    Case #2
    capital gains tax 15 %, income tax 25%, 30 years horizon.

    Stocks in TD, bonds in taxable (unchanged from case #1 above):
    57.15*(1.07^30)*0.75= 326.28
    42.85*(1.03^30)= 104.01
    total after 30 years same as in case #1 above:
    430.29

    Bonds in TD:
    57.15*(1.04^30)*0.75= 139.02
    stocks in taxable:
    42.85*((1.07^30-1)*0.85+1)=283.68
    total after 30 years:
    422.70, minimally lower than the reverse and better than in case #1, now only about 2% difference.

    The only thing that I wanted to show through this example is that there is a tradeoff for stocks being taxed at capital gains rates vs stocks in tax deferred accounts where they are taxed at marginal income rates.

  17. Harry says

    theo – I’m not surprised that a lower capital gains tax rate will lower the cost of holding stocks in taxable account. If that large blue circle at the end in my chart is smaller it will mean smaller red circles representing the average cost per year. It doesn’t contradict what we discussed so far. It’s also consistent with my tax cost calculator. When you lower the tax on capital gains, the tax cost for holding stocks in taxable gets lower.

  18. allan roth says

    If both the yield on the bond and the stocks are equal (say about 2.2%), then one benefits today with a lower tax rate on stocks held in the taxable account. Where the benefit really comes, however, is in the withdrawal phase. IF long term capital gains are still taxed at a lower rate than ordinary income, then the last thing you’d want to do is to hold stocks in the tax-deferred account. That’s because you’d be converting higher expected growth from a long-term capital gain to ordinary income.

    I agree that any investment yielding .05% or less has very little in tax consequences. But one shouldn’t have any significant amounts of funds earning this rate.

    • Harry says

      Allan – Thank you for stopping by. It’s been established that a tax deferred account is equivalent to a Roth account when the tax rates at the time of contribution and at the time of distribution are the same. For most people when the tax rate in retirement is lower, a tax deferred account is better than a Roth account. I think of it as a “super Roth” account. Earnings in a Roth account are tax free. More so in a “super Roth” account. There’s no converting capital gains to ordinary income. If someone doesn’t like paying tax on the capital gains, there’s always the choice of using a Roth account to begin with or converting to Roth along the way.

  19. allan roth says

    Harry – my pleasure. I didn’t even see Roth mentioned in your piece though I agree that a traditional IRA is superior IF one has a lower marginal tax rate in retirement. Since we don’t know future tax rates, I happen to believe all three pots (taxable, tax-deferred, and tax-free) give some diversification against Congress.

    What I’m referring to is that it’s still better to hold stocks in the taxable account and not in the tax-deferred. The location is at least as good now if the yields are similar but much better later on. Stocks have the likelihood (no guarantee) to grow faster and, when withdrawn, will incur ordinary income. If one had located the stocks in the taxable account, they would get a lower LTCG rate, at least under current law.

  20. Robert Bradley says

    Interesting analysis, but I think it ignores risk. In the example above, putting stocks in the (let’s say traditional IRA) shelter first results in lower portfolio risk than putting bonds in the shelter on an after tax basis, since taxes in the Tr. IRA are higher.

    Only when modelling and equalizing risk can we make a definitive statement like: ” the investment with a larger absolute tax cost should be sheltered in tax advantaged accounts.”

    Additionally, the point Allan Roth was trying to make – that you’d rather have a large tax friendly taxable account than a large Tr. IRA to draw down in retirement – is a further reason this decision isn’t quite so simple.

    • Harry Sit says

      Please see my reply to Allan Roth above. Because of the up front tax deduction, a traditional IRA is at least as good as a Roth account. In many cases it’s better than a Roth. If it’s worse, you can always convert it to a Roth now. Therefore we are really comparing money in a Roth or a super-Roth and money in a taxable account. Whatever you leave outside the Roth or super-Roth, you pay the tax cost.

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