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:
| 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.
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Random Poster says
Thanks. Your calculator is very helpful.
Ted says
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.