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.
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.]