For some time those ?in the know? have been recommending that if you have both taxable and tax-protected accounts, that you preferentially place stocks into the taxable account and more tax-inefficient bonds into the tax-protected accounts (like IRAs and 401Ks.)? This makes sense because stocks are inherently more tax-efficient than bonds, since much of their growth is deferred, and even distributed capital gains and dividends are only taxed at the lower tax rate.? I wasn?t initially convinced, so I did the math once, and sure enough, it made sense to put stocks in taxable.? This is actually the main argument I used against using municipal bonds- because most investors are better off using fully taxable bonds in their tax-protected accounts.
Current Market Environment Changes Assumptions
Since I?ve done that math, however, two very significant things have happened in the market.? The most important is that interest rates have come way down.? Less important, but still significant, the spread between municipal bond yields and similarly risky taxable bond yields has narrowed a great deal.? These changes mean that the assumptions plugged into the equations now have to change.? In this case, when you change the assumptions, you also change the conclusions.
TFB Gets It Right
Harry Sit, over at The Finance Buff, recently pointed this out.? His argument was that it?s important to consider the ABSOLUTE tax cost of an investment, not necessarily the RELATIVE tax cost. His example changes the assumptions used in previous calculations.? He asks which should be put in a taxable account first, a stock fund returning 7% taxed at 20%, or a bond fund returning 2% taxed at 40%?? The stock fund loses 1.4% a year to taxed, whereas the bond fund loses 0.8% a year to taxes.? Although the stock fund is relatively more tax-efficient, on an absolute basis, the bond fund is more tax-efficient.? I think he?s absolutely correct.
Forget Putting Your E- Fund Into Tax-Protected
A few years ago investing math nerds were figuring out ways to put their emergency fund into their tax protected accounts (basically when you needed money you?d sell the exact amount of stocks you needed in taxable and buy those same stocks in the tax-protected account so you never had to sell stocks low.)? Now this approach doesn?t make any sense at all, since any investment that is reasonably safe enough to be an emergency fund has a yield of 1% or less.? It?s really all about the expected returns.
Importance of Being Financially Sophisticated
Many investors (and I?m sure I?m somewhat guilty too) simply learn a handful of rules of thumb rather than reading the primary literature from which they come, such as these articles by investment authorities recommending ?stocks in taxable?: Journal of Finance, TIAA-CREF, and Vanguard. ? But if you don?t understand the assumptions and methods used to derive those rules of thumb, you won?t realize when it is time to ditch them.? Lowered expected returns not only affects the ?bonds in taxable? rule, but it also affects other well-known rules such as the 4% withdrawal rule.? Your financial education must be ongoing throughout your life, just like your continuing medical education.
What should you do?
So what should you do now that you?ve realized stocks in taxable is no longer right?? Probably nothing, but it depends.? I won?t be making any changes because nearly my entire portfolio is in tax-protected accounts.? The question is simply irrelevant to my current portfolio, and perhaps yours as well.? If you have no taxable account, you don?t need either stocks or bonds in it.
Even if you do have a taxable account, you still may not want to do anything dramatic, especially if your stocks or stock funds have a low relative cost basis.? They may still be highly tax-efficient if you plan on either dying (your heirs get a step up in basis) or donating the shares to charity (no tax cost) any time soon. Even if you don?t anticipate either of these occurring in the near future, the small advantage in increased tax efficiency each year isn?t worth paying a big tax bill (plus possible fees and commissions) this year in order to reorganize the portfolio.
So if you do want to make this change, it would behoove you to do it gradually, mostly with new money.? The advantage is quite small (1.4% vs 0.8% currently with The Finance Buff?s assumptions), and will shrink as interest rates rise.? It just doesn?t matter as much as it did with higher interest rates.
Don?t worry about getting burned if interest rates rise and you need to switch back.? As The Finance Buff rightly points out, if interest rates rise your bond funds will likely have a capital loss so selling them in taxable isn?t going to hurt your tax situation any (and might even help!)
Muni Bonds Back On The Menu
Since holding bonds in taxable is reasonable again, you?ll need to choose between taxable and municipal bonds.? Most high income professionals who do the calculation (if Taxable yield * (1-marginal tax rate) < Municipal Yield means use munis) will find a municipal bond fund to be a great option.
Asset location matters, but how much it matters (as well as where optimal asset location may be for stocks and bonds) varies with changes in interest rates.
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