Tax (in)efficiency in taxable accounts
Hoping the smart people here can enlighten me. I read a lot about how one should avoid investing in tax inefficient investments outside of a tax-advantaged account like a 401k.
The logic goes something like this: investments that generate lots of dividends raise one’s taxable income, as these dividends are taxed as ordinary income at the marginal tax rate. For taxable accounts, one should use CDs, tax-free municipal bonds, short-term bonds (lower yields), or stock mutual funds to minimize dividends and avoid taxes.
But what if the higher yielding taxable investment is actually making more money after taxes than these other accounts? Here’s an example: I have $50k in a taxable high yield bond fund that generates a nominal 6% return. That’s an after-tax return of more than 4.5% in the 22% tax bracket. Yes, bond fund prices fluctuate and this affects real return but not anything like the stock market, and as yields and price move inversely, they sort of cancel each other’s effects. This fund pretty much stays steady every year and generates a lot of income. Yes, I pay taxes but after taxes I’m still making money.
On the other hand, my TIPS fund and short-term bond fund really struggle to hand in much of a return. In fact, over the last year the TIPS has lost money. But boy are they tax efficient—if you don’t make any money you aren’t taxed! Sooo....
Why would I invest in CDs (barely keeping up with inflation—maybe), tax-advantaged bonds (weak returns) or expose myself to risks in the stock market (2018 anyone?) to avoid taxes on an investment that actually pays a good return?
Of note, I live in Texas, where we have no state income tax.
Hoping the smart people here can enlighten me. I read a lot about how one should avoid investing in tax inefficient investments outside of a tax-advantaged account like a 401k.
The logic goes something like this: investments that generate lots of dividends raise one’s taxable income, as these dividends are taxed as ordinary income at the marginal tax rate. For taxable accounts, one should use CDs, tax-free municipal bonds, short-term bonds (lower yields), or stock mutual funds to minimize dividends and avoid taxes.
But what if the higher yielding taxable investment is actually making more money after taxes than these other accounts? Here’s an example: I have $50k in a taxable high yield bond fund that generates a nominal 6% return. That’s an after-tax return of more than 4.5% in the 22% tax bracket. Yes, bond fund prices fluctuate and this affects real return but not anything like the stock market, and as yields and price move inversely, they sort of cancel each other’s effects. This fund pretty much stays steady every year and generates a lot of income. Yes, I pay taxes but after taxes I’m still making money.
On the other hand, my TIPS fund and short-term bond fund really struggle to hand in much of a return. In fact, over the last year the TIPS has lost money. But boy are they tax efficient—if you don’t make any money you aren’t taxed! Sooo....
Why would I invest in CDs (barely keeping up with inflation—maybe), tax-advantaged bonds (weak returns) or expose myself to risks in the stock market (2018 anyone?) to avoid taxes on an investment that actually pays a good return?
Of note, I live in Texas, where we have no state income tax.
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