When to use tax exempt funds

[whatnot]

We are in the cash accumulation stage prior to our retirement in 20 months or so. I am trying to find the best place to park this cash. Currently:
CU $64k : 0-25k 3.5%, >25k .50%
CD $25k (3 yr) 1.74%
Ally $57k @ 1%

Thinking of moving $50k to Vanguard High-Yield Tax Exempt fund (VWALX).Yield is approx 3.69%.

We had $300k gross income in 2015, maxed out our 401k's 24k each (project same for 2016 & 2017). DH contributes max to HSA. No deductions so we are in high tax bracket. Also, current 401k is slightly over 2.mil. Have done back door Roth IRA for DH last 2 years as well.

So basically trying to get the most return for the cash with relatively small risk. Does this sound like a reasonable plan? Thoughts, critique welcome.
Thanks in advance.

 

[LOL!]

I don't have any cash nor fixed income in any taxable account. That is, no savings account, no CDs, no bonds, no bond funds, etc. The reason is taxes. I don't want to earn any interest or dividends that increase my income and cause me to pay more taxes.

Instead, I use my tax-deferred accounts to hold all bond funds that I need for my asset allocation. In my taxable account, I just use a tax-efficient stock index fund.

The reason to use a tax-efficient stock index fund is three-fold:
1. If it goes up in value and I need some money, then I just sell it. I would not pay any taxes on the gains because of previous tax-loss harvesting. It usually would not even increase my AGI because I have sufficient carryover losses from years and years of TLHing.

2. If it goes down in value, so what? I just tax-loss harvest and I save on taxes. If I need to raise money, I am happy to sell at a loss because I save on taxes AND I can restore my asset allocation by exchanging from a bond fund to an equity fund in one or more of my tax-advantaged accounts. Note that if I had the stock fund in a tax-advantaged account, that would not have prevented it from losing money anyways.

3. If it stays about the same, then no-harm and minimal taxes.

I've got to put stock funds somewhere, so I think it is best to hold them in a taxable account and fixed income in a 401(k) or other tax-deferred account if there is room for all my fixed income in tax-deferred accounts (and there is, plus more room for equities, too).

At your income level, you probably have about 20 years of expenses in your taxable account anyways, so having a tax-exempt bond fund there is not going to do you any good anyways nor change your risk level at all.

I think the only time to use tax-exempt bond funds in a taxable account is when one's tax-deferred accounts are already 100% fixed income, so no more room there AND one needs even more fixed income funds to meet one's asset allocation goals.

 

[COcheesehead]

High yield is not without credit and quality risk. Less return, but less risk would be something like MUB. It is also AMT tax free which you might be running into at your income level.
I am more or less in the same boat.

 

[whatnot]

LOL - Thank you for your response.
1st, our 401k's are 70% stock, 30% bond. The cash is what we are saving outside of our 401k. Basically, my 2-3 year buffer if the stock market crashes and I do not want to liquidate stocks from our 401k in retirement.
2nd, regarding the tax issue. From what I understand any distribution from the fund ((VWALX) is tax exempt by definition. So basically, earning 2.5% more than what I am earining at Ally + no tax owed on earnings so an additional benefit.
These were the assumptions I was using when contemplating the use of the Vanguard High-Yield tax exempt fund. I just thought it might be a better place to park the money until it is needed in the future.

 

[LOL!]

Only tax-exempt dividends from VWALX are tax-exempt. Any capital gains distributions would not be tax-exempt. It has not paid any cap gains distros in the past few years. Any cap gains from selling at a gain (higher NAV than purchase) would not be tax-exempt. Losses might be deductible, but there are some rules for losses in tax-exempt funds.

I have my buffer if the stock market crashes in my 401(k) where I think it belongs in a bond fund with decent credit rating. What happened to VWALX in 2008-2009? Not too bad, it dropped about 14%. Contrast that with VBTLX over the same time period which dropped less and recovered by the time VWALX was still down 14%.

 

[COcheesehead]

If you still want to go down the tax free high yield road, HYD is another ETF to look at. It will yield about 4.43% right now.

 

[scrabbler1]

I use an intermediate-term muni bond fund as my second-tier emergency fund. It has checkwriting privileges so it is a little more easily accessible than most other mutual funds. I have about $40k in this fund, earning mostly tax-free interest at about 2.6% annually with little risk to the principal. I rarely have to tap into it, on average about once a year in the 22 years I have been in this fund. I hate having large blobs of money sitting around doing nothing so at least I earn something decent in this fund.

 

[pb4uski]

As you know, VWLAX has credit risk and interest rate risk that your CDs and online saving account do not.

That 3.5% rate on the first $25k at your CU is a sweet deal. Can you double dip by having one for you, one for your spouse and another joint account?

 

[whatnot]

Thanks for all your replies. By credit risk do you mean loss of principal? If so, then yes I am aware of that, but when I looked at the historical performance - the fund has done well. (i know that history is not a guarantee of future performance)

COcheesehead - I looked up VanEck Vectors High-Yield Municipal Index ETF(NYSE Arca : HYD but the Vanguard website shows "information is currently unavailable for this fund".

I was just trying to find a better yield for the cash buffer we are builing. I know there is additional risk, but was just looking and do appreciate the comments. I will look for muni bonds as suggested above as well. Thanks again.

 

[MrLoco]

I don't have any cash nor fixed income in any taxable account. That is, no savings account, no CDs, no bonds, no bond funds, etc. The reason is taxes. I don't want to earn any interest or dividends that increase my income and cause me to pay more taxes.

Instead, I use my tax-deferred accounts to hold all bond funds that I need for my asset allocation. In my taxable account, I just use a tax-efficient stock index fund.

The reason to use a tax-efficient stock index fund is three-fold:
1. If it goes up in value and I need some money, then I just sell it. I would not pay any taxes on the gains because of previous tax-loss harvesting. It usually would not even increase my AGI because I have sufficient carryover losses from years and years of TLHing.

2. If it goes down in value, so what? I just tax-loss harvest and I save on taxes. If I need to raise money, I am happy to sell at a loss because I save on taxes AND I can restore my asset allocation by exchanging from a bond fund to an equity fund in one or more of my tax-advantaged accounts. Note that if I had the stock fund in a tax-advantaged account, that would not have prevented it from losing money anyways.

3. If it stays about the same, then no-harm and minimal taxes.

I've got to put stock funds somewhere, so I think it is best to hold them in a taxable account and fixed income in a 401(k) or other tax-deferred account if there is room for all my fixed income in tax-deferred accounts (and there is, plus more room for equities, too).

At your income level, you probably have about 20 years of expenses in your taxable account anyways, so having a tax-exempt bond fund there is not going to do you any good anyways nor change your risk level at all.

I think the only time to use tax-exempt bond funds in a taxable account is when one's tax-deferred accounts are already 100% fixed income, so no more room there AND one needs even more fixed income funds to meet one's asset allocation goals.

This scenario does not work for many retirees. If one has SS or pension income or rental income sure. But for retirees relying on their portfolio for the majority of their income....not so much.

You are limited a $3,000 capital loss in any year. By carrying over loss amounts beyond $3,000, you are in effect giving the govt. an interest free loan until the next year.

So in 2008-2009, if you had a huge unexpected expense of say $50,000....then selling at a huge loss may result in many future years of TLH. Not something I would want to do.

 

[DrRoy]

The dividends will be federal income tax free, but not state income tax free.

 

[COcheesehead]

Thanks for all your replies. By credit risk do you mean loss of principal? If so, then yes I am aware of that, but when I looked at the historical performance - the fund has done well. (i know that history is not a guarantee of future performance)

COcheesehead - I looked up VanEck Vectors High-Yield Municipal Index ETF(NYSE Arca : HYD but the Vanguard website shows "information is currently unavailable for this fund".

I was just trying to find a better yield for the cash buffer we are builing. I know there is additional risk, but was just looking and do appreciate the comments. I will look for muni bonds as suggested above as well. Thanks again.

Credit risk meaning unrated bonds are in the portfolio, true junk, so the risk of default is higher and could hurt the performance of the ETF.
Not sure why Vanguard wouldn't show HYD, it is a prominent ETF in the high yield space. Here is the Yahoo link to it. HYD : Summary for VanEck Vectors High Yield Munic - Yahoo Finance

 

[LOL!]

Thanks for all your replies. By credit risk do you mean loss of principal? If so, then yes I am aware of that, but when I looked at the historical performance - the fund has done well. (i know that history is not a guarantee of future performance).

A 14% loss in a few months for a bond fund is not what I would consider "has done well." It is pretty atrocious.

 

[whatnot]

LOL! Yikes I will go back and give it another look. But I think I am keeping my cash where it is for now. I need to really get up to speed on the tax efficiency issues.

 

[LOL!]

So in 2008-2009, if you had a huge unexpected expense of say $50,000....then selling at a huge loss may result in many future years of TLH. Not something I would want to do.

I'm don't understand. One would tax-loss harvest the huge loss in the year it happened. There would not be future years of TLH unless losses occurred in those years.

We tax-loss harvested losses in 2008-2009 in the mid-6-figure range. Those carryover losses are the reason we do not have to pay much in the way of taxes as retirees today. For instance, if I sell $100,000 of stocks with $50,000 of capital gains, then I offset that $50,000 of capital gains with losses harvesting in 2008 and my taxable income is zero. Actually, it is better than that because I do Roth conversion because my taxable income is so low even though I have plenty of money to spend on expenses.

But quite a few people misunderstand how tax-loss harvesting works. I am happy to go into detail on how it works for anybody that wants to know.

 

[COcheesehead]

A 14% loss in a few months for a bond fund is not what I would consider "has done well." It is pretty atrocious.

Which one are you referring to? There are several referenced in this thread.

 

[LOL!]

Which one are you referring to? There are several referenced in this thread.

VWALX. Anybody can go to morningstar.com and chart the history of funds. Here are a couple of charts. The first shows a 14% drop in total return of VWALX in just a couple of months back in 2008. The second shows the past 10 years. The other fund in the charts for comparison is just the total US bond index fund.

 

[COcheesehead]

In comparison to other asset classes at that time in the market, I would have loved only a 14% drop. LOL. I wonder what the yield was at that point. Had to be to the moon.

 

[LOL!]

In comparison to other asset classes at that time in the market, I would have loved only a 14% drop. LOL. I wonder what the yield was at that point. Had to be to the moon.

Treasuries and even total US bond market index funds were clearly much better than a junk bond fund.

If one is going to buy a bond fund in case the market crashes, it would seem to me they would want to buy a bond fund that doesn't crash when the market crashes.

Added: The charts include re-invested dividends, so yield is implicitly included.

 

[audreyh1]

I wouldn't consider any high yield fund for cash. They are too volatile.

I do use short term muni bond funds as part of my cash position. These only yield slightly more that high yield savings accounts, but it's tax-free.

I also use muni funds as part of my bond allocation. They are govt backed, and while not quite as safe as treasuries, they often behave well during market turmoil - better than corporate bond funds which are more credit sensitive. They work well as an asset class for diversification against other types of bond funds. There are occasional "muni scares". These have been good rebalancing opportunities.

 

[COcheesehead]

Treasuries and even total US bond market index funds were clearly much better than a junk bond fund.

That higher yield comes at a cost.

 

[ownyourfuture]

Only tax-exempt dividends from VWALX are tax-exempt. Any capital gains distributions would not be tax-exempt.

Does that also apply to municipal bonds ?
SMTFX Sit Minnesota Tax-Free for instance

Thanks!

 

[LOL!]

Does that also apply to municipal bonds ?
SMTFX Sit Minnesota Tax-Free for instance

Thanks!

Yes it does.

 

[MrLoco]

I'm don't understand. One would tax-loss harvest the huge loss in the year it happened. There would not be future years of TLH unless losses occurred in those years.

We tax-loss harvested losses in 2008-2009 in the mid-6-figure range. Those carryover losses are the reason we do not have to pay much in the way of taxes as retirees today. For instance, if I sell $100,000 of stocks with $50,000 of capital gains, then I offset that $50,000 of capital gains with losses harvesting in 2008 and my taxable income is zero. Actually, it is better than that because I do Roth conversion because my taxable income is so low even though I have plenty of money to spend on expenses.

But quite a few people misunderstand how tax-loss harvesting works. I am happy to go into detail on how it works for anybody that wants to know.

You are making assumptions here. You are assuming that in a year with a huge market drop and subsequent huge capital losses, one would be able
to tax loss harvest. What if there were not sufficient gains to offset a huge capital loss. Sure you were able to do it in 2008-2009 because the gains had probably been building for years. This is not always the case which is where a cash reserve comes in handy.

My point was if there is no corresponding gain to offset a huge loss....the loss needs to be carried over year after year and can only be offset by $3,000 in each subsequent year. That's the tax code as of today. Hope that makes it a little clearer.

 

[pb4uski]

I'm don't understand. One would tax-loss harvest the huge loss in the year it happened. There would not be future years of TLH unless losses occurred in those years.

We tax-loss harvested losses in 2008-2009 in the mid-6-figure range. Those carryover losses are the reason we do not have to pay much in the way of taxes as retirees today. For instance, if I sell $100,000 of stocks with $50,000 of capital gains, then I offset that $50,000 of capital gains with losses harvesting in 2008 and my taxable income is zero. Actually, it is better than that because I do Roth conversion because my taxable income is so low even though I have plenty of money to spend on expenses.

But quite a few people misunderstand how tax-loss harvesting works. I am happy to go into detail on how it works for anybody that wants to know.

To be fair though, many early retirees are in the 15% tax bracket or lower and would typically pay 0% on capital gains anyway... though it is nice that you can do more low tax cost Roth conversions because of your tax losses.