muni vs taxable bonds

[Travelwanted]

Because of my income I have been 100% munis on the bond side of my portfolio. However, next year I will have no ordinary income for the first time.

I have been trying to calculate the best after-tax scenario. In other words, should I sell my munis and buy taxable bonds? So I plugged in the numbers into turbo tax (2017 edition).

Surprisingly, keeping the muni bonds even with no ordinary income was the best after tax result. I am questioning this result somewhat so I bring it for a second opinion.

Scenario 1 - 3,469,000 in a combo of tax-exempt high yield, intermediate(82%) and limited term
current weighted yield is 2.594%

Scenario 2 - above # in a combo of total bond fund and intermed term inv bond
current weighted yield is 3.24%

I reported the muni bond income in box 10 under dividends in scenario 1. In scenario 2 in entered the bond interest in the interest earned section. My inputs were the otherwise the same for ordinary div/qualified dividend as well as for the interest and capital gains.

This calculation also included my state income tax which is not exempt for the munis I own.

I was expecting the opposite so please feel free to point out any errors I may have made. TIA!

 

[RunningBum]

Bond interest is taxed as ordinary income, right? You'd generate over $100K of income if it is not in a muni. You're also pushing any other dividends you have into being taxable, which may add to the tax bill. Hard to say without seeing all of the numbers and knowing if you file joint or single, but I'm not too surprised to see munis better at this amount.

My guess is that moving part of it out of munis, perhaps just to the point where your dividends and LTCGs would be taxed, would be a better plan. Or to some income tax bracket threshold, like 22% and below. Remember that you have to keep all of your taxable income, including the divs and gains (less deductions and exemptions) below the threshold to keep those divs and LTCGs from being taxed. Keep running scenarios in Turbo Tax and you'll see what I mean. Pay attention to the Qualified Dividends and Capital Gain Tax worksheet.

 

[ESRwannabe]

Just something to keep in mind about Munis. IMHO they are safer because if we ever did have an inflation spike you wouldn't end up being penalized paying taxes on a high yield, which was high just to offset inflation.

For all fixed income, part of the return is just there to offset the inflation rate. Why pay taxes on that, especially if inflation spikes then you'd be paying more in taxes on the yield that does nothing for you.

Hope that makes sense...

P.S. Don't overlook preferred stocks as part of the fixed income. You can buy a tax managed fund of preferred stocks so that the dividends are all qualified. One example of that would be the CEF John Hancock Tax-Advantaged Dividend with ticker HTD. Its got 50% in common stock and 50% in preferred stock, all qualified dividends. Note this fund uses leverage.

Also, besides preferred and munis don't overlook treasuries tax advantages. Treasury bonds are state tax exempt.

Another option to keep in mind are muni CEFs where you can get a much higher yield because they use leverage. I would recommend starting with the ETF with ticker XMPT, which is an ETF of 70+ muni CEFs.

Lastly I would recommend Vanguard's Tax Managed Balanced fund ticker VTMFX which is 50% total US stock market and 50% muni bonds.

Disclosure: I am long HTD, XMPT, and VTMFX.

 

[Travelwanted]

Bond interest is taxed as ordinary income, right? You'd generate over $100K of income if it is not in a muni. You're also pushing any other dividends you have into being taxable, which may add to the tax bill. Hard to say without seeing all of the numbers and knowing if you file joint or single, but I'm not too surprised to see munis better at this amount.

My guess is that moving part of it out of munis, perhaps just to the point where your dividends and LTCGs would be taxed, would be a better plan. Or to some income tax bracket threshold, like 22% and below. Remember that you have to keep all of your taxable income, including the divs and gains (less deductions and exemptions) below the threshold to keep those divs and LTCGs from being taxed. Keep running scenarios in Turbo Tax and you'll see what I mean. Pay attention to the Qualified Dividends and Capital Gain Tax worksheet.

Thanks RunningBum. Yep, I should have known this. It's in my notes: ordinary income (interest) < 77,200...qualified div/LTCG at 0%. So to your point, I could potentially maximize my after-tax income by earning UP TO 77k in taxable bond interest, leaving the remainder in munis.

>95% of our dividends are qualified already, ESR. Thanks for the suggestions. TBH I haven't even considered treasuries.

A key last point for everyone is that muni bond income does count towards your AGI, which in turn affects SS and medicare. At my age this is not an issue for me but eventually will be.

 

[ESRwannabe]

Just throwing out two more options, but you may not be interested as they are equities.

For tax advantaged income you can also look for investments that pay out Return of Capital (ROC). ROC is tax free but it reduces your cost basis in the asset. Once the cost basis reaches zero it is then taxed as long term capital gains.

Two options for this would be Master Limited Partnerships (MLPs) and Option Income CEFs. Note that MLPs have been beaten up badly from the oil declines the last few years and are on the recovery. Also on MLPs you will have K-1s to enter at tax time, which is not a big deal.

For MLPs I would suggest using the Alerian ETF (AMLP) as a stock screener and then buy the individual MLPs that look good to you. If you bought the ETF itself it is setup as a C-corp, so you would pay qualified dividends on it and avoid the K-1s.

For option income I would look at the CEFs from Nuveen, BlackRock, and Eaton Vance for options. For example from Nuveen QQQX and SPXX. Note, only buy when they are selling at a discount. You can use cefconnect.com, cefdata.com, and cefa.com to research CEFs.

 

[Travelwanted]

Well...again not what I expected.

So to keep below the 77,000 income threshold took 1/2 of the money from the munis and put it into the 2 taxable bond funds above. That created about 45,000 in tax-exempt and 56,200 in taxable.

I plugged those into turbo tax using the exact same info on everything else. The after tax amount was still slightly higher for the 100% munis vs the 50% munis/50% taxable bonds.

 

[ESRwannabe]

Throwing this out there as another thing to consider with Treasuries.

During down turns treasury bonds will perform better than other types of bonds. If you were looking for the best type of bond to counterbalance equities then I would suggest long duration treasuries like ETF VGLT.

Also throwing out there that you may want to consider inflation protected securities like the fund VAIPX. You are guaranteed to always have a real yield that way.

 

[ESRwannabe]

Another idea. Don't discount CDs and savings accounts. These are usually state tax free.

Also for treasuries you can buy them directly at treasurydirect.

https://www.treasurydirect.gov/

 

[ESRwannabe]

One more idea and then I think I am done...

Theoretically you can tilt your equities towards minimum volatility and it will have a similar affect as some combination of a balanced fund of equities and bonds, while minimizing taxes to only qualified dividends. Also low volatility factor has outperformed historically.

VMNVX is Vanguard's global minimum volatility fund.

https://en.wikipedia.org/wiki/Low-volatility_anomaly

https://seekingalpha.com/article/4007947-understanding-low-volatility-factor

 

[kaneohe]

Thanks RunningBum. Yep, I should have known this. It's in my notes: ordinary income (interest) < 77,200...qualified div/LTCG at 0%. .........................................

It may be helpful to others to post relevant info such as : age/filing status.
Perhaps it is there and I missed it. Your comment above regarding the 0%
QDIV/LTCG suggests MFJ (the number for single is lower) but that may not be correct. Also 2018 taxes can be significantly different than 2017 so I would use something like the HR Block tax calculator that gives 2018 taxes (in addition to 2017) rather than TT 2017.