FREE NEWSLETTER
IF YOU’RE IN A HIGH income tax bracket, buying tax-free municipal bonds in your taxable account might seem like a no-brainer. But there’s a strategy that could give you a better return: Use your taxable account to pursue a tax-efficient stock strategy, such as investing in stock index funds, while buying corporate bonds within your retirement account.
The corporate bonds should have a higher yield than tax-free munis and, because you’re buying them in a retirement account, you don’t have to worry about paying tax each year on the interest generated. Meanwhile, in your taxable account, you might favor stock investments that will be taxed at the preferential long-term capital gains rate, including any qualified dividends you receive. An added bonus: If you hold those stock investments until your death, the embedded capital gains tax bill disappears and your heirs receive the investments free of all income taxes.
This strategy doesn’t sit well with some people, who prefer to have bonds in their taxable account, where they can be easily sold if these folks suddenly need cash. But you can effectively do the same thing, even if you have stocks in your taxable account and bonds in your retirement account. How? Suppose you suddenly need $20,000.
To generate the cash, you could sell $20,000 of the stocks you have in your taxable account. If we’re in the midst of a bear market, the timing wouldn’t be ideal. But in this case, it wouldn’t matter because you would simultaneously move $20,000 from bonds to stocks within your retirement account. Result: Your stock exposure remains the same, you have sold $20,000 in bonds—and you have the cash you need.
Next: Asset Location
Previous: Munis vs. Taxables
I’ve struggled with the liquidity vs. tax efficiency trade-off for some time. I like the solution you proposed in the last paragraph, but believe you would need to be mindful of “wash sale” restrictions when replacing the stock position in the retirement account. Is that a valid concern?
It is a valid concern. But keep in mind that 1) the wash sale rule only comes into play if you sell your taxable-account stocks or stock funds at a loss and 2) you could avoid violating the wash-sale run by purchasing somewhat different investments (e.g. an S&P 500 fund instead of a total market fund).
Thinking this thru a bit further…..
If I have $100k of stock with a $50k basis, the $20k withdrawal will result in being taxed on $10k of LTCG. At 20% means $2k in taxes.
If I have $100k in bonds paying 5% which is being used to live on, I’m paying taxes of the 5K at what ever my tax rate is. This plus the $15k principle I withdraw equals the $20k.
It looks like bonds in taxable would win in my simplistic scenario. What am I missing?
If you have $100,000 in bonds paying 5% and you’re in the 24% tax bracket, you’re paying $1,200 in income taxes every year. If you have a onetime $10,000 capital gain and pay tax at the 15% (not 20%) long-term capital gains rate, you’ll have a onetime tax bill of $1,500.
I have been grappling with this liquidity issue you reference here by keeping substantial amounts of muni funds (VTEB) in my taxable accounts. I feel like such a moron for not thinking about the simple strategy you mentioned in the last paragraph. Thanks for keeping me humble…