For many investors, the decision of where to hold various asset classes is as critical as the asset allocation itself. This is particularly true for bonds within a taxable brokerage account, where the interplay between tax efficiency and the crucial protection against sequence of returns risk creates a complex balancing act. Over the past decade, market dynamics, interest rate shifts, and evolving tax considerations have underscored the importance of this strategic placement.
Traditionally, bonds serve as the ballast in a diversified portfolio, offering stability, income, and a hedge against equity market volatility. They are often seen as a capital preservation tool, providing a smoother ride during turbulent times. However, when these assets reside in a taxable account, their income generation can become a significant tax drag, potentially eroding real returns.
The main tax aspect for bonds held in an account concerns how interest income is handled. Interest earned from bonds and U.S. Treasury bonds (which are exempt from federal taxes but not from state or local taxes) is usually taxed as ordinary income according to your marginal tax bracket. This rate can be significantly higher than the long-term capital gains tax rates rendering yield taxable bonds less appealing after taxes for individuals, in elevated income categories. For instance, a 4% corporate bond yield might shrink to a 2.5% after-tax yield for someone in a 37% federal tax bracket, plus state taxes.
This is where municipal bonds often enter the discussion. Interest income from municipal bonds is typically exempt from federal income tax, and often from state and local taxes if you reside in the issuing state. While their nominal yields are usually lower than comparable corporate or Treasury bonds, their tax-exempt status can make their tax-equivalent yield significantly more appealing, especially for high-income earners. The calculation of tax-equivalent yield is essential for a fair comparison, revealing the true after-tax return.
Besides tax efficiency the flip side concerns protection against sequence of returns risk. This danger is especially critical for those approaching or already in retirement who are regularly withdrawing income from their investments. Experiencing a sequence of returns—namely substantial market declines at the start of retirement—can greatly diminish a portfolio hindering its ability to rebound and support ongoing withdrawals for an extended duration. Bonds, as a steady asset class serve as a cushion. During equity market corrections, an investor can draw from their bond allocation rather than being forced to sell depreciated stocks, thus preserving the equity portion for recovery.
Lets examine a 10-year outlook. Between 2014 and 2024 we observed intervals of low interest rates followed by a swift increase beginning in 2022. During the years of this decade when bond yields were modest the tax burden on taxable bonds had a reduced effect primarily because the nominal income remained very low. Nonetheless the safeguard, against sequence of returns risk remained important as bonds offered stability despite the yield. For instance, during the brief but sharp COVID-19 market correction in early 2020, bonds largely held their value, allowing investors to avoid selling equities at a loss.
With the increase in interest rates starting in 2022 bond yields turned considerably more appealing. A 5% return, on a Treasury bond despite being liable to income taxation provides a notably stronger income flow compared to a 1% return. Nonetheless this elevated nominal yield also results in an absolute sum exposed to ordinary income taxes. For a high-income investor, the tax drag on a 5% corporate bond could still make a lower-yielding municipal bond a superior choice on an after-tax basis. Conversely, for someone in a lower tax bracket, the higher nominal yield of a taxable bond might outweigh the tax benefits of a municipal bond.
The trade-off becomes stark: do you prioritize the higher potential after-tax return of a tax-exempt municipal bond, accepting its typically lower nominal yield, or do you opt for the higher nominal yield of a taxable bond, understanding the tax implications, but perhaps valuing its specific role in mitigating sequence of returns risk or providing liquidity for rebalancing? The answer often lies in a strategy known as asset location.
Asset location refers to the allocation of various asset categories across different types of accounts (taxable tax-deferred tax-exempt) to optimize after-tax earnings. Typically assets that incur high tax liabilities like yield corporate bonds or actively managed bond funds with frequent trading are optimally placed in tax-favored accounts such as 401(k)s or IRAs which protect their income and capital gains, from yearly taxes. Conversely, tax-efficient assets, like municipal bonds or low-turnover equity index funds, are often suitable for taxable accounts.
Nonetheless the necessity for sequence of returns protection may occasionally take precedence over tax efficiency. If an investor needs a bond portion in their taxable account to ensure consistent cash flow for withdrawals or to adjust their portfolio during market declines without realizing capital gains, on stocks maintaining some taxable bonds could be an essential trade-off. For example, a retiree might hold a ladder of individual Treasury bonds in a taxable account to meet specific spending needs, even if the interest is federally taxed, because the predictability and safety of principal are paramount.
The last ten years have demonstrated that market environments are constantly changing. What was ideal during a period of interest rates might no longer be suitable when rates rise. Choosing to keep bonds in an account as well as selecting the bond type demands a thorough evaluation of a person’s present and anticipated tax bracket how close they are, to retirement the total size of their portfolio and their particular level of risk acceptance. It's an ongoing evaluation of balancing the desire to minimize tax liabilities with the critical need to protect against adverse market timing during withdrawal phases.
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