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How Do Interest Rates and Dividend Yields Affect Asset Location?

For many years, the conventional wisdom with asset location has been that, if you have to hold some investments in taxable accounts (as opposed to being able to keep everything in retirement accounts), it’s better to hold stocks rather than bonds in the taxable account, given the favorable tax treatment of qualified dividends and long-term capital gains.

This conventional wisdom overlooks the fact that tax efficiency depends not only on the tax rate you would have to pay on the income generated, but also on the amount of income generated.

As an extreme example: If you own 1-month Treasury bills, yes, they generate interest that is fully taxable at the federal level, but the amount of that interest is so small that the total return lost to taxes will actually be quite low.

Calculating Expected Tax Costs

When deciding which fund(s) you will hold in your taxable account, it can be helpful to calculate the approximate tax cost for each of your various holdings.

For example, if you live in Missouri and you’re in the 25% federal tax bracket and 6% state tax bracket:

  • Ordinary interest income would be taxable at a 25% federal tax rate and 6% state tax rate,
  • Treasury bond interest would be taxable at a 25% federal tax rate but untaxed at the state level, and
  • Qualified dividends and long-term capital gains would be taxed at a 15% federal tax rate and 6% state tax rate.

So, we can use that information to get a rough estimate of the tax cost you would likely incur as a result of holding various funds in a taxable account.

In other words, the stock fund will probably result in a higher tax cost than either of the Treasury funds, and that’s not even including the eventual capital gains tax that you will (probably) owe on price appreciation for the stock fund.

Figuring out a ballpark estimate of the tax cost for something like Vanguard Total Bond Market Index Fund is a bit trickier, because approximately 40% of the fund is invested in Treasury bonds (which aren’t taxed at the state level), while the rest of the fund is invested in bonds that are taxed at the state level. The fund currently has an SEC yield of 1.74%. We can multiply 40% of that yield by a tax rate of 25% and the remaining 60% of that yield by a tax rate of 31% to determine that the fund would have a tax cost of very roughly 0.50%. But this understates the cost somewhat because the Treasury bonds account for less than 40% of the yield despite being 40% of the portfolio.

In short, the idea that stocks are more tax-efficient than bonds is only sometimes true. It depends which bonds and which stocks we’re talking about. And it depends on whether interest rates (and dividend yields) are currently high or low. With interest rates as low as they are right now, bonds are more tax-efficient than they would otherwise be. And as you can see above, some taxpayers will find that certain taxable bond funds are currently more tax-efficient than stock funds.

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