Get new articles by email:

Oblivious Investor offers a free newsletter providing tips on low-maintenance investing, tax planning, and retirement planning.

Join over 20,000 email subscribers:

Articles are published every Monday. You can unsubscribe at any time.

Which Bonds are Most Tax-Efficient?

A reader writes in, asking:

“I know that some stocks relative to other stocks are more efficient regarding taxes [eg foreign stocks being better because of the foreign tax credit] but what about bonds? If investing in a taxable account, are some bonds better than other bonds?”

Yes, there absolutely are differences in the relative tax-efficiency of different types of bonds.

Most obviously, municipal bonds are exempt from federal income tax, making them very tax-efficient.

After munis, Treasury bonds are the most tax-efficient for most investors because they’re exempt from state and local income taxes. This is true not only for plain-vanilla Treasury bonds (such as those held in a Treasury bond fund), but also for TIPS and savings bonds.

Because they generate less interest income, bonds with lower yields are generally more tax-efficient than bonds with higher yields. This makes shorter-term bonds more tax-efficient than longer-term bonds, and higher-credit-quality bonds more tax-efficient than lower-rated bonds.

The most obvious application here is for making asset location decisions — that is, for choosing which investments to tax-shelter when you have a limited amount of space in your tax-advantaged retirement accounts.

Example: Ben’s portfolio includes holdings of Vanguard High-Yield Fund, Vanguard Total Bond Market Index Fund, and Vanguard Intermediate-Term Treasury Fund, but he only has room for one of those funds in his retirement accounts. Ben stands to gain the most from tax-sheltering the high-yield fund and the least from tax-sheltering the Treasury fund.

But knowing about the relative tax-efficiency of different types of bonds can even be helpful when choosing an asset allocation.

Example: Due to having sold her business for a large sum, Jessica’s portfolio is almost entirely in taxable accounts. She knows that muni bonds make sense for her, given her tax bracket, but she’s not comfortable devoting her entire bond allocation to muni bonds, given the budget troubles that most state and local governments are facing. For the remainder of Jessica’s bond allocation, rather than using a typical “total bond market” type of fund, she could benefit by using short-term Treasuries and then simply using a slightly higher stock allocation.

By doing this, she keeps the overall level of risk and expected return the same (because she has shifted to safer bonds, but slightly decreased the total allocation to bonds), but more of her expected return comes in the form of qualified dividends and long-term capital gains than it would if she were using a “total bond” fund and a slightly larger bond allocation.

New to Investing? See My Related Book:


Investing Made Simple: Investing in Index Funds Explained in 100 Pages or Less

Topics Covered in the Book:
  • Asset Allocation: Why it's so important, and how to determine your own,
  • How to to pick winning mutual funds,
  • Roth IRA vs. traditional IRA vs. 401(k),
  • Click here to see the full list.

A Testimonial:

"A wonderful book that tells its readers, with simple logical explanations, our Boglehead Philosophy for successful investing." - Taylor Larimore, author of The Bogleheads' Guide to Investing
Disclaimer: By using this site, you explicitly agree to its Terms of Use and agree not to hold Simple Subjects, LLC or any of its members liable in any way for damages arising from decisions you make based on the information made available on this site. The information on this site is for informational and entertainment purposes only and does not constitute financial advice.

Copyright 2024 Simple Subjects, LLC - All rights reserved. To be clear: This means that, aside from small quotations, the material on this site may not be republished elsewhere without my express permission. Terms of Use and Privacy Policy

My Social Security calculator: Open Social Security