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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.

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