I had a very interesting conversation today that got me thinking about a tax issue I had never given serious thought to before, and which I think is probably totally unknown to most investors, but that affects virtually all of them: the exclusion of US federal interest payments from state income tax liability. Upon just a moment’s reflection, I realized that a vast swathe of US investors are making a simple and (relatively) easily avoidable error.
Asset allocation, asset location, and asset selection
In order to optimize your long-term rate of return, you typically have to take into account three factors:
- Asset allocation, or risk tolerance. This could be as simple as a 60% allocation to stocks and a 40% allocation to bonds, or as complicated as a carefully weighted average of every region and asset class in the world, rebalanced daily. There’s no one right asset allocation for everybody but, in general, the more you depend on your assets for ongoing income, the less volatility you should be willing to tolerate in their value, and the more you plan on leaving to your children or grandchildren the less you should care about their day-to-day value and the more you should focus on the long-term potential for appreciation.
- Asset location. Some assets are more tax-efficient than others: if you own mutual funds that are constantly spinning off capital gains, the taxes you pay each year represent a drag on your overall returns. Those funds are best held in accounts where capital gains are shielded from annual taxation. Likewise, shares in companies like Berkshire Hathaway that refuse to pay dividends and instead reinvest their profits internally are a better fit for taxable accounts, since owning them generates little or no tax liability.
- Asset selection. Once you’ve settled on your asset allocation, and set up your IRA, 401(k), and 529 plan contributions, you still have to implement the allocation by choosing the securities you want to invest in. The simplest example is municipal bonds. Based on your marginal state and federal tax rates, you may find that buying municipal bonds issued in your state of residence gives you a higher after-tax yield on your portfolio’s bond allocation than buying taxable bonds, even if the coupon payments on those bonds are in fact lower; after all, keeping 100% of $4.50 leaves you with more income than keeping 80% of $5. But that advantage is lost when you hold municipal bonds in a qualified account: if you get to keep 100% of your coupon payments regardless, just buy the higher-yielding security.
Most federal interest payments are exempt from state income taxes
Just as most municipal bond interest payments are exempt from federal income taxes, a reciprocal rule applies to federal interest payments: while federal income taxes are due on bond payments, state income taxes are typically not. Claiming this exemption involves looking up the share of your calendar year income attributable to federal securities and excluding it from your taxable income on your state return. You can find Vanguard’s 2019 guidance here, for example:
- One share of the Vanguard Inflation-Protected Securities Fund paid out 29.2 cents in dividends in 2019, and Vanguard avers that 99.19% of that payout was due to income from US government obligations. That share of the otherwise-taxable income is likely exempt from state taxes.
Target retirement date funds are a bad tax fit for retirement accounts
If you know anything about target retirement date or target risk funds, then the problem is likely coming into view, but I want to dig into it. Take, for example, Vanguard’s Lifestrategy Growth Fund. It holds:
- 48.3% Vanguard Total Stock Market Index Fund Investor Shares
- 31.4% Vanguard Total International Stock Index Fund Investor Shares
- 14.2% Vanguard Total Bond Market II Index Fund Investor Shares
- and 6.1% Vanguard Total International Bond Index Fund Investor Shares
A perfectly reasonable asset allocation for someone with a long-term investment horizon. The problem is that it also owns an embedded tax asset: 5.76% of the fund’s income in 2019 was attributable to income on federal securities, and could be excluded from state income taxes if it were held in a taxable account. That’s because, like most total bond market funds, the Vanguard version is weighted heavily towards US bonds, comprising as they do a majority of domestic bonds.
As bad as that is, the situation becomes even more dire in target retirement date accounts: 24.68% of the income from the Vanguard Target Retirement 2015 Fund is attributed to federal sources!
Just like municipal bonds pay lower coupons to reflect their lower tax liability to high-income taxpayers, the federal bonds embedded in target-risk funds are able to pay lower coupons due to the embedded tax asset of exemption from state and local income taxes.
Whatever your risk tolerance, don’t pay for tax benefits you’re not getting
The nice thing about target risk and target retirement date funds is they’re calibrated to your risk tolerance and/or age, and that’s not something you should sacrifice easily. Whether your risk tolerance indicates an 80/20 or a 40/60 stock/bond asset allocation, that’s what you should invest in; I’m not here to judge.
But when it comes to asset selection in your tax-exempt accounts, you shouldn’t be sacrificing interest payments for the sake of a tax exclusion that doesn’t apply to you.
On the contrary, you should be able to mechanically achieve higher and/or more stable returns by swapping your federal bond allocation for higher-yielding, taxable corporate bonds and cash or cash-like securities like CD’s within your tax-exempt accounts.
Thanks for an interesting post.
Let me look at the case of retirement portfolio and assume no taxes will be paid until the retirement date.
The correction for unused tax benefits should happen automatically if, given certain risk tolerance, one chooses the portfolio components individually rather than investing 100% into something like Vanguard Target Retirement 20xx. Because some assets can afford to pay lower rates of return thanks to implicit tax benefits, the return/risk ratio for them will be lower. If one performs “manual” portfolio selection using some variation of Modern Portfolio Theory:
https://en.wikipedia.org/wiki/Modern_portfolio_theory
the assets with unused tax benefits will be downweighted.
At the same time, if Vanguard Target Retirement 2015 was put together using MPT approach, it’s not clear why the proportion of tax exempt assets is so large. It may be the case that such assets deliver lower risk in addition to lower returns, or provide some diversification benefit.
Nik,
The simplest answer is that Vanguard target retirement and target risk funds are definitely NOT put together using an MPT approach. They’re a mechanical blend of four Vanguard funds, in different ratios depending on the retirement year and target risk. This is good, in the sense that they’re very large, very liquid, and very low cost, but they’re designed to be held in both taxable and qualified retirement accounts, and they pay no attention whatsoever to the tax implications of their holdings (except the tax advantages built into Vanguard mutual funds due to their patented ETF technology).
Your last point is worth thinking about carefully. US Treasury securities have two separate features: they’re extremely safe AND they’re exempt from state income taxation. Both of these features push in the same direction: extremely safe assets pay lower interest than riskier assets, and tax-advantaged assets pay lower interest than riskier assets. However, in a tax-advantaged account, you’re only “using” one of those features (the extreme safety) but “paying” for both. What you’d like to find, in that case, is an equally safe asset that paid a higher “taxable” rate of interest (since you’re not paying taxes on it anyway in your qualified retirement accounts).
So, for example, corporate securities are riskier than US treasuries because of the chance of default, so they pay a higher interest rate, but shorter-term securities are less risky than longer-term securities (because a lower maturity makes their price less subject to changes in interest rates). However, the corporate securities ALSO don’t have the embedded tax asset you’re not using. That means you should theoretically be able to find a shorter-term (safer), higher-paying investment-grade corporate security to replace medium-term (riskier) US treasuries in a qualified account. And indeed, this is precisely what you find: VFITX, Vanguard’s intermediate-term treasury fund, has an SEC yield of 1.31% (exempt from state taxes), while VSCSX, their short-term corporate bond fund, has an SEC yield of 1.87%. In this case, the safety and tax advantages of the treasury fund are reducing the fund’s yield, while the riskiness and tax treatment of the corporate fund are raising its yield.
The point is that in a qualified retirement account you should theoretically be able to replace some portion of a VFITX holding with VSCSX and increase your return without increasing your risk, just like you would by turning down an insurance rider you know you’ll never need.
In a future post I may try to work out the exact calculations, but the point of this post was simply to point out this interesting theoretical possibility.
—Indy