Part of must-read guide: How to build an all-weather portfolio, step-by-step.
Step 9: Taxes matter. Learn how and when to use tax-advantaged accounts.
- Use tax-advantaged retirement accounts to your advantage.
- Start early to build a tax-advantaged account so that you’ll have room to hold bonds there when you’ll need it.
Taxes are complicated, and every good citizen must pay their fair share. We can say a few more things about taxes with certainty:
Tax-advantaged accounts are valuable. There are two flavors of these. The tax-deferred variety includes the IRA, 401(k), 403b, SEP IRA, and Simple IRA. You don’t have to pay tax on money you earn this year that you invest in one of these accounts, because you will pay tax when you use it in retirement. But, that’s huge. Paying your taxes way off in the future is a tremendous advantage. Inflation lets you pay those taxes with cheaper dollars, and for many, their future tax rate will be at a lower level in retirement.
Tax-free is the other variety. These are Roth IRAs and Roth 401k’s. You pay tax today, but not on the earnings. These also are ideal for young adults because you can withdraw the principal contributed without a penalty if you need to, making it an emergency Emergency-Fund.
We can also say, with certainty, that if your investments are all in tax-advantaged accounts, fund placement will not make much difference to your returns. (But, put highest expected growth in your Roth accounts because they are forever tax-free.)
Finally, investors need to know that different sources of investment income are taxed at different rates in a taxable account. Regular bond interest currently gets taxed at your ordinary tax bracket rate, whereas both qualified stock distributions and capital gains from long-term stock holdings are currently taxed at a much lower rate.
Another thing we can say with certainty. Not only are taxes complicated, they vary from year to year, from state to state, and every individual situation is different. So the last solid thing I can say is that to optimize your tax situation you must do a little scenario analysis which will involve assumptions about future market returns, future tax policy and your future personal situation.
If you choose to have a taxable account, then normally the conventional wisdom has been to put your stock investments there and to put your bonds in tax-advantaged account. This assumes that you will hold your stocks. Tax on capital gains is not only deferred until you sell the stocks, but the tax is at a lower rate.
This advice has become a lot weaker for the past few years because bond yields have been at record lows. To illustrate, let’s take an investor in the 25% tax bracket and examine the annual tax on stocks in a taxable account:
(Qualified stock dividends) x 15% tax rate = tax cost for stocks
A total market stock index typically yields about 2% of its value as qualified stock dividends for a tax cost of 2% x 15% = 0.30% plus deferred capital gains taxes.
The annual tax for bonds in a taxable account would be:
(Bond dividends) x 25% tax rate = tax cost for bonds
When bond yields are very low (say, 1%), then the tax cost would be 1% x 25% = 0.25%, or slightly more efficient than stocks. But when bond yields are higher (say, 3%), then the tax cost would be
3% x 25% = 0.75%, which is less efficient than stocks.
One more point is worth making. It is generally true that investors need to become more conservative as they age. Growing some stock funds in a tax-advantaged account creates the space for the desired bond holding later in your career. Not only can the stocks be gradually converted to bonds without any tax consequence in that account, but annual re-balancing to maintain desired risk level can be done without creating any additional current taxes.
It’s complicated and constantly changing. Everyone needs to engage in lifelong learning.
High-income individuals need to additionally learn about municipal bonds and where to hold them, state taxes and which bonds are exempt from these, and the advantages of tax loss harvesting in taxable accounts.
That’s it! Perhaps all you need to know about bonds, although lifelong learning is a part of responsible investing. I’ll try to put all the key points from this book on the next page and a half. See if you are comfortable with each of these, and if you are you will do well. Investing doesn’t require high IQ; it requires discipline.
Summary: Key Points in This Guide
- Bonds are like IOUs. Buying a bond means you are lending out your money.
- Bonds are also called fixed-income securities because the cash flow from them is fixed.
- Stocks are equity; bonds are debt.
- The key reason to purchase bonds is because stocks are risky. Bonds both stabilize and diversify your portfolio.
- The issuers of bonds are governments and corporations.
- Certificates of Deposit (CDs) are similar to traditional bonds and are issued by banks or credit unions.
- A bond is characterized by its face value, coupon rate, maturity and issuer.
- Bonds do not appreciate in price like stocks do, but their prices do fluctuate over time.
- Yield is the rate of return you get on a bond.
- When price goes up, yield goes down, and vice versa.
- When interest rates rise, the price of bonds in the market falls, and vice versa. Nobody can predict future interest rates. Don’t try.
- Bills, notes and bonds are all fixed-income securities classified by maturity.
- Government bonds are the safest bonds. Don’t invest in bonds with less than investment-grade credit quality.
- Government-insured CDs are sometimes even better than bonds.
- All other bonds are not risk free. It’s always possible—especially in the case of corporate bonds—for the borrower to default on the debt payments.
- High-risk/high-yield bonds are known as junk bonds
- You can purchase most bonds through a brokerage or bank. If you are a U.S. citizen, you can buy government bonds through TreasuryDirect.gov.
- Often, brokers will not charge a commission to buy bonds but will mark-up the price instead. However, many brokers will sell U.S. Treasuries without any fees.
- Bond mutual funds provide liquidity, are convenient, and many are both excellent and low cost.
- The duration of a bond, or a bond fund, is a measure of its price sensitivity to interest rate changes.
- Individual bonds have declining duration. This is useful.
- Bond funds have constant duration. This is also useful.
- Treasury Inflation Protected Securities (TIPS) are bonds issued at a lower yield but the principal is indexed to inflation.
- TIPS are better than traditional bonds if future inflation is greater than current expectations.
- Low cost is key.
- Your allocation to bonds is your most important investing decision.
- Choose a balance of stocks and bonds according to your unique circumstances—your investment objectives, your time horizon, your level of comfort with risk, and your financial resources.
- Many people choose a simple way to manage this balance, like “own your age in bonds,” or “own your age minus 10% in bonds.” What you choose is much less important than sticking to your plan!
- Inflation and our investing behavior (if not disciplined) are the two worst enemies for investors.
- Start early. Keep it simple. Stick with your plan. And live life fully.
Time to check in …
How’s that “classic investor stew” coming along?
Do you better understand about how bonds work, how much to own, and what kind to buy?
That’s our sole purpose for making these books and the free videos on our website—to help you and your investments weather all the financial storms that will inevitable pass through during your investing lifetime. We wish everyone to achieve common life goals such as owning a home, providing for yourself or your family, taking fun vacations, and retiring in comfort—all free from financial stress.
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Next is STEP 10. Review your plan by comparing with example portfolios. See some example all-weather portfolios.