Tax efficient bond investing

From Reddit we read:  Q. After an earlier post on putting some of your emergency stash into an investment account, it got me thinking. If you are gonna go this route, typically this money should be vested in something safe like a bond fund. But most investing advice says to put as much of your bond investments into tax advantaged accounts first for tax efficiency. Are there bond funds that would work well for this type of investing?  Most of my investing has been in tax advantaged accounts with Vanguard or my company 401k up to this point. So just starting to delve into the fun of taxes and investing.

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[–]pier70 3 points 10 hours ago

You could get tax-exempt bonds from counties/municipalities/etc. in your state. Just make sure they are safe and liquid enough to use as an emergency fund.

Also, realize that any income you make from the investments, taxed or not, is better than no income.

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[–]radix07[S] 2 points 9 hours ago

Forgot about municipal funds, thanks! Although living in IL, that may not be the safest bet.

Taxes are probably not the biggest concern if your priority is an emergency fund regardless...

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[–]sfade 1 point 7 hours ago

Never thought of this before - are there any tax-exempt bonds for federal taxes? (I don't have state income tax here in TX)

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[–]United Statesvisirale 2 points 6 hours ago

Yes, generally all muni bonds are tax-exempt for federal purposes (line 8b on the 1040). Where you get into complications is state and local taxation of muni bonds not within their jurisdiction. But you have no state income tax, so that's not a problem.

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[–]lauraredcloud 2 points 10 hours ago

Are you trying to find someplace to put your emergency fund, or are you trying to save for retirement?

A 401(k) or traditional IRA are not appropriate places to put your emergency fund because they incur heavy penalties if you try to withdraw the money before retirement age. Not something you want for an emergency fund, which you may need to withdraw at any time.

A Roth IRA is better because you can withdraw the principal (not the interest/investment gains) at any time without penalty, and if you set aside an amount that you invest only in bond funds to be your emergency fund, that sounds like a solid choice for an emergency fund.

Be aware, though, that with a Roth, the tax advantage is delayed--it doesn't help you now, it helps Future Retired You--so it's not a huge advantage to have your e-fund in a Roth if you do expect to use it before you retire (which is the whole point of an e-fund).

Also, because IRAs have a relatively yearly contribution limit, you may find yourself in a position where the amount you want to save for retirement + the amount you want to build/pay back your emergency fund is greater than the contribution limit. In that case, you probably want to have your IRA's mix of stocks and bonds balanced toward retirement as it was intended.

You can still keep your e-fund (partially) in bonds. (You should still have some in need-it-now cash.) Someone else may be a better expert on this than I am, but buying your bonds directly from the US Treasury at TreasuryDirect.gov may save you from the management fees, low as they may be, on a bond fund. AFAIK, you don't get a big advantage from management when it comes to bonds.

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[–]radix07[S] 1 point 9 hours ago

I am not looking to withdraw from any of my retirement funds for this, as I am currently maxing my roth, and heavily contributing to my 401k. I'd prefer not to lose any roth allocations due to an emergency. My EF has gotten to a size (~1 year) that it doesn't all need to be easily accessible. I guess at this point I am pretty much considering this as after tax investing. I don't have anymore big things to save for as I have a house and no other debt. So I guess this would be used toward early retirement/whatever may come up.

I am likely just going to invest in a broad stock fund and keep my bonds in my tax advantaged accounts, as I don't need a 1 year buffer. I was more just curious on taxes and bond options if I were to go that route. It seems municiple bonds or I-bonds are probably the best the way to go for that

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[–]lauraredcloud 1 point 9 hours ago

Ahh, I was assuming you were still working on building your efund. In your position, where you've got more efund than you need, I would just keep pumping more into the 401(k) until I hit the max before I started investing in taxable accounts. If you need to eat into your efund, you can always reduce your 401(k) contributions until you build it back up.

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[–]radix07[S] 1 point 9 hours ago

That actually leads into another questions I was considering posting... I only contribute to my 401k till I hit the 15% tax bracket, at that point, I don't see a reason to continue to do so. If I am taxed at a long term capital gains rate (15%), it would either cost the same or less tax-wise than my 401k if I am contributing at a 15% tax rate. I also have access to much cheaper funds than my employer offers. If I understand how I get taxed in a normal account properly, than I don't see a reason to max my 401k since I have the ability to drop my tax bracket. Obviously tax rates can change, but they are more likely to go higher than lower.

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[–]United Statesethidda 1 point 10 hours ago

Also, keep in mind that interest is taxed as earned income anyway.

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[–]radix07[S] 1 point 10 hours ago

Isn't it taxed as long term capital gains as long as it's been vested more than a year?

http://www.irs.gov/Individuals/What-is-Earned-Income%3F

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[–]United Statesethidda 2 points 9 hours ago

I meant interest if you'd kept the money in cash at a bank.http://taxes.about.com/od/income/qt/interest_income.htm

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[–]United Statesvisirale 1 point 6 hours ago

No, interest is taxed at your ordinary rate.

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[–]kurds_way 1 point 9 hours ago

typically this money should be vested in something safe like a bond fund

Bond funds can be quite risky, so you're better off keeping it in a savings account or CDs. As pier70 notes, munis are an option, however most muni funds have longer durations, as well as some default risk, and are not diversified if a single state fund.

A better alternative, if you can hold them for a year, might be I Bonds, which at least grow tax deferred and are state tax free. Generally, rates are so low now it doesn't matter too much what you do.

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