It turns-out that the tax efficiency of treasuries is not terrible when comparing purchase of the treasury in a taxable versus tax-deferred account. This is due in part to the state tax exemption of US treasuries. For example, consider the relative after-tax returns based upon the following assumptions:
Federal marginal rate = 33%
State tax rate = 6%
Holding period = 20 years
Tax rates the same every year (for 20 years)
Consider a 20 year treasury paying 3.5%, and reinvestment of dividends at this same rate. Following are the after-tax returns for taxable versus tax-deferred:
Taxable - 100*[(1+0.67*0.035)^20 - 1] = 58.98%
Tax-Deferred - 100*[(1+0.035)^20 - 1]*0.61 = 60.38%
So you earn a mere 1.4% (cumulative) more over the 20 years (an average of 0.07%/year) in the tax-deferred account. This is a difference I can comfortably ignore. Comments welcome.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein
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Re: Tax Efficiency of Treasuries
Are you really going to have the same marginal tax rate 20 years in the future?
Re: Tax Efficiency of Treasuries
jdilla1107 wrote:Are you really going to have the same marginal tax rate 20 years in the future?
Excellent question. I don't know for sure - but it is very possible since I will be over 70 1/2, and subject to RMD. Since I project a good size retirement account, it is very possible to have the same rate. It is even possible it will be higher.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein
Re: Tax Efficiency of Treasuries
The SEC yields of VWLTX (Vanguard Long-Term Tax-Exempt Fund Investor Shares) and VUSTX (Vanguard Long-Term Tax-Exempt Fund Investor Shares) are 2.60% and 3.06%, for a yield ratio of 85%. (This ratio should be adjusted downward slightly to account for the credit risk of investment-grade muni bonds, but by how much?) I think an investor in a federal income tax bracket of 35% or higher may be better off putting stocks in the tax-deferred account and municipal bonds in the taxable account. In fact, with the ratio of muni yields to taxable yields so high, I wonder if Treasury bonds make sense only for very conservative investors who don't want to own stocks. They can own munis in taxable accounts and Treasuries in tax-deferred ones.
Re: Tax Efficiency of Treasuries
If your state taxes are deductible on your federal return, you keep
(1 - .06)(1 - .33) = .6298, not .61, in the tax deferred account.
Long version. Pay .06 to state. Deduct. Pay federal tax on .94. Federal tax is .33 (.94) = .3102. Total tax is .06 + .3102 = .3702. You keep 1 - .3702 = .6298. The short version is easier to remember and apply, but confuses some people.
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Re: Tax Efficiency of Treasuries
Beliavsky wrote:The SEC yields of VWLTX (Vanguard Long-Term Tax-Exempt Fund Investor Shares) and VUSTX (Vanguard Long-Term Tax-Exempt Fund Investor Shares) are 2.60% and 3.06%, for a yield ratio of 85%. (This ratio should be adjusted downward slightly to account for the credit risk of investment-grade muni bonds, but by how much?) I think an investor in a federal income tax bracket of 35% or higher may be better off putting stocks in the tax-deferred account and municipal bonds in the taxable account. In fact, with the ratio of muni yields to taxable yields so high, I wonder if Treasury bonds make sense only for very conservative investors who don't want to own stocks. They can own munis in taxable accounts and Treasuries in tax-deferred ones.
Rate wise it is a no brainer but they have a different credit risk. In one your betting on the US government. In the other your betting on the states. See 2008 for when they diverged.
These numbers change over time. When bonds are paying out 8%, the tax drag gets larger. Or if you live in 0% state.
And of course the tax deferral is a minor part of the traditional IRA/401(k). That extra 36% or so worth of money to start with matters a heck of a lot more.
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Re: Tax Efficiency of Treasuries
You should be able to improve the tax efficiency of your treasuries a bit by selling prior to maturity, once you have ridden the yield curve down quite a bit. In effect you'll be capturing a portion of future coupon payments immediately as a long term capital gain rather than as interest income. I'm not sure how you would model this, though, as it depends on the future shape of the yield curve--something you can only guess at.
Re: Tax Efficiency of Treasuries
Some states (eg PA) do not tax retirement income. Kiplingers has a state by state guide to the retirement friendliness of various states' tax policies. Even my own state, NY, which they designate as one of the least tax friendly states for retirees, has a deal which will lower my marginal state rate quite a bit. NY does not tax any SS benefits and annually exempts the first 20k of private pensions and IRA withdrawals from state tax. Also gov pensions (federal, military, NYS and subdivisions thereof) are tax free. So my marginal state rate will go down a good bit. On the other hand, there are lots of implicit taxes on income in retirement based on AGI beyond the income tax code. E.g. large deferred income could result in loss of property tax exemption for seniors, higher Medicare premiums, etc.
Re: Tax Efficiency of Treasuries
Call_Me_Op wrote:Taxable - 100*[(1+0.67*0.035)^20 - 1] = 58.98%
Tax-Deferred - 100*[(1+0.035)^20 - 1]*0.61 = 60.38%
So you earn a mere 1.4% (cumulative) more over the 20 years (an average of 0.07%/year) in the tax-deferred account. This is a difference I can comfortably ignore. Comments welcome.
UK 1900 to 2010 20 year Treasury yields averaged 5.8%. Revise your calculation to use that instead of 3.5% and the differences rises to 0.6%/year.
During the 1970's/1980's under high inflation 20 year yields averaged 12.6% 1970 - 1989 inclusive. Drop that figure in and .... ouch! 5.4%/year difference. Oh - btw, the tendency was also for higher (rising) taxes during those years.
Re: Tax Efficiency of Treasuries
And use the correct tax rates, as I suggested earlier. When you don't pay a state tax on your treasuries in your taxable account, you lose the deduction for the state taxes that you didn't pay. I don't like paying taxes, but if I am going to pay a tax, I like it to be deductible.
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Re: Tax Efficiency of Treasuries
Beliavsky wrote:The SEC yields of VWLTX (Vanguard Long-Term Tax-Exempt Fund Investor Shares) and VUSTX (Vanguard Long-Term Tax-Exempt Fund Investor Shares) are 2.60% and 3.06%, for a yield ratio of 85%. (This ratio should be adjusted downward slightly to account for the credit risk of investment-grade muni bonds, but by how much?) I think an investor in a federal income tax bracket of 35% or higher may be better off putting stocks in the tax-deferred account and municipal bonds in the taxable account. In fact, with the ratio of muni yields to taxable yields so high, I wonder if Treasury bonds make sense only for very conservative investors who don't want to own stocks. They can own munis in taxable accounts and Treasuries in tax-deferred ones.
Municipals (unless AAA) are not a good substitute for treasuries as they do not provide the same flight-to-quality boosts. I think treasuries make an excellent complement to stocks. While the expected return of taxable muni's is greater, you are taking greater risk to boot.
That said, if I could find a substitute for BMBIX that I could purchase without a transaction fee, I would substitute it for some of the treasuries.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein
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Re: Tax Efficiency of Treasuries
sscritic wrote:If your state taxes are deductible on your federal return, you keep
(1 - .06)(1 - .33) = .6298, not .61, in the tax deferred account.
Long version. Pay .06 to state. Deduct. Pay federal tax on .94. Federal tax is .33 (.94) = .3102. Total tax is .06 + .3102 = .3702. You keep 1 - .3702 = .6298. The short version is easier to remember and apply, but confuses some people.
Good point; relatively minor adjustment but relevant.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein
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Re: Tax Efficiency of Treasuries
Call_Me_Op wrote:Good point; relatively minor adjustment but relevant.
But you are looking at small differences. A small change can thus be a large percentage change.
Taxable = 58.98%
Tax-Deferred = 60.38% x .6298/.61 = 62.34%
62.34 is 5.7% larger than 58.98.
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Re: Tax Efficiency of Treasuries
sscritic wrote:If your state taxes are deductible on your federal return, you keep
(1 - .06)(1 - .33) = .6298, not .61, in the tax deferred account.
Long version. Pay .06 to state. Deduct. Pay federal tax on .94. Federal tax is .33 (.94) = .3102. Total tax is .06 + .3102 = .3702. You keep 1 - .3702 = .6298. The short version is easier to remember and apply, but confuses some people.
I'll see your deduction of state taxes and raise you a phase out of itemized deductions about specified income limits.
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Re: Tax Efficiency of Treasuries
sscritic wrote:
Call_Me_Op wrote:Good point; relatively minor adjustment but relevant.
But you are looking at small differences. A small change can thus be a large percentage change.
Taxable = 58.98%
Tax-Deferred = 60.38% x .6298/.61 = 62.34%
62.34 is 5.7% larger than 58.98.
Yes - but that's still just an effective interest rate penalty of 0.1%. If I want treasuries (for their safety) and can only hold them in taxable, that's not going to bother me.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein
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Re: Tax Efficiency of Treasuries
Are you sure about your original numbers?
Make $10,000.
1) Taxable: Pay $600 to the state and $3102 to the feds. Buy $6298 of treasuries.
First year: earn 3.5%. Keep 67% after fed tax (no state), so your yield is 2.345%.
Compound for 20 years. You end up with
6298 x 1.02345^20 = $10,012.33 after all taxes, all of which were pay as you go. No more taxes due.
2) Tax deferred: buy $10,000 of treasuries (no taxes paid yet; you put it all into your tax deferred account).
After 20 years, have
10000 x 1.035^20 = $19,897.89
Take it out as a lump sum and keep 62.98%
19897.89 (.6298) = $12,531.69 after all taxes.
Annual returns after all taxes:
1) Taxable: 1.001233^(1/20) - 1 = 0.00616% per year
2) Tax deferred: 1.253169^(1/20) -1 = 1.135% per year
$10k in taxable represents a lot more money earned than $10k in tax-deferred. That's what deferring the taxes does for you; you can invest more in tax deferred with the same earnings.
Check my numbers; I do make mistakes.
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Re: Tax Efficiency of Treasuries
sscritic wrote:Check my numbers; I do make mistakes.
Not this time, SS, your figures are correct. 
I've expanded on your example to illustrate, in a different way, Call_Me_Op's point. Assume one has $20,000 available before taxes to invest; but that one can only put $10,000 of it in a tax deferred account. Also assume that one wants to invest in only Treasury bonds or CDs and that both will pay 3.5% interest over the next 20 years.
Code: Select all
20 Years
20,000 Total pretax available to invest
3.50% Treasury interest rate
3.50% CD interest rate
33.00% Federal tax rate
37.02% Federal + state combined tax rate (6% + 33% X 94%)
In Scenario A one puts a Treasury bond in the IRA and a CD in the taxable account. In Scenario B one does the reverse. Which is better?
Code: Select all
--- Scenario A --- ---- Scenario B ----
Treasury CD in CD in Treasury
in IRA Taxable IRA in Taxable
------ ------- ------ ----------
Invested 10,000 6,298 10,000 6,298
Growth rate 3.500% 2.204% 3.500% 2.345%
Grows to 19,898 9,741 19,898 10,012
Tax (7,366) - (7,366) -
After tax 12,532 9,741 12,532 10,012
---------------- ------------------
Total 22,272 22,544
Both the Treasury bond and the CD produce the same after tax balance in the IRA ($12,532). But because of the state tax exemption, the Treasury bond produces more than the CD ($10,012 vs $9,741) in the taxable account. Thus, as one would expect, Scenario B is better.
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Re: Tax Efficiency of Treasuries
#Cruncher's post illustrates an important point. When comparing things, you have to know what you are comparing.
I was making $10k and comparing putting in all in treasuries in taxable to all in treasuries in tax deferred.
#Cruncher was making $20k and sending $10k to a CD and $10k to treasuries and comparing treasuries in taxable and the CD in tax deferred vs the reverse.
Different questions, different comparisons, different answers.
Re: Tax Efficiency of Treasuries
by Doc » Need to forget about the ROTH/Traditional IRA "dilemma". That is a separate issue involving future tax rates and contribution limit differences between the two accounts. Just consider the ROTH which has no tax and get your answer quickly. Settle the tIRA/ROTH debate again in another thread.
The pretax yield on the ten is about 2.5% which means you have a tax of $62.50 per year for a $1000 investment in the 25%/0% Fed/State tax bracket.
Meanwhile a large cap blend index fund with a 2% dividend has an annual tax of $42.00 per year on the same investment in the 15%/6% Fed(dividend)/State tax bracket on the dividend alone. Plus many of us will also have additional LTCG taxes to pay in the future as well as other tax "gotchas".
I consider a large cap blend index fund to be very tax efficient as do most of the Bogleheads and similarly the ten year Treasury is also very tax efficient.
The reason the Treasury is so tax efficient is not so much the zero state tax rate but because the interest rate is currently so low.
A scientist looks for THE answer to a problem, an engineer looks for AN answer. Investing is not a science.
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Re: Tax Efficiency of Treasuries
sscritic,
You are assuming (in your example above) that the tax-deferred case starts with a tax-deductible principal. That is not the problem I was solving. I was comparing the two accounts (taxable and tax-deferred) on an equal footing - that is, with the same input. An example of this is investing in an after-tax IRA versus a taxable account.
The math is very different if we are deferring income (e.g., 401k). But that's a different problem than I was addressing.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein
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