I Asked an Advisor Which Bonds Belong in a Taxable Account — Here’s the Logic
Written by
Chris Adam
Edited by
Rebekah Evans
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Now that we’re in another tax time, lots of Americans begin to question their money choices and how they impact the taxes they owe.
Among those questions is which bonds belong in taxable accounts.
Read on for some advisor-backed ideas that may help protect your money in future tax years.
Keep State Laws in Mind
“Advisors who make blanket recommendations of placing municipals in taxable accounts and corporates in accounts with tax deferral ignore the specifics of state-specific tax law,” said Chad Cummings, attorney and certified public accountant (CPA) at Cummings & Cummings Law, who previously worked in finance and tax with American Airlines, PwC and JPMorgan Chase. “Texas and Florida, for example, levy no state income tax. The yield discount you accept on municipals buys you zero benefit at the state level. You pay more for a feature you cannot use.”
In addition, according to Cummings, the de minimis rule under IRC Section 1288 creates a trap.
“Purchase a bond at a discount below the threshold and the IRS recharacterizes your gain as income at sale,” he said. “Your ‘tax-free’ bond generates a tax bill. Surprise.”
Don’t Forget About Interest and Social Security Benefits
“Here is what no one discusses: bond interest from municipals counts toward provisional income under IRC Section 86,” Cummings added. “Loading a taxable account with municipals can push Social Security benefits into taxation. That’s a biggie.”
He went on to add that a retiree collecting $30,000 in Social Security and $40,000 in bond interest could see up to 85% of those benefits hit at up to 37%.
Focus on Location and Efficiency
According to Marguerita Cheng, certified financial planner (CFP) and CEO of Blue Ocean Global Wealth, asset location can be just as important as asset allocation.
“It’s best to avoid including corporate bonds and high yield bonds in taxable accounts,” she added. “It’s more advantageous to invest in these bonds in tax-deferred accounts because the interest on corporate bonds is taxed as ordinary income at federal, state and local levels. While the high income associated with high-yield bonds is attractive, having them in a taxable account means taxable income at federal, state and local levels as well.”
Cheng said that in taxable taxes, it’s important to focus on tax-efficiency.
“Consider investing in tax-efficient bonds, such as municipal bonds for tax-free federal and often state, income,” she said. “U.S. Treasury bonds may also be appropriate because they are exempt from state and local taxes.”
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