Since I began investing a few years ago, I've always read that I should fill tax-shelters with bonds first, and then let stocks spill over into taxable accounts if necessary. It still comes up often, but the idea seems to rely almost entirely on two facts that are changing:

1. Dividends from stocks (if "qualified") are taxed at rates lower than interest income, which has only been true for the last decade, and will no longer be true (as the law is currently written) on 1 January 2013.

2. Stock dividend yield is usually lower than bond yield, which was not true before 1960, and is no longer true today (S&P 500 yields 2.2% while the total bond market yields 1.7%).

So as I see it, in a few months stocks will actually be more expensive than bonds to hold in a taxable account. Your thoughts?

Tim

First, this is assuming congress takes no action. And then, it is assuming that CEO's of these "dividend" companies (who are heavily invested in their company and know they always need an exit plan) won't make changes to keep the share price from plummeting.

Next, Is it fair today, to take a snapshot in time and extrapolate it out forever? In other words, will the S&P 500 continue to have a higher yield than the total bond market? Certainly, we all want to look at our after tax return.

If the overall question is, will changes need to be made if the current tax laws don't remain in place? The answer is yes. But I'm waiting until the Rube Goldberg machine in Washington poops something out.

I suppose it should be said that qualified dividends were already scheduled to expire twice before in 2008 and 2010, and were extended.

The idea that companies might slash dividends if they stop receiving preferential tax treatment is a fair point that I hadn't considered.

Tim

The question then becomes, the dividend companies will have cash. Can they grow their business with it? I am one to think of a company who delves out a dividend to be one which can't grow their company and be rewarded as well if they handed out a dividend. So, do you trust that company to be able to handle the cash without fumbling?

There's no other way to say it than do the math. Remember, the ultimate goal is to maximize after tax income, not to minimize taxes.

A little hypothetical may help.

Which would you choose?
A) An investment profit of $50,000, taxed at 40%.
B) An investment profit of $20,000, tax free.

I'm not saying that trying to lower taxes is a bad idea, I'm just saying don't make that your only criteria. In other words, do the math first, then make your choice.

But the question is not, "should one buy stocks or bonds?" The question is, "if one has both stocks and bonds, which ones are better to hold in tax-sheltered space?"

Tim

And the answer is "do the math". Make your assumptions about how much each will return over time, put it in a spreadsheet that incorporates tax differences, try different scenarios, look at the results, then pick a strategy.

Yeah, I guess the problem is in the assumptions... garbage in - garbage out. I brought this up because the back-of-the-envelope math I did (using tax rates set to take effect in 2013) flies in the face of the commonly accepted answer. So I suppose the real question is, "Am I missing something in my assumptions?" Are tax rates, interest rates, and dividend yields the only factors?

Tim

Are you factoring in what will happen to the economy and hence your returns if that tax policy remains? Regardless of your politics if congress fails to act it would be disastrous and few doubt that. The only debate seems to be about spending and about taxes on those making over 250k. Both side will act like idiots until after the election before agreeing on something. Some details are up in the air but i doubt that you will see much messing with dividend taxation since no one seems to favor it.

Good discussion on this also taking place over here...

http://www.bogleheads.org/forum/viewtop ... st=1513464

The only conclusion that doesn't make sense to me, so far, is that tax-exempt bonds would be automatically better than taxable bonds. One person points out that the duration (about 5 years) and the interest rates (1.7%) of VBMFX and VWITX are currently the same, but ignores the difference in credit quality: the tax-exempt fund is mostly AA while the total bond market fund is mostly US Government. Although VWITX is clearly the better choice for someone in a high tax bracket (which probably describes most people doing taxable investing).

Tim