Don't pay for tax benefits you're not using

Become a Patron!I had a very interesting conversation today that got me thinking about a tax issue I had never given serious thought to before, and which I think is probably totally unknown to most investors, but that affects virtually all of them: the exclusion of US federal interest payments from state income tax liability. Upon just a moment's reflection, I realized that a vast swathe of US investors are making a simple and (relatively) easily avoidable error.

Asset allocation, asset location, and asset selection

In order to optimize your long-term rate of return, you typically have to take into account three factors:

• Asset allocation, or risk tolerance. This could be as simple as a 60% allocation to stocks and a 40% allocation to bonds, or as complicated as a carefully weighted average of every region and asset class in the world, rebalanced daily. There's no one right asset allocation for everybody but, in general, the more you depend on your assets for ongoing income, the less volatility you should be willing to tolerate in their value, and the more you plan on leaving to your children or grandchildren the less you should care about their day-to-day value and the more you should focus on the long-term potential for appreciation.
• Asset location. Some assets are more tax-efficient than others: if you own mutual funds that are constantly spinning off capital gains, the taxes you pay each year represent a drag on your overall returns. Those funds are best held in accounts where capital gains are shielded from annual taxation. Likewise, shares in companies like Berkshire Hathaway that refuse to pay dividends and instead reinvest their profits internally are a better fit for taxable accounts, since owning them generates little or no tax liability.
• Asset selection. Once you've settled on your asset allocation, and set up your IRA, 401(k), and 529 plan contributions, you still have to implement the allocation by choosing the securities you want to invest in. The simplest example is municipal bonds. Based on your marginal state and federal tax rates, you may find that buying municipal bonds issued in your state of residence gives you a higher after-tax yield on your portfolio's bond allocation than buying taxable bonds, even if the coupon payments on those bonds are in fact lower; after all, keeping 100% of $4.50 leaves you with more income than keeping 80% of $5. But that advantage is lost when you hold municipal bonds in a qualified account: if you get to keep 100% of your coupon payments regardless, just buy the higher-yielding security.

Most federal interest payments are exempt from state income taxes

Just as most municipal bond interest payments are exempt from federal income taxes, a reciprocal rule applies to federal interest payments: while federal income taxes are due on bond payments, state income taxes are typically not. Claiming this exemption involves looking up the share of your calendar year income attributable to federal securities and excluding it from your taxable income on your state return. You can find Vanguard's 2019 guidance here, for example:

• One share of the Vanguard Inflation-Protected Securities Fund paid out 29.2 cents in dividends in 2019, and Vanguard avers that 99.19% of that payout was due to income from US government obligations. That share of the otherwise-taxable income is likely exempt from state taxes.

Target retirement date funds are a bad tax fit for retirement accounts

If you know anything about target retirement date or target risk funds, then the problem is likely coming into view, but I want to dig into it. Take, for example, Vanguard's Lifestrategy Growth Fund. It holds:

• 48.3% Vanguard Total Stock Market Index Fund Investor Shares
• 31.4% Vanguard Total International Stock Index Fund Investor Shares
• 14.2% Vanguard Total Bond Market II Index Fund Investor Shares
• and 6.1% Vanguard Total International Bond Index Fund Investor Shares

A perfectly reasonable asset allocation for someone with a long-term investment horizon. The problem is that it also owns an embedded tax asset: 5.76% of the fund's income in 2019 was attributable to income on federal securities, and could be excluded from state income taxes if it were held in a taxable account. That's because, like most total bond market funds, the Vanguard version is weighted heavily towards US bonds, comprising as they do a majority of domestic bonds.As bad as that is, the situation becomes even more dire in target retirement date accounts: 24.68% of the income from the Vanguard Target Retirement 2015 Fund is attributed to federal sources!Just like municipal bonds pay lower coupons to reflect their lower tax liability to high-income taxpayers, the federal bonds embedded in target-risk funds are able to pay lower coupons due to the embedded tax asset of exemption from state and local income taxes.

Whatever your risk tolerance, don't pay for tax benefits you're not getting

The nice thing about target risk and target retirement date funds is they're calibrated to your risk tolerance and/or age, and that's not something you should sacrifice easily. Whether your risk tolerance indicates an 80/20 or a 40/60 stock/bond asset allocation, that's what you should invest in; I'm not here to judge.But when it comes to asset selection in your tax-exempt accounts, you shouldn't be sacrificing interest payments for the sake of a tax exclusion that doesn't apply to you.On the contrary, you should be able to mechanically achieve higher and/or more stable returns by swapping your federal bond allocation for higher-yielding, taxable corporate bonds and cash or cash-like securities like CD's within your tax-exempt accounts.Become a Patron!