Is It Time To Ditch Bonds In Your Taxable Investment Account?
The short answer is yeah, probably.
The better answer is yeah, probably, but there's some nuance to this so let's pump the brakes so there are no surprises at tax time.
LET'S START WITH THE BASICS
Almost all bonds generate interest, often referred to as "yield". Bond interest is taxed at "ordinary" income tax rates.
Most people are already familiar with ordinary income tax rates. When we say "I'm in the 22% tax bracket", we're talking about our ordinary income tax rate.
You may have also heard of federal "marginal" tax brackets, which are based on ordinary income. Here are the current rates through 2025:
Almost all Americans pay federal ordinary income taxes at these rates. You're probably one of them.
Additionally, unless you live in one of these 9 STATES, you also pay ordinary income tax on most of your bonds at the state level. This gets complicated really fast, so I'm sticking to general bond tax mechanics for simplicity throughout this post.
Bond funds (mutual funds & ETFs) aggregate the interest of all the underlying individual bonds in the fund and pass this income on to investors in the form of a dividend.
Bond fund dividends are classified as "nonqualified" income. Nonqualified income is taxed at ordinary income rates.
A "taxable" account is a general brokerage account that's not structured as a 401(k), IRA, Roth IRA, etc. Investors need to pay attention to how their investments are taxed in taxable accounts.
As an investor's tax bracket, number of bonds held, and bond yield increase, tax efficiency decreases.
The lower an investor's tax efficiency, the more of their gains they lose to taxation. We refer to this as "after-tax return", and it's this return that matters most for investors.
GOT IT, SO WHAT'S THE FUSS ABOUT?
Remember all those Fed interest rate increases last year (and last month)? For almost 15 years, interest rates were so low that the amount of bond interest barely mattered for tax purposes.
At this time last year, the average bond yield wasn't even paying 2%. Today, typical bond yields are 3x what they used to be.
This is good for investors because we're being paid more to hold bonds. It's bad if we hold too many bonds in our taxable accounts because we're about to pay a lot more in ordinary income tax.
PROBLEM IDENTIFIED, WHAT DO WE DO ABOUT IT?
Instead of owning bonds (or bond funds) in our taxable accounts, we can replace bonds with stocks (or stock funds).
When bond yields are medium or high, stocks are preferable holdings in taxable accounts because they are more tax efficient.
The reason stocks are more tax efficient is twofold; first, they generally produce a smaller dividend, and second, stock dividends are taxed at an investor's long-term capital gains rate.
Paying long-term capital gains rates is preferable to paying ordinary income rates. Here are the current capital gains rates based on different levels of taxable income:
GIVE ME AN EXAMPLE
Let's say you own $300,000 worth of bond funds in your taxable account. Now let's also assume your bond funds are yielding 4%. And let's further assume that most, if not all of your bonds, are corporate bonds, i.e., limited or no government bonds.
Our last assumption is that you're in the 22% federal bracket + 4% state. Colorado residents actually pay 4.4% (sometimes it's actually lower than that because our system is complicated).
Assumptions defined, your bond funds are generating $12,000 in nonqualified dividends and this income is subject to taxation at a combined rate of 26%. Yes, I'm rounding a bit for easy math.
What this means is $3,120 of the $12,000 nonqualified dividend income is lost to taxation. Bummer...
Let's compare a bond's nonqualified dividend income to a stock's dividend income. When that same $12,000 dividend income comes from stocks, it's taxed at 0% in your taxable income is low enough (see chart above).
For folks with taxable incomes a bit higher, the rate is 15%. In either case, we can all agree that a 0% or 15% tax rate is better than a 26% tax rate.
Continuing the example at the 15% capital gains rate, only $1,800 of the $12,000 dividend income is lost to taxation.
To summarize, replacing bond funds with stock funds in a taxable account resulted in saving $1,320 in taxes. This is the $3,120 - $1,800, i.e., the difference between paying tax on nonqualified dividends vs. plain old stock dividends.
REASONS NOT TO REPLACE BONDS WITH STOCKS
There are a few scenarios where you might want to say no or at least hit the pause button.
Scenario #1, you need to tap into your taxable account in the near future.
Let's say you need a big chunk from your taxable account for a down payment on a house, to buy a car, or you're a new retiree that is delaying claiming Social Security and therefore taking most of your distributions from your taxable investment account.
In these cases, you may value reducing expected volatility more than growth because your need is more short-term. Bonds have typically provided a volatility buffer compared to stocks, and so owning at least some bonds helps mitigate the risk of selling assets at a loss to raise cash for various financial goals.
Scenario # 2, your taxable account is large relative to your retirement accounts.
In this case, we have account size complexity. If we need to move hundreds of thousands worth of bonds out of the taxable portfolio, we might be out of luck if we only have, say, $50,000 or $100,000 in cumulative IRA/401(k)/Roth account balance(s).
Essentially, there's not enough room in the tax-deferred accounts to accommodate an influx of bonds. If we went ahead and replaced all bonds in the taxable account, we might be inadvertently increasing the overall allocation of stocks to a higher percentage than what we're comfortable with.
Scenario #3, your bonds have "unrealized" short-term capital gains.
I'm actually seeing some of this currently. It's almost always a result of the TAX LOSS HARVESTING work I just wrapped up in 2022.
What happens is when we sell a fund at a loss, we don't just leave the proceeds in cash. We buy a replacement fund as an equivalent. This happened a lot last year.
If that replacement fund increases in value, then if we don't wait a full year before selling shares, that sale gets coded as a short-term capital gain.
Short-term capital gains are taxed the same as, you guessed it, ordinary income!
If the amount of short-term capital gains tax owed from selling bonds is greater than the amount of projected nonqualified dividend income for the remainder of the year, then you're actually creating a worse tax situation for yourself by replacing bonds with stocks.
In this scenario, it's probably best to hold tight and reevaluate once those unrealized short-term capital gains turn into long-term gains taxed at more favorable rates.
There are probably a few other highly unique circumstances that would make keeping your bonds in the taxable account a better option, but they are rare and not worth detailing in this post.
HOW DO I MAKE A DECISION ON ALL THIS?
If you're a wealth management client at the firm, I'll be talking to you about this personally at some point this spring if I haven't brought it up already.
Should you want to chat about it sooner rather than later, just email me and we'll put time on the calendar to explain what's best in your specific situation.
If you're reading this and you haven't hired us yet, then I suggest you talk to your existing financial advisor and/or tax preparer.
There's a lot that many of my readers are perfectly capable of navigating on their own. However, the decision to adjust the allocation of bonds in a taxable account is probably best approached with a second set of professional eyes on things.
If you're not currently a client but haven't had this conversation with your current financial advisor, they are dropping the ball. Send me a message using the "Contact" link at the top of this page and we'll start getting you squared away.
Happy to help even if it doesn't mean you become a client at the firm.
Thank you for investing time in your financial health and have a wonderful day!