The tax efficiency conversation often narrows to two questions: (1) Active or passive funds? And (2) mutual funds or exchange-traded funds (ETFs)?
I’m as guilty as the next for focusing on those questions. I answered the active versus passive question here. I have also given my analysis in two articles recently—here and here—comparing Vanguard’s mutual funds and ETFs.
Not to undermine my previous efforts, but arguably, for Vanguard investors in particular, those questions (and their answers) may be irrelevant. Said differently, whether you choose indexing over active management or funds over ETFs isn’t going to move the tax needle much.
For example, Vanguard’s average U.S. stock index mutual fund has been 96% tax-efficient over the past decade. That’s certainly better than the 85% tax efficiency of its average active U.S. stock mutual fund, but we are still choosing between two reasonably tax-friendly options.
The margins are even finer when comparing index mutual funds and ETFs. As I told you in Vanguard’s Exception to the Rule, despite all the hoopla, there’s really no difference between Vanguard’s index mutual funds and its ETFs.
Lost in the conversation is the one place where investors can find a massive tax advantage: municipal bond funds.
If you review the Bond Fund table at the bottom of my Taxing Returns: 2024 article, you’ll see that Vanguard’s bond funds were, on average, just 35% tax efficient over the last ten years. That’s a big chunk of your return going to the IRS! (Of course, that number makes sense since the bulk of a bond fund’s return is made up of interest income, which is taxed as, well, income.)
One way to deal with the tax drag that comes with owning taxable bonds is to hold them in retirement accounts—a strategy best known as “asset location,” and Vanguard is a proponent of it.
But another solution exists: Vanguard’s tax-exempt bond funds let you keep (nearly) all of your income.
So, if you want to be tax-smart and own bonds, should you follow Vanguard’s asset location advice, or can municipal bonds offer a different path? Let’s start at the beginning.
Key Points
- If you own a taxable bond fund in a brokerage account, the IRS will take a big bite out of your returns.
- Asset location (holding taxable bonds in your retirement accounts) may be one strategy—Vanguard certainly thinks so—but it’s not for everyone and is only half of a smart investor’s solution.
- Municipal bond funds offer a viable option for investors who want to own bonds and keep their tax bill in check.
What Are Municipal Bonds?
Just as the U.S. government and businesses borrow money for various purposes, states, cities and towns have their own funding needs for projects of all shapes and sizes. Repairing roads, expanding a sewage plant or building a new school are just a few of the projects investors finance by purchasing bonds issued by these municipalities. That’s why they’re called municipal or “muni” bonds.
What sets muni bonds apart from Treasury, corporate and mortgage-backed bonds is taxes. When you lend to a municipality by purchasing their bonds, the federal government does not tax the interest they pay. And if you live in the same state as the issuer, the income is not taxed by the state, either.
Hence, muni bonds are also called “tax-exempt” or “tax-free” bonds—though, of course, as I just mentioned, they may not be entirely tax-free.
Municipal bonds come in different flavors—and if you are curious, you can read my Muni Bonds 101 article to learn more—but for our purposes today, what matters is the tax-exempt status of the income muni bonds pay out.
Location, Location, Location
Put a pin in municipal bonds for a moment.
As I said, Vanguard’s preferred solution to the high tax cost associated with taxable bond funds is to stash them in retirement accounts. The technical term for this strategy is “asset location.”
Asset location means putting your investments in different accounts based on their tax treatment. Because different types of accounts are taxed differently, and capital gains, income, and dividends are also taxed at different rates, you can improve your after-tax returns by holding assets in the “right” kind of account.
The conventional asset location advice is to hold stocks in your taxable account and bonds in your retirement accounts. In a 2022 whitepaper, Vanguard said that by placing bonds first in traditional IRAs, then Roth IRAs and then taxable accounts, an investor could boost their after-tax returns by 0.05% to 0.30%. (They broadcast this claim in a 2023 blog post.)
I’m not going to refute Vanguard’s math. Intuitively, it makes sense—or at least I suspect it is directionally correct. If you hold taxable bonds in a taxable account, you will give up much of your return to the IRS. So, holding them in a retirement account should improve your after-tax returns, all things equal.
However, I have a few issues with asset location as a strategy.