Higher Interest Rates May Lead to a Tax Surprise in April

The dramatic increase in interest rates is showing up in a big way in the dividends paid out by bond mutual funds and ETFs this year.  For savers and conservative investors, those returns are welcome after many years of near 0% yields on fixed income.  Just consider the current yields on a few of the bond funds we own in our client portfolios: 

Pimco Income Fund:  Trailing 12 month dividend yield:  7.49% 

Janus Global Developed Market Bond:  Trailing 12 month dividend yield:  9.92%

I-shares Ultra Short Term bond ETF:  current yield based on most recent payment:  5.64%

Those payouts look mighty attractive - but the higher interest / dividend payments may also lead to a tax surprise next year. 

Dividend income from bond funds (and also Real Estate Investment Trusts) is taxed as ordinary income, not capital gains.  Such dividends are also not exempt from tax in the lower tax brackets, as are qualified dividends from stocks and stock funds.  With bond fund yields soaring this year, many investors will find they are owing Uncle Sam a bigger chunk of change on their retirement income this year. 

The surprise will be especially unwelcome as many of the bond funds which are paying out these higher taxable distributions have decreased in value this year, as interest rates shot up again.  Investors may rightly wonder “how come I have to pay tax on income when my portfolio is down in value?”.  The reason can perhaps best be explained in terms of rental real estate: 

• You own a rental property worth $500,000.
• The real estate market slumps, so the home is now worth $400,000.
• This is like the decline in the value of an investors stock or bond funds during the year. The change in value has no impact on your taxes until the day you sell the property (just like stocks and stock funds). 
• But at the same time, the property generated $30,000 in rental income. This income will be taxed, regardless what happened to the value of your property.  This income is like dividends from your stock or bond funds. 

A key difference is that as the landlord, you actually see the income from your property in your bank account, so it is not a surprise at the end of the year.  Most investors don’t pay close enough attention to their portfolios to see their dividend income as separate from the overall change in their portfolio value.  It is usually just swept right up and used to buy more shares of the investment that generated them.  Reinvesting dividends is good practice, but also makes it difficult to appreciate or even notice these cash payouts that are happening during the course of the year!  

HOW TO LIMIT THE BITE!   Although it is a bit late in the year to be providing this advice, asset positioning may be the best strategy to reduce taxation on investment income.  Stock funds generate mostly capital gains income, which is realized and taxable only when the funds are sold.  (well, that’s not entirely true…but save capital gain fund distributions for another day…)  Stocks may also pay dividends, but dividends are usually less than those paid by bond funds, and are taxed at preferential capital gain rates of 15% for most taxpayers.  In contrast, bond funds generate most of their investment return via interest payments (non-qualified dividends taxed as ordinary income), and these must all be realized annually.   OPPORTUNITY:  If you have both tax deferred accounts (401k, IRA, etc.) and taxable investment accounts, consider stuffing all the (tax inefficient) bond funds into the tax deferred account while filling the taxable investment account with (more tax efficient) stock index funds.   You can maintain the same asset allocation across your whole portfolio, but with the stock portion in after tax accounts and the bond portion in tax deferred accounts. 

We have been working hard this year to (wherever possible) reposition higher yielding investments across our client portfolios to try to increase the tax efficiency of the portfolios as a whole.  It is rarely possible to completely shelter a portfolio from tax (after all, we do want to make money!)  – but we do our best to minimize the bite through effective asset positioning.  

What does this look like: 

Let’s say you have a 401k and an after tax investment account, both with $100,000 allocated to 50% stocks and 50% bonds. 

You can sell the $50,000 worth of bond investments in the after tax account, and the $50,000 worth of stocks in the 401k, and buy the opposite.  Now your 401k is 100% in bonds, and the after tax account is 100% in stocks – but your overall allocation is still exactly the same as it was before.  You should earn the same return, and have the same risk as you did before – but now 100% of your bond interest will be tax deferred!

Over time you will need to re-balance of course, to maintain your 50/50 allocation.  And I would acknowledge that there are certain situations such as cash distribution needs which might mean you want to keep some of your (generally safer) fixed income in your taxable account.  Nonetheless, strategic positioning of investments within your portfolio based on their relative tax exposures may be able to save you a sizable chunk of change come tax time.