One of the basic pillars of a well balanced portfolio is the class of fixed income securities. When it comes to fixed income securities, the rule of thumb for the passive, well-informed personal finance aficionado is to pick a nice basket of bonds through a bond mutual fund or exchange-traded fund, and slowly increase one’s exposure to the asset class along with age.
With fixed income securities like bonds, tax efficiency is a very important factor. In fact, it is useful to compare the performance of three Vanguard fund that offer exposure to baskets of bonds: VBTLX, VWAHX, and VCITX. The great thing about fixed income securities is the regular, stable yield of returns, which comes at the expense of being taxable. Thus, it is wise to include things like bond funds in tax deferred or tax exempt accounts such as 401(k)s or IRAs. For taxable accounts, one can consider bond funds that offer benefits such as being exempt from federal or even state income taxes. This is where VWAHX and VCITX come in.
As of this writing, VBTLX offers a widely diversified basket of bonds that provides a good yield of 4.24% since its inception. The diverse holdings of 8000+ bonds means that the fund itself can weather the vagaries of the market, and is less susceptible to defaults. On the other hand, VWAHX and VCITX offer yields of 6.55% and 5.97%, both of which are exempt from federal income taxes. In addition, bond funds like VCITX are doubly tax efficient, offering California residents a shelter from state income taxes due to the funds’ investments in the bonds of California municipalities. Factoring in the state income savings, we can see that a municipal bond fund like VCITX can be the best choice.
On an initial investment of $10,000, the total bond market fund of VBTLX yields $424 after one year, which is then subject to federal and state income tax. For a California resident with an effective federal tax rate of, say, 35% and a state income tax rate of 10%, the effective yield becomes $248.04 after one year. Applying the same initial investment to VWAHX, the effective yield is $589.50 since returns from the fund are exempt from federal income taxes. Ultimately, the most tax efficient VCTIX - for a California resident in the hypothetical tax brackets - would yield the highest after tax earnings of $597.
Thus, it is well advised for one to take a close look at municipal bond funds that not only offer federal income tax exempt yields, but, for residents of states with income taxes, yields that are also exempt from state income taxes.