The Problem with Bond Taxation for HNW Clients

Original article posted on "Separating Value From Bias" Substack here: #14: The Problem With Bond Taxation for HNW Clients

Investing in taxable bonds as a retirement strategy for HNW clients stops making mathematical sense due to the large drag taxes play on bond returns.

So in our last post we covered how even though bonds have lower historical returns (and lower long-term projections) in comparison with stock returns, bonds are also expected to have less volatility associated with them.

So as clients move closer towards retirement, their retirement fund typically starts selling part of its stock portfolio and buying a bond portfolio instead in order to reduce the risk of the client running out of money in retirement.

Chart 1: Sample Glidepath of Retirement Portfolio that Increase Bond Allocation of Portfolio as Client Ages

By replacing stocks with bonds clients are reducing the overall risk in their portfolio. This reduced risk can actually lead to both a higher chance of the client meeting their retirement income goals as well as the after-tax wealth that they leave to their beneficiaries.

In other words, by reducing risk in the portfolio as the client nears retirement and starts taking withdrawals, clients can actually create more wealth than by purely focusing on the asset that has the highest expected return.

The best way to see this is by doing what’s known as a Monte Carlo simulation.

For those who might not be familiar with a Monte Carlo simulation, it’s a mathematical technique that helps financial planners understand the probabilities of certain outcomes given a certain set of assumptions.

For example, if I’m currently 55 with a $3M portfolio of stocks and bonds and want to retire at 65 and start taking out $250k a year for the rest of my life, what is the chance that I’ll meet my retirement goal?

How much can I expect to leave to my beneficiaries when I die?

These are the two key goals that financial planners evaluate when doing retirement projections:

1. Chance meeting retirement income needs: One of the key criteria used in evaluating a client’s retirement plan is whether they have enough assets to meet their desired retirement income goals. If they don’t, then they either need to grow their assets more to support their desired retirement income goals or reduce the amount of income they plan to draw from their portfolio in retirement.

2. Amount of after-tax wealth left at death to beneficiaries: The second key criteria used to evaluate a client’s retirement plan is the amount of after-tax wealth left at death to the client’s beneficiaries. Usually this is in direct conflict with the amount of retirement income the client needs in retirement. The more income the client needs for themselves in retirement, the less they have to give to their beneficiaries at death.

The way financial planners evaluate how the client’s retirement plan looks like with regards to these two goals is by doing what’s known as a Monte Carlo simulation.

A Monte Carlo simulation helps us get an idea of what these two retirement goals might look like for the client given their retirement income needs as well as the current value and composition of their retirement/investment portfolio.

It’s worthwhile noting that a projection is just that—a projection. It gives us an idea of what outcomes we can expect given our assumptions with regards to their retirement income needs as well as the returns we are assuming their investment portfolio will earn.

The projection itself is heavily dependent on these assumptions. If the portfolio actually earns more or less than what we are assuming it will earn, the projections will be off.

Nevertheless, the projection still helps us get an idea of the overall idea of whether the client is being too aggressive or conservative with their retirement income needs, whether they need to contribute to their portfolio more before retiring, or whether they need to change the composition of their portfolio to be more aggressive or conservative dependent on their needs.

In order to understand the value of a Monte Carlo simulation, let’s look at a simple case study that I’ll be using now and in future posts.

Let’s assume you have a married couple, John and Sally, who are both 55 and living in California. They collectively make $500k a year in W2 income and have a $3 million portfolio. They would like to retire at age 65 and pull out $250,000/year every year that they are in retirement with that amount increasing by 2% a year in retirement.

How should they allocate their $3 million portfolio to best ensure that they maximize their chance of meeting their retirement income goals AND the amount of after-tax wealth they leave to their beneficiaries?

Should they invest 100% in stocks? 70% in stocks and 30% in bonds? Or what about 60% in stocks and 40% in bonds?

By simulating the returns across a large number of scenarios (in our case 1000 scenarios), we’re able to assess the results here.

The full assumptions behind the simulations are shown in the table below.

Note that the assumptions assume that there are no taxes on the gains. This will be an important point, later on in the article.

The table below shows John and Sally’s chance of meeting their retirement income goals as well as the after-tax wealth they would leave to their beneficiaries if they were to die at 95 (Note that the joint life expectancy here is at 93, but I used 95 since that’s a standard age of death assumption used in financial planning).

Table 1: Monte Carlo Results of Case Study Assumptions Assuming No Tax

The above table shows us the clear tradeoff between shifting the asset allocation of the portfolio away from stocks and towards bonds.

The three asset allocations looked at in the table are:

1) 100% Stocks/0% Bonds

2) 70% Stocks/30% Bonds

3) 60% Stocks/40% Bonds

Shifting the portfolio away from stocks and towards a heavier bond allocation increases the chance of the client meeting their retirement goals, but at the cost of the wealth they leave to their beneficiaries at age 95.

For example, with a 100% stock portfolio there is a 68% chance of the couple meeting their retirement income goals and $9,659,542 that they can be expected to leave their beneficiaries at age 95.

If the client choses to go with the 70% Stock/30% Portfolio, then the client increases their chance of retirement success from 68% to 75% but decreases the after-tax wealth they leave to their beneficiaries at age 95 from $9.7 million to $6.4 million.

Is the 7% increase in retirement success, worth the loss of $3.3 million on the back end?

Well, that’s a question for the retiree to answer.

What is the marginal loss in beneficiary wealth the client is willing to give up for an extra percentage point of their own retirement success?

$3.3 million loss for an extra 7% chance of success amounts to $460,486 loss in future wealth per extra percentage point of the chance of meeting retirement success.

People often think this is purely a choice between the retiree’s own desire for safety versus their beneficiary’s desire to maximize the wealth they receive.

But it’s not that simple.

Maximizing the wealth in the later years of the retiree’s life also means they have more money to spend on things like assisted living and end of life care that gets increasingly expensive for clients at the end of their life that is typically not accounted for in financial planning projections because it’s an all or nothing event.

Either the client won’t need the extra wealth at the end of their life or the amount they need will be massive.

This is an all-or-nothing, binary, tail risk event that can’t accurately be captured in static, “expected” financial planning costs.

So, giving up that extra $3.3 million at the end of a client’s life is not so inconsequential.

At any rate, shifting the portfolio away from stocks and towards bonds accomplishes the original goal of increasing the client’s chance of meeting their retirement income goals (that don’t include a large end of life expenditure) but at the expense of the wealth they will create at the end of their life.

However, an important caveat here is that we did the original projection assuming that no taxes were paid by the client.

In other words, the client got to receive the full benefit of their investment returns without the drag of taxes on the portfolio.

What happens when we add taxes to the mix?

We can see that in the table below.

Table 2: Monte Carlo Assumption of Case Study Assumptions Assuming Taxes Paid

We can see from the table above that both the chance of meeting the couple’s retirement income goals as well as the after-tax wealth that they have at age 95 is drastically reduced due to the taxes owed on the gains.

The chance of meeting their retirement income goals drops by 11 to 19 percentage points while the after-tax wealth they have at age 95 drops by 64% to 77% as shown in the table below.

Loss of Retirement Success and Median After-Tax Wealth at Age 95 Due to Taxation

The above table compares the loss in both chance of the client meeting their retirement income needs with no taxation versus no taxation in the lefthand three columns according to three different asset allocations.

The righthand three columns compare the after-tax wealth at age 95 according to the three different asset allocations.

Across all three allocations we notice a decrease in both the chance of retirement success and after-tax wealth left at age 95. This makes sense of course because of the drag taxes have on the portfolio.

However, what’s extremely worthwhile noticing is that the more you shift assets away from stocks and towards bonds (e.g. going from 100% stocks/0% bonds to 60% stocks/40% bonds) the larger the tax-drag becomes.

The 60/40 portfolio has a reduction in retirement success of 19 percentage points due to taxation compared to only 11 percentage points for the 100% stock portfolio.

More importantly, the effect of taxation makes the value proposition for bonds in retirement planning almost negligible.

When we account for taxation, the 100% stock portfolio actually has a higher chance of meeting the client’s retirement income needs than the 60% stock/40% bond portfolio (57% vs 56%).

Analogously, the 60/40 portfolio loses nearly 77% of its after-tax wealth at age 95 while the 100% stock portfolio only loses 64% of its after-tax wealth.

The latter numbers should shock you.

This is the compound effect on taxation.

It’s not just the taxation that causes the loss in wealth here. It’s the limitation on compounding over the 40 years that happens as a result of the taxation.

So, if you’re looking to pass on wealth to the next generation one of your key concerns should be how to minimize the loss of wealth due to taxation on your assets.

The data in the table should get you to ask 2 key questions with regards to retirement planning:

1. Why are investing in bonds so tax-inefficient and cause so much drag on the portfolio in comparison to investing in stocks?

2. If bond taxation is so detrimental to the portfolio, and I’m getting a higher percentage chance of meeting my retirement income goals AND after-tax wealth for my beneficiaries by investing in 100% stock portfolio, then why am I investing in bonds to begin with?

The next two sections answer these questions.

Why are Bonds so Tax-Inefficient?

So, the key question to ask here is why bond returns are taxed so heavily when compared to stock returns.

And the answer lies in the tax code.

Nearly 100% of bond returns come from dividend payments from those bonds or short-term capital gains from the selling of those bonds which are taxed at higher rates than long-term capital gains.

We can see an example of this by looking at the yield distributions from Vanguard’s Total Bond Market Index Fund below.

Vanguard Total Bond Market Index (VBTIX) Income vs Capital Gains Distributions

As the above table shows, only a small fraction (2.5%) of the bond returns from VBTIX come from capital gains distributions as opposed to the higher taxed ordinary income distributions.

Why is this important?

Well it’s because taxes owed on distributions deemed to be ordinary income are significantly higher than those taxed at long-term capital gains.

For example, the top federal tax-rate on long-term capital gains is only 20% while the top federal tax-rate on ordinary income is 37%.

Stock funds are a lot more tax-efficient since most of the gains of stock-funds are unrealized capital gains that come from the price appreciation of the stock—which are not taxed in that year. The table below breaking down the returns of an S&P500 fund from Vanguard (VOO) help illustrate this.

Vanguard S&P500 Index Fund (VOO) Income Return

This is important for the following reasons:

1) Unrealized capital gains are not taxed in the year of appreciation

2) Unrealized capital gains can be deferred until the client is in a lower tax-bracket

3) Unrealized capital gains can never be taxed due to step-up in basis

The above benefits are not possible with bond funds since bond returns are taxed in the year that they are gained.

1) Unrealized capital gains are not taxed in the year of appreciation: First, unrealized capital gains are not taxed. You can defer the taxation on these gains until you actually sell the position and realize the capital gains. The ability to defer taxation on these gains is a major advantage if you are planning on holding a position for the long-term.

For example, let’s assume you are planning on investing $1 million into a bond fund and $1 million into a stock fund for 30 years.

Both earn 6%.

Both are taxed at 50%.

However, the bond fund is taxed every year, while the stock fund is only taxed at the end of 30 years.

What’s the difference in the value of the two funds at the end of 30 years?

The answer is that the bond fund is worth $2.4 million and the stock fund is worth $3.4 million.

That’s an increase of 39% for the stock fund over the bond fund simply due to the tax-deferral.

2) Unrealized capital gains can be deferred until the client is in a lower tax bracket: Capital gains are taxed based on the total income a client earns in a year. Below are the federal tax brackets for a married couple based on their income in a given year.

2025 Federal Capital Gains Tax Brackets for Married Couple

As the above table shows, as the client’s income increases so does the tax-rate that they pay on their capital gains.

So for example, if our couple is already earning $500k in a year through work and they want to realize $1M of their stock gains, only the first $130,050 would be taxed at 15%. The rest would be taxed at 20%.

However, if the couple waits until they retire, and their working income is $0, they can slowly realize that $1M in gains over time. For example, imagine if the couple decided to take out $100k in gains each year for 10 years in retirement. Since the client is under the $126,700 threshold in each of those 10 years, they would pay 0% in taxes on their $1 million gain. That is a $193,500 in extra cash they would have in their hands since they didn’t pay taxes on the gains.

This again is something that can’t be done with bond funds due to the taxes being realized and owed in the year of gain. Furthermore, since bond gains are realized in the year of gain, they also push up your tax rates on the capital gains part of your portfolio. So for example, if I have $0 in income then I qualify for the 0% capital gains tax rate. However, if I have a $130,000 in realized bond gains in a year, then I no longer qualify for this 0% capital gains tax rates.

So not only are bond gains tax-inefficient in and of themselves, they can also make your capital gains more tax-inefficient by pushing up the tax-rates that that they are taxed at.

In fact, if you have a high net worth in retirement and live in a state with a high-income tax, then it’s quite possible that the effective tax rate you are paying on the capital gains portion of your portfolio will be higher than the effective tax-rate on the bond/ordinary income you are generating. And that’s because the effective tax rate on the bond/ordinary income portion of your gains is being reduced by both the standard deduction and a progressive tax-rate, whereas the capital gains portion is subject to the highest marginal tax-rates.

For example, assume that our married couple client is 65, in retirement, living in California—where capital gains is subject to state income taxes on top of federal taxes. Our client is generating $100,000 in taxable bond income and $150,000 in capital gains income for a total of $250,000 in taxable income. However, the bond income makes up the lowest part of the client’s taxable income, whereas the capital gains income makes up the highest part of the client’s taxable income.

So, the bond income benefits from the progressive tax rates (and the large standard deduction) which means that the effective tax rate on this $100,000 of bond income is fairly low. However, since capital gains fills in the top part of client’s income bracket, it is subject to the client’s highest marginal tax rates. So, for most HNW retirees in a 60/40 portfolio, the effective tax-rate on their bond income will most likely be lower than the effective tax-rate on their capital gains income simply because the bond income is pushing the capital gains income into higher marginal tax brackets.

In the case of our client, their effective tax-rate on their $100,000 of bond income is only 12%, but the effective tax rate on their capital gains income is 23% as shown in the table below.

"In fact, if you have a high net worth in retirement and live in a state with a high-income tax, then it’s quite possible that the effective tax rate you are paying on the capital gains portion of your portfolio will be higher than the effective tax-rate on the bond/ordinary income you are generating."

1) Unrealized capital gains can never be taxed due to step-up in basis: Another benefit that stock funds offer that bond funds do not is the ability to pass on all of the appreciation tax-free without you or your beneficiaries ever paying taxes on it.

For example, let’s say you buy a share of Apple stock at $200. Let’s assume you die 30 years later, and that stock is now worth $1 million. That’s a gain of $999,800. Your children would inherit the stock and could sell it without having to pay any taxes on that gain. This is due to a provision in the tax-code known as step-up in basis. This “no taxes” owed provision only applies if your total net worth at death is less than the current estate exemption at the time. Currently this exemption is about $28 million for a married couple. Which means if HNW couples plan properly, they can spend enough in their lifetime to never hit this exemption limit (provided this exemption limit doesn’t come down). Which means their kids can inherit this Apple stock entirely tax-free.

This of course also doesn’t realistically apply to bond funds since all gains are already taxed in the year of appreciation as we’ve mentioned previously.

So, there is no opportunity to play this inherit assets tax-free “step-up in basis” game with bond funds that you can with stock funds.

Maximizing the Value of Bonds in Financial Planning for HNW clients

So, if you’re a HNW client planning for retirement—or generational wealth transfer—based on the previous two sections you’re probably questioning if you should be investing in bonds at all.

After all, bonds are low-earning over the long-run in comparison to stocks, pose interest rate risk, are positively correlated to equity risk during periods of high growth and inflation, and are horribly tax-inefficient as I’ve demonstrated in this article.

However, if you were to invest in bonds through a vehicle that solves for all of these issues—while also adding additional yield and reduced volatility that comes from risk-pooling—then using bonds as a backstop to provide and protect for your income needs in retirement starts to make a lot more mathematical sense.

By doing this you create higher after-tax, risk-adjusted returns from the bond side of the portfolio that you can draw down on in retirement to meet your income liabilities while you allow the higher earning equity portfolio to compound over the long-run without being drawn down to meet those same needs.