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Should High Earners Be Buying Bonds Again?

Since 1986, the last year in which the tax code was significantly revised, the investment advice (from a tax perspective) for high earners has generally been the same: avoid bonds and other forms of interest income in favor of equities, particularly those that pay little to no dividends. This made sense - interest income has historically been taxed at the same rate as ordinary income (top marginal rate is 39.6%) whereas qualified dividends and long-term capital gains were at the much lower capital gains rate (20% + 3.8% Obamacare surcharge).

Trump's election has, however, turned this advice on its head. Both him and the House leadership call for changing tax rates, such that dividends/capital gains and interest income are taxed at the same (lower) rate, equal to 50% of a taxpayer's ordinary income rate(achieved through something called a 50% "exclusion"). For earners in the highest bracket (33% - as proposed under the Republican Act), bond (and bond-like) income will be taxed at a 16.5% marginal rate. For high-earners, it is hard to overstate the significance of this. Imagine your tax rate going from 39.6% to 16.5%, or a decrease of over 40%, overnight and how it would impact your investment mix. Consider the table below for the implications for all taxpayers:

Marginal Rate

(current law) (%)

Marginal Rate

(proposed law) (%)

Interest Income Tax Rate

(current law) (%)

Interest Income Tax Rate

(proposed law) (%)

Increase in After-Tax Income (%)

10

12

10

6

40

15

12

15

6

60

25

25

25

12.5

50

28

25

28

12.5

55

33

33

33

16.5

50

35

33

35

16.5

53

39.6

33

39.6

16.5

58

Let's break this down: for a taxpayer currently in the highest bracket, their tax rate on bond and interest income would be decreased by 58%! Even for taxpayers in the lowest bracket, such income would be taxed 40% less than before. What's also implied here is that taxes on equity investments will go up for certain taxpayers in the lower tax brackets, some of whom pay no tax on capital gains.

So, how can an investor take advantage of this? First, two caveats. One: this is a PROPOSED plan and, although likely in my opinion to be enacted, there are certainly no guarantees in politics. Second: this is not to be construed as tax or legal advice. Consult an accountant and/or attorney before making any investment decisions and, as always, do not rely on the opinions or advice of others without doing your own due diligence.

That being said, if such a tax plan were enacted, there are certain investments that become more significantly more attractive, on an after-tax basis, to investors in the highest tax brackets. Hint: they are all bonds or "bond-like" (i.e., pays interest income) and were previously taxed at ordinary income rates. Following are some of such investments:

Bonds of any kind Preferred Stocks REITs MLPs High-yield savings accounts Lending Club and other P2P lending sites that sell debt-like securities Real estate investing (Fundrise, Realty Mogul, RealtyShares)

Particularly with rates rising, many of these asset classes have sold off and may be worth a second look with this in mind (though, of course, taxes are only relevant if you have gains to tax them at!).

One final thought: many investors ignore taxes as nothing more than another transaction cost. I used to think similarly, but one article completely changed my perspective. Without repeating the conclusion of the article, essentially taxes have the potential to turn a phenomenal year into one in which you underperformed your friends who sat the year entirely in index funds (yes, I know, another plug for index funds).