Quick Read
Tax location matters: Holding taxable bond ETFs like BND in a taxable brokerage account can significantly reduce after-tax returns because much of the income is taxed as ordinary income.
Small differences add up: On a $400,000 bond allocation, Vanguard’s own after-tax return figures imply roughly $6,600 less wealth over one year compared with the pre-tax return assumption.
Municipal bonds deserve a look: VTEB offers federally tax-exempt income and can provide a more tax-efficient bond allocation for many retirees investing outside tax-advantaged accounts.
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Despite its shortcomings during years like 2022, I still think the classic 60/40 portfolio of stocks and bonds remains one of the better frameworks for retirement investing. It’s diversified, inexpensive to implement with index ETFs, intuitive to understand, and easy to rebalance over time.
Much of the criticism surrounding the strategy has focused on whether bonds can still provide meaningful downside protection when inflation is high and interest rates are rising. That’s a fair debate. However, I think another issue deserves more attention: taxes.
A common choice for the 40% bond allocation is the Vanguard Total Bond Market ETF (BND). I have nothing against the fund itself. Paying just a 0.03% expense ratio for exposure to more than 11,000 investment-grade corporate bonds, U.S. Treasuries, and agency mortgage-backed securities is an excellent value.
The problem isn’t the ETF. It’s where many retirees hold it. Because much of BND’s income is taxed as ordinary income, the annual tax bill can quietly erode returns. On a large retirement portfolio, that tax drag can easily amount to thousands of dollars every year. Let’s run the numbers using a $1 million portfolio with a 60/40 allocation to see just how large that gap can become.
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Why BND Can Create Tax Drag
The issue comes down to the type of income BND generates. While the fund does own U.S. Treasury securities, it also holds a substantial allocation to investment-grade corporate bonds. Interest from corporate bonds is generally taxed as ordinary income at the federal level and, unlike Treasury interest, is also typically subject to state and local income taxes.
That differs from Treasury bond funds, whose Treasury interest is generally exempt from state and local income taxes, and municipal bond funds, whose income is generally exempt from federal income tax. The impact becomes noticeable over time.
