Should You Own Bonds in an IRA?
Individual retirement accounts (IRAs) are typically thought of as a place for long-term investments such as stock funds, but bonds can play an essential part in retirement planning—particularly as investors move closer to the end of their earning years.
Learn how to use bonds in your IRA to reduce taxes and maximize your returns.
A Short IRA Review
For those 49 and under, an individual retirement account allows investors to contribute the greater of $6,000 or the individual’s taxable compensation for the year. People over the age of 50 can contribute $7,000 per year, called catch-up contributions.
Investors don’t have to pay taxes on the interest and capital gains they earn within the IRA. Instead, when they begin taking distributions (i.e., removing money from the IRA), they pay taxes on these distributions as regular income.
IRAs are excellent tax shelters for your money. Taxes are deferred until you retire.
The IRA owner can begin taking these distributions without penalty at age 59.5, but they aren't required to take a distribution until April 1 of the year that follows the year they turned age 72.
It’s important to think of your IRA as part of your overall investment plan and not as a distinct entity. In other words, the IRA doesn’t have to be fully diversified on its own if you have other investments that hedge the risk of focusing on one type of investment.
Instead, investors can use an IRA strategically to hold investments that generate the highest level of taxable income or capital gains distributions. That way, the tax is deferred until a much later date, rather than being due at tax time.
IRAs Can Increase Bond Yield
The tax-deferred nature of IRAs is the reason investors place bond funds in their IRA. Since the income produced by bond funds is taxable, investors who generate this income in non-taxable accounts can defer their taxes until they begin to draw from the account, usually increasing the overall amount they receive.
For example, an investment with a 4% yield offers an after-tax yield of only 3% to an investor in the 25% tax bracket—paying taxes reduces the amount they receive. If the investment is moved to a tax-deferred IRA, the investor defers the capital gains tax until after they retire.
High-yield bonds, emerging market bonds or any other market segment that produces above-average income are typically well-suited for an IRA account.
Since income is generally lower in retirement, the investor will have an excellent chance of ending up in a tax bracket that doesn't need to pay capital gains taxes. This strategy has the effect of increasing the investment's yield.
Gains on Bonds Are Income
Stocks are more likely to produce long-term capital gains—and the associated tax liability—than bonds. However, bond and bond fund interest falls under income for tax purposes, which adds to an investor's taxable income. The IRS taxes long-term capital gains (gains on the sale of assets held more than one year) at lower rates than income.
Tax Deferment and Implications
Some investors in the 22% tax bracket and all investors in the 24%, 32%, or 35% tax brackets pay 15% on long-term capital gains. Investors in higher tax brackets pay 20% on capital gains that exceed the thresholds for the 15% capital gains tax rate.
Investors with less than $80,000 in annual income are generally not taxed on long-term capital gains.
Because interest on bonds is regarded as income, placing them in an IRA reduces an investor's near-term tax liabilities because it defers the higher income taxes. For this reason, buy-and-hold stock investments and tax-efficient stock funds are more suitable for a regular (non-IRA) account because the interest they produce is taxed at a lower rate.
Keep in mind is that trading accounts or stock funds that generate a lot of short-term capital gains work well in an IRA because the gains are taxed as ordinary income.
It's also important to note that an investor's life stage plays a role in bond placement. Since stocks tend to outperform bonds over time, a younger person who may have as many as 50 years to invest could see substantially higher capital gains from stocks rather than bonds, which would argue for putting stocks in an IRA at first.
In general, investors tend to re-balance their portfolios in favor of bonds as they grow older. As the investor ages, they sell their stocks and use the funds to purchase bonds with maturity dates that coincide when they want the funds. This has the effect of preserving their investment principal while generating gains at the same time.
Municipal Bonds in an IRA
One of the most critical considerations is to ensure you avoid placing municipal bonds (munis) in an IRA. The primary attraction of munis is that the interest on individual muni bonds and municipal bond funds is tax-exempt, which means that they also tend to offer lower pre-tax yields than taxable bonds.
The key to strategically using an IRA is to use the tax advantages of the account on investments that otherwise don't provide an advantage.
Since the interest and capital gains in an IRA are already tax-exempt, there isn’t any benefit to holding munis in the IRA. Instead, use a regular (non-IRA) account to hold munis and save the IRA for other investments that require a tax shelter.
TIPS in an IRA
Treasury Inflation-Protected Securities (TIPS) can be a good choice for an IRA account. The principal value of a TIPS rises in conjunction with inflation, allowing investors to generate a positive real (after-inflation) return.
However, the catch is that the bonds' value adjusts each year from when the bond is issued until it matures—and investors need to pay a tax on this upward adjustment. If an investor places TIPS in an IRA, it allows them to gain the full benefit of the inflation adjustment and avoid paying the annual tax.
A Final Thought
Tax considerations are a crucial element of a sound investment strategy since they can help investors maximize their after-tax returns. But keep in mind that the essential components of a well-thought-out plan are your objectives, risk tolerance, and time horizon. As the old saying goes, “Don’t let the tax tail wag the investment dog”—or don't let the tax advantages dictate your investment strategy.