Should You Own Bonds in an IRA?

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Individual retirement accounts (IRAs) are typically thought of as home to long-term investments such as stock funds, but bonds can play an important part in retirement planning – particularly as investors move closer to the end of their earning years.

How IRAs Work

First, a quick review of how IRAs work. For those 49 and under, an individual retirement account allows investors to contribute the greater of $5,500 or the individual’s taxable compensation for the year, based on 2014 rules. Those aged 50 and over can contribute $6,500 per year.

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. The IRA owner can begin taking these distributions without penalty at age 59 ½, but he or she isn’t required to take a distribution until age 70 ½. The full list of IRA rules is available from the Internal Revenue Service.

The IRA as Part of the Total Picture

With regard to the IRA investment strategy, it’s important to think of the account 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. Instead, it can be used strategically to hold investments that are most likely to generate the highest level of taxable income and/or capital gains distributions. That way, the tax is deferred until a much later date, rather than being due in the following April.

Making the Most of the Tax Exemption

The tax-deferred nature of IRAs is the reason investors are often advised to put bond funds in their IRA. Since the income produced by bond funds is taxable, investors who generate this income in taxable accounts can see a substantial hit to their after-tax returns. Looked at another way, an investment with a 4% yield offers an after-tax yield of only 3% to an investor in the 25% bracket. As a result, high-yield and emerging market bonds – or any other market segment that produces above-average income – are typically well suited to an IRA account.

Stock Funds: IRA or Regular Account?

How do stocks work into the equation? After all, stocks are more likely to produce long-term capital gains – and the associated tax bill – than bonds. However, long-term capital gains (gains on the sale of assets held more than one year) are currently taxed at more favorable rates than income (a category includes the interest from bonds and bond funds). Under 2014 rules, investors in the 25%, 28%, 33%, or 35% tax brackets pay 15% on long-term capital gains, while those in the 39.6% bracket pay 20%. Those in the sub-25% brackets have a 0% tax rate on long-term capital gains.

Generally speaking, buy-and-hold stock investments and tax-efficient stock funds are therefore more suitable for a regular (non-IRA) account, while bonds are more suitable for tax-deferred vehicles such as IRAs.

Having said that, trading accounts or stock funds that throw off a lot of short-term capital gains are good choices for an IRA rather than a regular account. Keep in mind that this is only a general guide and that each individual has a different situation.

It's also important to note that life stage plays a role. 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. Over time, however, investors typically rebalance their portfolios in favor of bonds as they grow older and need to preserve principal. In this case, it may make sense to use the IRA for this purpose.

Avoid Holding Municipal Bonds in an IRA

One of the most important considerations is making sure to avoid owning municipal bonds in an IRA. The primary attraction of munis is that the interest on both 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. Since the interest and capital gains in an IRA is 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.

TIPS in an IRA

Treasury Inflation-Protected Securities (TIPS) can be a good choice for an IRA account. The principal value of TIPS rises in conjunction with inflation, which allows investors to generate a positive real (after-inflation) return. However, the catch is that the value of the bonds adjusts each year from the time the bond is issued until it matures – and investors need to pay a tax on this upward adjustment. Holding TIPS in an IRA, therefore makes sense, because it allows investors to gain the full benefit of the inflation adjustment and avoid the headaches associated with paying this annual tax.

A Final Thought

Tax considerations are a key element of a sound investment strategy since they can help investors maximize their after-tax returns. But keep in mind, that the more important 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.”

Also, keep in mind that this is only a guide. If you have specific questions about your personal situation, be sure to contact a fee-only financial advisor.

The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Be sure to consult investment and tax professionals before you invest.