Municipal Bonds Belong in a Taxable Account, Not an IRA or 401(k)
Some things that are great individually simply don’t go together – like peanut butter and pizza. The same holds true for municipal bonds and retirement accounts.
Tax-free investments typically pay lower yields than their taxable equivalents, but their after-tax yields are often higher than the yields on taxable equivalents. This benefit can only occur if you hold tax-exempt investments in a taxable account.
If you hold them in a retirement account, where taxes are deferred, you gain no benefit from the tax-free nature of the investment – all you get is the lower yield.
Not only does putting municipal bonds in a retirement account take away the tax benefit associated with munis, it also creates an opportunity cost. By allocating dollars within a tax-deferred account to an investment that is already tax-exempt, an investor is missing the opportunity to shelter other investments from taxation.
As a result, investors should strive to hold taxable income-paying securities – such as dividend-paying stocks – in IRA or 401(k) accounts, while holding tax-free investments in a taxable account.
Making the Most of Tax Benefits
Consider this example. In late February, 2014, the iShares 7-10 Year Treasury Bond ETF (IEF) had a 30-day SEC yield of 2.3%. On the same day, the iShares National AMT-Free Muni Bond ETF (MUB) also offered a yield of 2.3%. But here’s the key point: since municipal bonds are tax-exempt, an investor with a 28% tax rate has a higher tax-equivalent yield on the municipal bond fund: 3.2% to be exact.
By holding this fund in an IRA or 401(k), this tax benefit is taken away and all the investor gets is the 2.3% yield. This approach therefore makes no sense, and it is best avoided at all costs.
This brings us to a more general consideration: allocating investments among your various accounts (regular account, IRA, 401(k), etc.) in such a way as to maximize tax benefits. In any given year, this type of allocation decision may not make a huge difference. Over time, however, these small differences can add up to be quite a bit – which means that investors need to take advantage of every benefit that Uncle Sam provides. For more on this topic, see my article “Should You Own Bonds in an IRA?”
Does this mean you can’t hold municipal bonds in a retirement account? Not at all – the option is certainly available for someone who chooses to take this route, or for someone whose entire portfolio is invested in municipal bonds. However, allocating munis to taxable account options enables investors to gain the full benefit of the options available to minimize taxes.
Disclaimer: 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. Always consult an investment advisor and tax professional before you invest.
Tax-free investments typically pay lower yields than their taxable equivalents, but their after-tax yields are often higher than the yields on taxable equivalents. This benefit can only occur if you hold tax-exempt investments in a taxable account.
If you hold them in a retirement account, where taxes are deferred, you gain no benefit from the tax-free nature of the investment – all you get is the lower yield.
Not only does putting municipal bonds in a retirement account take away the tax benefit associated with munis, it also creates an opportunity cost. By allocating dollars within a tax-deferred account to an investment that is already tax-exempt, an investor is missing the opportunity to shelter other investments from taxation.
As a result, investors should strive to hold taxable income-paying securities – such as dividend-paying stocks – in IRA or 401(k) accounts, while holding tax-free investments in a taxable account.
Making the Most of Tax Benefits
Consider this example. In late February, 2014, the iShares 7-10 Year Treasury Bond ETF (IEF) had a 30-day SEC yield of 2.3%. On the same day, the iShares National AMT-Free Muni Bond ETF (MUB) also offered a yield of 2.3%. But here’s the key point: since municipal bonds are tax-exempt, an investor with a 28% tax rate has a higher tax-equivalent yield on the municipal bond fund: 3.2% to be exact.
By holding this fund in an IRA or 401(k), this tax benefit is taken away and all the investor gets is the 2.3% yield. This approach therefore makes no sense, and it is best avoided at all costs.
This brings us to a more general consideration: allocating investments among your various accounts (regular account, IRA, 401(k), etc.) in such a way as to maximize tax benefits. In any given year, this type of allocation decision may not make a huge difference. Over time, however, these small differences can add up to be quite a bit – which means that investors need to take advantage of every benefit that Uncle Sam provides. For more on this topic, see my article “Should You Own Bonds in an IRA?”
Does this mean you can’t hold municipal bonds in a retirement account? Not at all – the option is certainly available for someone who chooses to take this route, or for someone whose entire portfolio is invested in municipal bonds. However, allocating munis to taxable account options enables investors to gain the full benefit of the options available to minimize taxes.
Disclaimer: 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. Always consult an investment advisor and tax professional before you invest.