It is rare for there to be absolute rules in life, but there is one mistake you should not make as a new investor. It may seem that holding tax-free municipal bonds in a tax-protected account, such as a Roth IRA, is a great way to enhance your tax-free investments, but this is a financial mistake.
Advantages and Limitations of a Roth IRA
One of the main benefits of your Roth IRA is that all income generated within it is tax-protected. There are no taxes on dividends, no taxes on interest, no taxes on rents, and no taxes on capital gains.
The yield on tax-free municipal bonds is already tax-exempt, so you gain no additional benefit from placing them in a Roth IRA. Most investors can contribute up to $6,000 annually to a Roth IRA for the tax years 2021 and 2022.
Note: It is better to limit your contributions to your Roth IRA to investments that will be subject to taxes instead, due to the contribution limit.
Tax-Free Municipal Bonds Yield Less Than Taxable Bonds
Tax-free municipal bonds yield less than their taxable counterparts, such as corporate bonds and government bonds. You should calculate the equivalent taxable yield to balance them. In November 2021, AAA-rated taxable corporate bonds yielded about 2.62%, while AAA-rated 30-year municipal bonds yielded 1.70% in December 2021.
This difference of more than 1% is not trivial. Imagine you have $100,000 in a Roth IRA after years of saving diligently. You would be looking at two bonds in this case, both rated AAA, both maturing in 30 years. You would receive $2,620 annually in interest from the corporate bond, while you would only receive $1,700 annually from the municipal bond. No sane person would leave $920 on the table.
The power of your Roth IRA is significant enough that it effectively makes corporate bonds tax-free as well.
Asset Location in a Roth IRA
A portfolio management strategy known as “asset location” considers such scenarios, often relying on the Roth IRA. You can work to maximize the after-tax net cash you can keep by looking at where your passive income is generated and considering the types of income that are taxable based on how they are held.
Imagine you have no assets other than a $500,000 portfolio, with $250,000 held in a Roth IRA and $250,000 in a taxable brokerage account. You have only two investments. The first is a collection of bonds yielding 5%, or $12,500 total each year. The second is a collection of high-quality stocks that do not pay dividends.
You would receive $9,500 of net after-tax income annually if you placed the non-dividend-paying stocks in the Roth IRA and kept the taxable bonds in the brokerage account, assuming you are in the 24% tax bracket.
But you would get to keep all $12,500 if you switched those two investments and placed the taxable bonds in the Roth IRA and the non-dividend-paying stocks in the brokerage account. That amounts to an additional $3,000, or 24% of the extra money you otherwise wouldn’t have had, due to how you hold your investment positions. Your savings could be even greater if you are in a higher tax bracket.
Of course,
This assumes that the money is not needed for another purpose, such as living expenses. The asset allocation may not be in your best interest if that is the case.
Note: An additional $3,000 invested at a 7% return for 30 years would amount to approximately $300,000. Indeed, paying attention to your assets and where you place them is crucial.
General Rule for Investments in a Roth IRA
Each individual’s circumstances are unique, but there is a general rule for investments in a Roth IRA that you should aim to place tax-inefficient securities and assets into the account, while keeping tax-efficient securities and assets in other standard types of accounts. These may include direct registration, automatic investment programs, and brokerage accounts.
Assets that tend to appreciate are generally more tax-efficient compared to those that generate most of their wealth in cash. Regular corporate bonds often make a good option for a Roth IRA, as well as dividend-paying stocks and real estate investment trusts.
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Sources:
Internal Revenue Service. “Retirement Topics: IRA Contribution Limits.”
Federal Reserve Economic Data. “Moody’s Seasoned AAA Corporate Bond Yield.”
FMSbonds. “Municipal Market Yields.”
Source: https://www.thebalancemoney.com/holding-tax-free-municipal-bonds-through-a-roth-ira-358034
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