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Dan Danford  |  January 30, 2020

EXPERTS OFTEN suggest putting bonds or bond funds in retirement accounts. I think this is kind of dumb—or, at the very least, it places the focus on the wrong thing.

It’s always a good idea to consider taxes. But my experience is that many people place too much emphasis on taxes, often to their own detriment. Municipal bonds are a great example of this: Many people who purchase them are in lower tax brackets, where the tradeoff between the tax savings and the lower yield doesn’t work in their favor. But they’re so strongly opposed to paying taxes that they buy them anyway, even though they’d be better off buying taxable bonds, collecting the higher yield and paying taxes on that income.

I recently reviewed a portfolio for a couple in their 90s. Their broker had been helping them buy municipal bonds for decades. I was appalled to discover a sizable portfolio invested in multiple individual bonds, most maturing 20 to 30 years from now. Of course, all the interest is tax-free, but their current marginal tax rate is low, the price of their bonds is highly volatile and I’d guess their broker made a Brink’s truck worth of commissions or spreads off that portfolio. He’ll do it again when he liquidates the bonds after both spouses are gone.

Back to retirement accounts. Let’s assume bonds are paying 3% a year. It’s correct that you’d end up paying annual income taxes on that interest in a regular, taxable brokerage account. But in truth, it wouldn’t be a lot of tax, because it’s not a lot of income.

Yes, if you put the bonds in a 401(k) or IRA, you’d avoid that little bit of tax every year. But you’ve also limited the tax-deferred annual growth of your 401(k) or IRA to just 3%. The opportunity cost of that choice is huge. You’ve given up tax-deferred compounding at a much higher rate for decades to come. Compare the compound growth of $50,000 for 20 years at 3% to 20 years at 6%. The difference is $70,000. And a 6% return for a diversified stock portfolio will, I suspect, prove to be a conservative estimate.

To be sure, that extra $70,000 will be subject to income taxes when withdrawn, but those taxes can be mitigated though good decisions when the time comes. In fact, 401(k) and IRA money can stay tax-deferred for decades and decades. Even with the elimination of the stretch IRA—part of the new SECURE Act—much of that money will still grow tax-deferred throughout your life, your spouse’s life and 10 years of your heir’s life.

Remember, asset allocation is a huge part of long-term investment success. One study even found that more than 90% of the variation in quarterly portfolio performance can be explained by the target allocation for stocks, bonds and cash investments.

From a purely tax standpoint, keeping bonds in tax-deferred accounts can make some sense. But that also means giving up potentially far higher compound growth in your IRA. The bottom line: Think about the unintended consequences of your choices—and focus less on tax savings and more on opportunity cost.

Dan Danford is a Certified Financial Planner with the Family Investment Center in Kansas City, Missouri. He learned early on about money from his father, who charged rent on the family lawnmower when Dan cut neighborhood lawns. Dan is a member of the National Association of Personal Financial Advisors and author of Stuck in the Middle: The Mistakes That Jeopardize Your Financial Success and How to Fix Them. His previous articles were Value for Money and Fake News.

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