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To be sure, that extra $70,000 will be subject to income taxes when withdrawn, but those taxes can be mitigated though good decisions when the time comes.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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While Mr. Danford has made some valid comments about not letting the desire to avoid taxes wag the investment dog (i.e. I 100% agree that municipal bonds likely shouldn’t be in tax-deferred accounts) I think he greatly oversimplifies the topic of optimizing asset location and therefore arrives at the incorrect conclusion that holding bonds in retirement accounts is “dumb”. There are a lot of individual factors that go into determining an ideal asset location strategy and in a great deal of cases, bonds should be held in your tax-deferred account. If you have the time I might suggest some more thorough resources on the topic of asset location at the bottom. They do a great job of explaining why putting tax inefficient investments such as bonds in tax deferred accounts is in many cases smart, not dumb. I will finish by saying Mr. Danford is right in his recommendation in cases where bond yields are paltry as they are today, but this won’t always be the case so it’s good to understand what matters in setting your plan. We worry about shaving basis points off our index fund fees, why not give similar care to minimizing taxes along the way.
Guilty …sort of. I like interest free income. It’s not totally logical, but it’s addictive. On the other hand I don’t use municipal bond funds for growth. When I take an RMD I put the net into a bond fund and reinvest the interest. Very likely I could earn a higher rate elsewhere, but still tax free …. so appealing; finally something for nothing. 🤣 My logic is I’m building an income stream my wife can use should she survive me.
Good points I should have given more thought to. But to get bond funds into my taxable account now I’d have to sell stock funds in the same account and pay taxes on those gains. In the non-taxable account it’s no problem switching back and forth between stock and bond funds.
So I’m in the 22% tax bracket. Not close to the next bracket. Are you saying I could do a Wellington fund in my taxable and just pay the taxes? Instead of buying a muni bond. I have a all stock portfolio in my Roth and 401k. Thanks.