Should You Own Bonds in an IRA?

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Individual retirement accounts (IRAs) are typically thought of as a place for long-term investments such as stock funds. Still, bonds can play an essential part in retirement planning—particularly as investors move closer to the end of their earning years.

Learn how to use bonds in your IRA to reduce taxes and maximize your returns.

Key Takeaways

  • Stocks tend to perform better than bonds over time, but older investors may shift their IRA balance toward bonds as they approach retirement age.
  • IRAs can effectively increase the yield of some bonds by decreasing the tax burden.
  • Municipal bonds are already tax-advantaged, so it isn't a good idea to hold those investments in an IRA.

A Short IRA Review

For those 49 and under, an individual retirement account allows investors to contribute $6,500 per year, or the individual's taxable compensation for the year if less. People over the age of 50 can contribute $7,500 per year, which includes catch-up contributions.

Investors don't have to pay taxes on the interest and capital gains they earn within a traditional IRA. Instead, they pay taxes on these distributions as regular income when they begin taking distributions (such as removing money from the IRA).

Note

IRAs are excellent tax shelters for your money. Taxes are deferred until you retire.

The IRA owner can begin taking these distributions without penalty at age 59 ½, but they aren't required to take a distribution until April 1 of the year that follows the year they turn age 72.

It's important to think of your IRA 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 if you have other investments that hedge the risk of focusing on one type of investment.

Instead, investors can use an IRA strategically to hold investments that generate the highest level of taxable income or capital gains distributions. That way, the tax is deferred until a much later date, rather than being due at tax time.

Traditional IRAs have an income cap if you decide to contribute to them. Normally, the contribution is deductible against your earned income if you make less than certain limits. For example, if you're single and have a workplace retirement plan, you can deduct your contributions if you make under $68,000 in 2022. After this income level, the deduction amount decreases to zero once you make $78,000 or more. Those limits rise annually to keep pace with inflation. In 2023, you can deduct your full contribution if you make less than $73,000 per year and take a partial deduction if you make less than $83,000.

Traditional IRAs still allow you to contribute to them after this income level. It's just the amount you can deduct on your taxes that is decided by your income and whether you have a workplace retirement plan. The IRA.gov website or a tax professional can tell you what your options are in more detail.

IRAs Can Increase Bond Yield

The tax-deferred nature of IRAs is the reason investors place bond funds in their IRA. Since the income produced by bond funds is taxable, investors who generate this income in non-taxable accounts can defer their taxes until they begin to draw from the account, usually increasing the overall amount they receive.

For example, an investment with a 4% yield offers an after-tax yield of only 3% to an investor in the 25% tax bracket—paying taxes reduces the amount they receive. If the investment is moved to a tax-deferred IRA, the investor defers the capital gains tax until after they retire.

Note

High-yield bonds, emerging market bonds, or any other market segment that produces above-average income are typically well-suited for an IRA account.

Since income is generally lower in retirement, the investor will have an excellent chance of ending up in a tax bracket that doesn't need to pay capital gains taxes. This strategy has the effect of increasing the investment's yield.

Gains on Bonds Are Income

Stocks are more likely to produce long-term capital gains—and the associated tax liability—than bonds. However, bond and bond fund interest falls under income for tax purposes, which adds to an investor's taxable income. The IRS taxes long-term capital gains (gains on the sale of assets held more than one year) at lower rates than income.

Tax Deferment and Implications

Most investors pay 15% on long-term capital gains. Single investors who earn more than $445,850 yearly pay 20% on capital gains, as do other investors whose income exceeds thresholds for the 15% tax rate.

Note

Investors with less than $40,400 in annual income are generally not taxed on long-term capital gains.

Because interest on bonds is regarded as income, placing them in an IRA reduces an investor's near-term tax liabilities because it defers the higher income taxes. For this reason, buy-and-hold stock investments and tax-efficient stock funds are more suitable for a regular (non-IRA) account because the interest they produce is taxed at a lower rate.

Keep in mind that trading accounts or stock funds that generate a lot of short-term capital gains work well in an IRA because the gains are taxed as ordinary income.

Portfolio Re-Balancing

It's also important to note that an investor's life stage plays a role in bond placement. 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.

In general, investors tend to re-balance their portfolios in favor of bonds as they grow older. As the investor ages, they sell their stocks and use the funds to purchase bonds with maturity dates that coincide with when they want the funds. This has the effect of preserving their investment principal while generating gains at the same time.

Municipal Bonds in an IRA

One of the most critical considerations is to ensure you avoid placing municipal bonds (munis) in an IRA. The primary attraction of munis is that the interest on individual muni bonds and municipal bond funds is tax-exempt, which means they also tend to offer lower pre-tax yields than taxable bonds.

Note

The key to strategically using an IRA is to use the tax advantages of the account on investments that otherwise don't provide an advantage.

Since the interest and capital gains in an IRA are already tax-exempt, there isn't any benefit to holding munis in an IRA. Instead, use a regular (non-IRA) account to hold munis and save the IRA for other investments that require a tax shelter.

TIPS in an IRA

Treasury Inflation-Protected Securities (TIPS) can be a good choice for an IRA account. The principal value of a TIPS rises in conjunction with inflation, allowing investors to generate a positive real (after-inflation) return.

However, the catch is that the bonds' value adjusts each year from when the bond is issued until it matures—and investors need to pay a tax on this upward adjustment. If an investor places TIPS in an IRA, it allows them to gain the full benefit of the inflation adjustment and avoid paying the annual tax.

A Final Thought

Tax considerations are a crucial element of a sound investment strategy since they can help investors maximize their after-tax returns. But keep in mind that the essential 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"—or don't let the tax advantages dictate your investment strategy.

Frequently Asked Questions

How much of my IRA should be in bonds?

The exact portion of your portfolio to hold in bonds depends on your age and investment goals. One rule of thumb is to own your age in bonds, with the rest in stocks and cash; for a 45-year-old investor, this would mean holding 45% of your portfolio in bonds. But another rule of thumb suggests holding a 50-50 split between stocks and bonds, as long as you expect to live at least another 15 years. Your financial advisor can help you refine your own personal investment mix.

Can I buy I-bonds with my IRA?

You can't buy an I-bond with your IRA. I-bonds are a type of savings bond issued by the U.S. Treasury Department. They provide a fixed rate of interest plus protection from inflation. You'll need to buy it straight from the Treasury, either electronically, through your company's payroll department, or via your federal income tax refund. TIPS are the inflation-protected security you can buy through your IRA.

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