Taxable Bond vs. Tax-exempt Bond within a Rollover IRA

[Daylily]

I have a check coming to me from my former employer that is payable to my Vanguard Rollover IRA. I would like to use the proceeds to invest in bonds because the remainder of the money in my Rollover IRA is in stock funds.

I want to make sure that I understand Taxable vs. Tax-exempt when it comes to bonds. Here is my perception:

Within my IRA, the taxable bond would not be taxable until I withdrew the funds at retirement. This would be the same for my other stock funds.

Within my IRA, it doesn’t make sense to purchase tax-exempt bonds because the IRA is already tax exempt until I make withdrawals and the tax-exempt bonds generally have lower yields.

Is this correct?

[scfr]

Correct

[MonkeyMama]

Yes - this is correct. IRAs are not taxed based on what is in the fund at all. So whether you invest aggressively in funds and stocks that reap in 10%+ per year, or if you invest in tax-exempt funds, they are all treated the same - taxed as ordinary income when you withdraw the funds. For this reason it is redundant to consider any tax-saving funds or bonds for IRAs.

You would consider bonds for different reasons - if you are extremely conservative and want the more steady income of bonds (as you near retirement).

[Daylily]

Originally Posted by MonkeyMama

For this reason it is redundant to consider any tax-saving funds or bonds for IRAs.

The bonds you mention above are only the tax-exempt bonds?
It would be okay to have taxable bonds in the IRA without the issue of the redundancy?

[scfr]

Absolutely okay to have taxable bonds in the IRA.

We have 2 bond funds with Vanguard:

- The Taxable Bond fund is inside our tax-deferred plan (what we have is a Keogh ... same idea as an IRA ...)

- The Tax-Exempt Bond fund is outside of our tax-deferred plan

These choices were made not only based on our readings and knowledge, but were confirmed as proper choices by a CFP.

[kv968]

You're correct in your thinking that you should hold taxable bonds in an IRA as opposed to tax-exempt bonds.

Basically you want to try to have your least tax-inefficient holdings in a tax-deferred account (ie. 401k, IRA, etc...). Taxable bonds are about the most tax-inefficient asset you can hold, as are REIT funds. Therefore these should be held in a 401k or IRA if applicable. Tax-exempt bonds however shouldn't really be held in such an account because you're defeating the purpose of the tax-deferring..

[Scanner]

Agree with other posters - I often recommend tax-free muni bonds here as a place to stick money but it often gets ignored ( I fear ) because of the teaser internet savings account high interest rates.

I think more of the forum should be using muni bonds as vehicles but yes, not for IRA's.

I'm a big fan of them.

[sweeps]

Originally Posted by Scanner

I often recommend tax-free muni bonds here as a place to stick money but it often gets ignored ( I fear ) because of the teaser internet savings account high interest rates.

Well not exactly. First, online savings account interest rate are pretty stable. If these are teaser rates, they're an awfully long tease.

Also muni bonds only make sense for people with relatively high federal and state income taxes. Most people wouldn't earn more than a savings account even after taxes are taken out. And finally, bond prices fluctuate and once in a blue moon muni bond issuers default resulting in a loss of principal.

[Scanner]

Well not exactly. First, online savings account interest rate are pretty stable. If these are teaser rates, they're an awfully long tease.

Well, I think the everbank one had a rate of 6.01% and then it dropped to 3.4%. . .now assuming a middle tax bracket, that would net about a 2.4% return.

Also muni bonds only make sense for people with relatively high federal and state income taxes. Most people wouldn't earn more than a savings account even after taxes are taken out.

I disagree - I think the middle tax bracket can benefit.

And finally, bond prices fluctuate and once in a blue moon muni bond issuers default resulting in a loss of principal.

Yeah, if you are going to trade the bond, I wouldn't mess with it.

If you are concerned about principal risk, the answer is to buy insured muni bonds. Your yield right now would be about 3.5% but since it's tax-free, that's more like a 4.5-5% return.

[sweeps]

Everbank is a really bad example -- and isn't even a savings account. It's a 3 month promo for a checking account.

As I've stated in another thread, people greatly overexaggerate their actual tax rate. One may be in a 28% tax bracket, for example, but their actual tax rate is usually much lower. If you live in a high-tax state like California, you may have a shot of a muni being the best deal, but I still would challenge someone to run the numbers.

Assuming you can actually achieve a before-tax rate of 5% on an insured muni, why bother? One could put that money in a GMAC savings account -- FDIC insured -- and earn 5.30%.