Should You Own Bonds in an IRA?

Bonds may be a good idea for your individual retirement account (IRA) if you are looking to invest in a more conservative way, such as if you're nearing retirement age. While stocks perform better, they're riskier. A diverse portfolio made up of both stocks and bonds is a good strategy. Just be sure to reallocate investments over time as your risk tolerance changes.

Here's how bonds in your IRA can help reduce taxes and maximize your returns.

A Short IRA Review

For those 49 and under, an individual retirement account allows investors to contribute $6,000 for tax year 2022, or the individual's taxable compensation for the year if less. People over the age of 50 can contribute $7,000 for 2022, which includes catch-up contributions. For 2023, those limits are $6,500 and $7,500, respectively.

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).

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, unless they're turning age 72 in 2023. In that case, the required minimum distribution doesn't start till they turn 73. It goes up to 75 in 2033.

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 and want to take a deduction at tax time. 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.

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 earned more than $459,750 in 2022 pay 20% on capital gains, as do other investors whose income exceeds thresholds for the 15% tax rate.

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.

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