There are hardly any rules in life which are complete, but under the tax laws which have been in place for years, there’s one error that you, as a new investor, should never commit. I see it all of the time.
What’s this fiscal fallacy?
Holding tax-free municipal bonds at a tax-sheltered accounts like a Roth IRA.
The Advantages and Limits of a Roth IRA
Do not forget that the significant advantage of your Roth IRA is that virtually all income earned within its protective shell is free of taxes. There are no dividend taxation, no interest taxes, no lease taxes, and no capital gain taxes.
However, the return on municipal bonds is already tax-free. So there is no additional advantage to placing them in a Roth IRA.
It is worth noting that using a Roth IRA, most investors can only contribute $5,500 annually. Given that restriction, it is best to limit your contributions to investments that would otherwise be taxed.
Tax-Free Municipal Bonds Yield Less Than Regular Taxable Bonds
Here is some math to help illustrate why putting municipal bonds in a Roth IRA is a bad idea.
It’s a truism that tax-free municipal bonds yield less than their taxable counterparts (corporate bonds, Treasury bonds, et cetera). To set them on parity, you have to calculate something called the taxable equivalent yield, that you may read more about. As of June 2018, 20-year AAA corporate bonds, which are fully taxable, are affording 3.85%, while 20-year AAA tax-free municipal bonds are yielding 2.95%.
That gap of nearly 1% isn’t insignificant.
Imagine you had $100,000 in your Roth IRA, built over years of carefully saving money. In cases like this, you would be considering two bonds, each of which are rated AAA, and both of which mature in 20 years. Still, the corporate bond will pay you $3,850 in interest annually, while the municipal bond will pay you $2,950 in interest annually. No sane person would give up the $900 in free cash that’s sitting on the table.
The ability of your Roth IRA is so great that it basically makes the corporate bonds tax-free, too!
Pay Focus to Asset Positioning Should You’ve Got a Roth IRA
There’s a form of portfolio management strategy called asset positioning that points in these kinds of situations, many of which rely upon a Roth IRA. By taking a look at where you create your passive income, and looking at which kinds of income are taxed based on how they are held, you can work to maximize the entire after-tax cash which you can keep.
Picture yourself with no assets except a $500,000 portfolio with $250,000 in a Roth IRA and $250,000 in a taxable broker account. You have just two investments. The first is a selection of bonds which pay 5 percent, or $12,500 total every year. The second is a selection of blue chip stocks that pay no dividends.
If you place the non-dividend paying stocks in the Roth IRA, held the taxable bonds in a brokerage account, and you’re in the 24% bracket, you’re going to wind up with $9,500 in cash income each year.
However, in the event you switched those two investments and place the taxable bonds in the Roth IRA and the non-dividend paying stocks in the brokerage accounts, you’re going to have to keep all $12,500. That is an additional $3,000, or 24 percent more money than you would have had, all because of the way you held your investment positions. And savings may be even larger if you’re in a higher tax bracket.
These tiny things matter, especially during a long time period. An extra $3,000 invested at 7% for 30 years is nearly $300,000. It pays, quite literally, to keep an eye on not only the particular assets you have, but where you park these resources.
The General Rule for Roth IRA Investments
Though everyone’s individual circumstances are different, and must be taken into consideration when a general guideline for Roth IRA investments is that you need to aim to place the least tax-efficient securities and assets in the IRA itself, while holding the maximum tax-efficient assets and securities through other, more conventional account forms, such as direct registration, DRIPs, and brokerage accounts.
Assets that typically appreciate are inherently tax-advantaged in contrast to those who throw off the majority of the wealth creation in the kind of cash. Regular corporate bonds are often a great selection for a Roth IRA, as are high-yielding dividend stocks and property investment trusts.