IRA Bonds: To Invest or Not To Invest?

IRAs or Individual retirement accounts are considered as long-term investments, which could be in the form of stock funds. Bonds are important in retirement planning especially when investors edge closer to retirement.

How do IRAs work, you ask? For those below 49, an IRA lets investors to contribute in excess of $5,500 or a person’s taxable income for 365 days, as say the 2014 rules. Individuals above 50 may contribute $6,500 every year. Investors don’t pay taxes on capital or interest gains earned from IRA investments. Instead, when remove their contribution from the IRA, taxes are paid on these utilizations, as regular income. The owner of the IRA can take the utilizations without penalty after 59½, but is not mandatory to take utilization until aged 70½.  To understand the nuances, the entire IRA rules, which is up on the Internal Revenue Service website, must be read carefully.

A Holistic view of IRAs

As regards an IRA investment strategy, it should be just a part of your investment plan, and is not a separate entity on it’s own. Instead, the IRA can be employed strategically to invest so as to create the peak level of capital gains benefits and/or taxable income. That way, taxing begins only much later, rather than falling due, the following April.

Optimizing Tax Exemptions

The tax-deferring nature of IRAs forces investors to keep bond funds in IRAs. As the income of bond funds are taxable, investors generating this income through taxable accounts experience a substantial hit in after-tax returns. Thus, a 4% yield on an investment offers 3% as after-tax yield to an investor who lies in the 25% bracket. As a result, emerging market and high-yield bonds or other market sections, which produce above-average incomes, are best suited for IRA accounts.

Stock Funds in IRAs

How do stocks figure in the IRA investment equation? Stocks are able to create long-term wealth gains and the allied tax bill, which is less likely when it comes to bonds. However, the long-term investment gains when the assets are sold off after one year or more are now carry a more promising tax rate than income (which includes bond and bond fund interest). As per the 2014 regulations, investors in the tax brackets of 25%, 28%, 33%, and 35%, pay 15% for financial gains earned in the long run, while people who fall in the tax bracket of 39.6%, pay 20%. The ones who fall below the 25% bracket have 0% tax rate on the same gains.

Avoid Municipal Bonds in IRAs

An important rule is to avoid maintaining municipal bonds within an IRA. The main attraction of municipal bonds is that interest on municipal bonds and funds, is their tax-exempted nature, meaning that these offer lower before-tax yieldsthan those bonds which are taxable. As capital and interest gain in an IRA are inherently tax-exempted, there is no benefit to have municipal bonds in an IRA. Instead, a non-IRA regular account can hold municipal bonds saving the IRA to indulge in other investments.

Take TIPS for an IRA

TIPS or Treasury Inflation-Protected Securities are a great choice for IRA accounts as the TIPS principal value rises due to inflation-indexing, which allow investors generate positive real returns, post-inflation.  But, there is a catch, as the value of the bond keeps adjusting each year from the time of bond issue till maturity with investors paying a tax on such upward adjustment. Maintaining TIPS in your IRA makes sense, as it allows you to receive the full advantage of inflation adjustment, while avoiding the headaches of paying this tax, annually.

Taxation and Risks

Tax planning is the key to a comprehensive investment strategy as they enable investors to maximize after-tax returns. Although, your objectives in a carefully crafted retirement investment plan are, risk toleranceand the time horizon. While buy-and-hold stock investments and tax-efficient stock funds are excellent for regular (non-IRA) accounts, bonds are suitable for tax-deferred vehicles like IRAs. Trading accounts or stock funds that ensure short-term capital gains are great for an IRA rather than regular investment accounts. Keep this as a general guide and every individual IRA has a different horizon.

It’s important to note that life stage investment plays a role as stocks  outperform bonds over time and a young person with a span of 50 years for investment has substantially higher capital gains from stocks rather than bonds, which argues the case for preferring stocks in an IRA. But over time, investors tend to rebalance portfolios favoring bonds as they age and need to preserve their principal amounts. It makes sense to use the IRA purposefully.