Never Hold Tax-Free Municipal Bonds Through a Roth IRA

Very few rules in life are absolute, but there's one mistake that you should never commit as a new investor. Holding tax-free municipal bonds in a tax-sheltered account, such as a Roth IRA, may seem like a great way to enhance your tax-free investments, but that's a fiscal fallacy.

The Advantages and Limits of a Roth IRA

One major benefit of your Roth IRA is that virtually all income earned within its protective shell is free from taxation. There are no dividend taxes, no interest taxes, no rent taxes, and no capital gains taxes.

The yield on municipal bonds is already tax-free, so you gain no additional advantage from putting them into a Roth IRA. And most investors can only contribute $6,000 annually to a Roth IRA for tax years 2021 and 2022.

Tax-Free Municipal Bonds Yield Less Than Taxable Bonds

Tax-free municipal bonds yield less than their taxable counterparts, such as corporate bonds and Treasury bonds. You must calculate the taxable equivalent yield to put them on parity. As of November 2021, seasoned AAA corporate bonds, which are fully taxable, yielded roughly 2.62%, while 30-year AAA tax-free municipal bonds yielded 1.70% in December 2021.

That difference of over 1% is not insignificant. Imagine you had $100,000 in your Roth IRA after years of carefully saving money. You would be looking at two bonds in that case, both of which are rated AAA, and both of which mature in 30 years. The corporate bond would pay you $2,620 in interest annually, while the municipal bond would pay you $1,700 in interest annually. No rational person would leave $920 in cash sitting on the table.

The power of your Roth IRA is so great that it essentially makes the corporate bonds tax-free, too.

Asset Positioning in a Roth IRA

A type of portfolio management strategy called "asset positioning" factors in these sorts of situations, many of which rely on a Roth IRA. You can work to maximize the total after-tax cash that you can keep by looking at where you generate your passive income and looking at which types of income are taxed based on how they're held.

Picture yourself with no assets except a $500,000 portfolio with $250,000 held in a Roth IRA and $250,000 in a taxable brokerage account. You have only two investments. The first is a collection of bonds that pay 5%, or $12,500 total each year. The second is a collection of blue-chip stocks that pay no dividends.

You'd end up with $9,500 in net after-tax income per year if you were to put the non-dividend-paying stocks in the Roth IRA and hold the taxable bonds in a brokerage account, and you're in the 24% tax bracket.

But you'd get to keep all $12,500 if you were to switch those two investments and put the taxable bonds in the Roth IRA and the non-dividend paying stocks in the brokerage account. That's an additional $3,000, or 24% more money than you would have had otherwise, all because of how you held your investment positions. Your savings could be even larger if you're in a higher tax bracket.

Of course, this assumes that the money isn't needed for another purpose, such as living expenses. The asset allocation might not be in your best interest if this is the case.

The General Rule for Roth IRA Investments

Everyone's individual circumstances are unique, but one general rule of thumb for Roth IRA investments is that you should strive to put the least tax-efficient securities and assets in the IRA while holding the most tax-efficient securities and assets through other, more standard account types. These might include direct registration, DRIPs, and brokerage accounts.

Assets that tend to appreciate are inherently tax-advantaged, compared to those that throw off most of their wealth creation in the form of cash. Regular corporate bonds are often a good choice for a Roth IRA, as are high-yielding dividend stocks and real estate investment trusts.