Suppose your portfolio consists of a brokerage account and an IRA. If you want an allocation to fixed-income, where should you hold your $250,000 worth of bonds?
You might hold municipal bonds in your taxable account, where they can generate tax-exempt income, year after year. With this plan, you’ll load up your IRA with stocks, which can grow untaxed.
However, with this arrangement all of the stock-market growth inside your plan would forfeit the preferential treatment of long-term capital gains. As the money comes out of the plan it would be subject to ordinary income taxes. Currently, most investors pay a 20% tax on long-term capital gains.
In the future, truly long-term gains (on assets held more than five years) will qualify for an 18% rate. However, when such gains are taken inside a retirement plan, the proceeds eventually will be taxed at higher rates, upon withdrawal. Under present law, you could be converting an 18% tax rate to a 39.6% tax rate.
Thus, consider holding taxable bonds inside your IRA. These bonds might yield 5%, 6%, 7% or more each year, yet no tax would be due until withdrawal. With bonds inside your IRA, stocks can be held outside, where any gains may qualify for favorable long-term capital gains taxation.
