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What is the best account to hold short-term bond funds?

I've decided to add a few short-term bond funds to my portfolio. I have a Roth IRA, a brokerage account, and traditional IRA. I'm 57 years old and I don't expect to have a need for this money for several years. Which account is the best for holding these funds?

Asset Allocation, Bonds / Fixed Income, IRAs
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June 2018

This is an excellent question. Investors often think of asset allocation, which refers to investing in a number of different asset classes/types. At its most basic level this would mean US- and non-US-based stocks and bonds, large- and small-cap stocks and cash or cash equivalents. You can expand your asset classes to include such categories as real estate, commodities, currencies, etc. Personally I believe in just sticking mostly to stocks along with an allocation to bonds and cash.

Your question takes things to the next level. You are referring to asset location. I wrote about this topic in a recent blog. Asset location refers to holding assets in the account that makes the most sense from a tax and overall portfolio perspective. If you hold short-term bond funds, the primary form of income you will receive is interest. Interest income is taxable at your marginal tax rate. This is likely higher than the tax rate that would apply to dividend payments or capital gains. Unless these funds hold tax-free municipal bonds, I would recommend holding them in your traditional IRA.

There are two reasons for this recommendation. When you withdraw money from your IRA it will be subject to tax at ordinary income rates. Amounts withdrawn from your Roth IRA are tax-exempt. The Roth account is typically viewed as the best place to locate assets with the greatest appreciation potential. The second-best place would be your taxable brokerage account (an exception would be if you trade frequently and are therefore liable for capital gains taxes on a regular basis - a similar exception may apply to mutual funds with relatively high turnover as you may receive annual distrirutions from such funds.). The third-best place would be your traditional IRA (as you would pay ordinary rates on withdrawal). Interest income earned by your short-term bond funds would be taxable currently if held in your brokerage account. Holding them in your traditional IRA defers these taxes until you start withdrawing the money. 

To recap, the general rule would be to hold short-term bond funds in your traditional IRA as it is the most tax-efficient account type for such funds.

I hope this helps. Feel free to reach out if you have further questions.

June 2018
June 2018
June 2018
June 2018