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?
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 Amounts withdrawn from your Roth IRA are tax-exempt.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.
In my practice, I generally position most bond funds in tax-deferred accounts like regular IRAs since the money grows tax-deferred. However, if you plan to use the short-term bond fund as a source of emergency money, then you could also add it to your brokerage account where you can access those assets anytime you desire. The last account I would use for any bond fund, not just a short-term bond fund, is a Roth IRA. A Roth IRA is one of the very best retirement accounts available and because assets in those accounts grow tax-free, you generally want to use growth-oriented investments in those accounts such as equities.
I also think equity funds like an index fund and/or even actively managed stock funds are better positioned in brokerage accounts because capital gain rates are generally lower than ordinary income rates. This may not apply to all taxpayers, but it may for most. Positioning bond funds in brokerage accounts subjects you to interest income, which is taxed at your highest ordinary tax rate. However, if you wanted to invest in a bond fund in a taxable brokerage account, then you may want to consider using a tax-free bond fund. There are many short-term tax-free bond funds available to purchase. This could be a solution depending on your tax bracket.
In summary, I like growth-oriented investments in Roth IRAs and brokerage accounts, and bond funds in IRA or tax-deferred accounts. However, the positioning of asset classes will depend on how much you have each of those accounts. If all you own is a brokerage account, then you will need to own bond funds to make sure you have adequate diversification. You could use taxable and/or tax-free bond funds.
I hope the above helped. Good luck to you!
Where to hold which asset classes is a common question that all investors should seriously consider. The answer could depend on your age, the type of accounts that you have, the magnitude of your portfolio, your goals and needs.
Your situation is ideal since you have a tax-free account (ROTH) a taxable account and a deferred account (IRA) and you do not plan to need the funds for years.
In this situation, I would want fixed income in the deferred account so that dividends are not added to your taxable income while you are working and can compound. This would include the short-term bonds.
You should want the most aggressive growth in the ROTH account, since that growth will be tax free t a point in time. The last thing I would want in the ROTH would be cash and short-term bonds.
I would also want growth assets in the taxable account, since when they are sold, the tax is at capital gains rate rather than ordinary income. Also, on your passing there is a step up in basis and your heirs could sell the holding and have no tax to pay.
I am a little concerned when you say that you want to add short term bonds at this point in time. You should have owned them for some time. You do not want long bonds at this point with the rising interest rate environment.
It could be worthwhile to have your portfolio reviewed to be sure that you are not missing out on other portfolio improvements. The goals of a portfolio design should be:
- To have the correct level of risk based on your goals
- Using investments that will give you the highest returns for that level of risk
- To be low cost
- To be tax efficient
- To have a portfolio design and management methodology that is easy for you to understand
Because of the tax implications and tax efficiencies of your different accounts, you should expect to invest your bond funds (which will usually pay a "yield" in a tax deferred account or, in your case, your traditional IRA.
I would definitely buy the bond funds in either Roth or the traditional IRA. Bond funds generate income, thus when you buy it in a taxable account, you end up paying tax every year. If you have quite a large of portfolio, maybe you want to invest an entire bond funds in the Roth as the traditional IRA has the RMD requirement in the future. On the other hand, just because Roth is a logic place to deposit the bond funds, you need some growth too to hedge inflation. Therefore, to balance the goal of growth and income, you may split the bond investment between the Roth and the traditional IRA. Best!