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Choose between Taxable and Tax-Advantaged Retirement Accounts

Chances are that you have both a taxable account where you can store your investments and a tax-advantaged account, such as an IRA, a Roth IRA, a 401(k), or a 529 college savings plan. Think of these as containers of sorts, which you fill up with your various investments.

Yesteryear, when corporations and municipalities were still offering bearer bonds — bonds that came with a certificate and were registered nowhere, with no one — you didn’t have to concern yourself with keeping them in any particular account. You could keep your bearer bonds in your safe, your glove compartment, or your underwear drawer. Today, it’s a different matter.

In which container do you keep your bonds?

Position your investments for minimal taxation

Say you’re in the 28 percent federal tax bracket. You’ll pay 28 percent tax (plus state income tax) on any bond interest dividends paid from any bonds held in a taxable account — except for tax-free municipal bonds.

Plain and simple, tax-advantaged accounts exist to allow you to escape — or at least postpone — paying income tax on your investment gains. It generally makes the most sense to keep your taxable income-generating investments, such as taxable bonds, in your retirement accounts.

Here are some other points to keep in mind:

  • Treasury bonds are free from state tax. Therefore, if you have room in your retirement accounts for only one kind of bond, it makes most sense for it to be corporate bonds.

  • Foreign bonds often require the paying of foreign tax, which usually is reimbursed to you by Uncle Sam, but only if those bonds are kept in a taxable account.

  • Tax-free municipal bonds always belong in your taxable accounts.

The figure illustrates where you want to keep your bond holdings.

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Factor in the early-withdrawal penalties and such

Keep in mind that any money withdrawn from an IRA, 401(k), or SEP (self-employed pension) prior to age 59 ½, except under certain special circumstances, is subject to a 10 percent penalty. (Income tax must be paid regardless of when you withdraw.) So any bonds you are planning to cash out prior to that age should not be put into your retirement account.

On the flip side, at age 70 ½, you must start taking minimum required distributions from most retirement accounts. That fact should be figured into your allocation decisions, as well. If your minimum required distributions — the amount the IRS requires you to pull from your account each year after age 70 ½ — are substantial, it can mess with your balance of investments.

Roth IRAs are different animals. You pay no tax when you withdraw, and you are not required to withdraw at any particular age. The money grows and grows, tax-free, potentially forever. Imagine.

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