Why Tax-Exempt Municipal Bonds Should Be Held Outside of Your IRA

The allure of municipal bonds (munis) for investors lies in their tax benefits and the potential to diversify a portfolio. However, a recent analysis suggests that holding tax-free munis in an individual retirement account (IRA) may not be the most advantageous strategy.

Municipal bonds are known for their tax-free interest payments at the federal level, making them an attractive option for investors in higher tax brackets. The lower nominal yield of munis compared to other securities is offset by the tax benefits they offer. But when it comes to IRAs, whether traditional or Roth, the tax advantages of these retirement accounts nullify the benefits of holding tax-free munis.

The key takeaway is that owning tax-free munis in an IRA doesn’t provide any additional tax benefits, as IRAs already offer their own tax perks. This means investors may be missing out on higher yields by choosing tax-free munis for their retirement accounts.

It’s worth noting that not all munis are tax-free. Approximately one-third of munis are taxable, offering higher yields than their tax-free counterparts. These taxable munis may be a better fit for IRAs, as they can provide higher interest payments without sacrificing the tax benefits of the retirement account.

In conclusion, while municipal bonds can be a smart investment choice, investors should carefully consider the tax implications and potential returns when deciding whether to hold tax-free munis in an IRA. Consulting with a financial advisor can help navigate the complexities of municipal bond investments and retirement account strategies.