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Stocks or Bonds: Which Are Better?
Conventional wisdom holds that investors should hold bonds in tax-protected vehicles like IRAs and stocks in their taxable accounts. Intuitively, that makes sense. After all, bonds throw off a lot of taxable income, which is taxed at rates as high as 35%. Meanwhile, stocks typically generate much less income, and that dividend income is taxed at a much lower rate—generally 15%. (Long-term capital gains from stocks enjoy the same rate.)
In this instance, however, the conventional wisdom has limitations. Stocks generally produce higher returns than bonds, and thanks to the magic of compounding, the differences in performance really add up over time. That's why the return from stocks can generate a much higher tax burden than bonds over the long haul. If you're a long way from retirement, it might make more sense to hold stocks in your IRA (and bonds if you are close to retiring).
Not All Investments Are Equal
So you've got a while until you retire, and you've decided that stocks are the right choice for your IRA. That decision only gets you so far. For an IRA, not all stock investments are created equal. For example, index funds' popularity has soared over the past decade, thanks in no small part to these offerings' often rock-bottom costs as well as the fact that so many active stock-pickers routinely lag their benchmarks. Such funds may also have the benefit of very good tax efficiency, because managers of large-cap index funds tend to buy and sell infrequently. In the same vein, actively-managed funds with very low turnover often don't generate a lot of taxable gains, either. Either fund type would work well as an IRA holding. However, to the extent that you own funds that do generate a lot of taxable capital gains, it makes sense to hold them in an IRA or other tax-sheltered account. In so doing, you take maximum advantage of the IRA's key attribute: tax-deferred (traditional IRA) or tax-free (Roth IRA) compounding.
As for bonds, municipal bonds don't belong in an IRA; such funds generate income that's exempt from federal and in some cases state income tax, and their yields are generally lower than taxable bonds as a result. Meanwhile, high-yield bonds are better contenders—they generate heaps of income, but IRA investors don't have to pay tax on those distributions. Alternative asset classes may also make ideal IRA candidates. REIT funds, for example, pay out heaps of income from their underlying real-estate holdings, and none of it is tax-advantaged; thus, to the extent that you own such an offering, you'll want to be sure to stash it in an IRA or other tax-sheltered vehicle.
Keep the Big Picture in Mind
How you split your portfolio between stocks and bonds should be based on your risk tolerance and time horizon, not what makes sense from a tax perspective. Your goal isn't necessarily to avoid taxes, but to maximize after-tax returns. Be sure to consult with a financial advisor or tax professional for the latest rules and regulations.
Past performance is no guarantee of future results. Stocks and REITs are not guaranteed and have been more volatile than bonds. REITs typically provide high dividends plus the potential for moderate, long-term capital appreciation. A REIT must distribute at least 90% of its taxable income to shareholders annually. Real estate investment options are subject to certain risks, such as risks associated with general and local economic conditions, interest rate fluctuation, credit risks, liquidity risks and corporate structure. High-yield corporate bonds exhibit significantly more risk of default than investment grade corporate bonds. Municipal bonds may be subject to the alternative minimum tax (AMT) and state and local taxes, and federal taxes would apply to any capital gains distributions.