If you’re in a high income tax bracket, buying tax-free municipal bonds in your taxable account might seem like a no-brainer. But there’s a strategy that could give you a better return: Use your taxable account to pursue a tax-efficient stock strategy, such as investing in stock index funds, while buying taxable bonds within your retirement account.
The taxable bonds should have a higher yield than tax-free munis and, because you’re buying them in a retirement account, you don’t have to worry about paying tax each year on the interest generated. Meanwhile, in your taxable account, you might favor stock investments that will be taxed at the preferential long-term capital gains rate, including any qualified dividends you receive.
This strategy doesn’t sit well with some people, who prefer to have bonds in their taxable account, where they can be easily sold if these folks suddenly need cash. But you can effectively do the same thing, even if you have stocks in your taxable account and bonds in your retirement account. How? Suppose you suddenly need $20,000.
To generate the cash, you could sell $20,000 of the stocks you have in your taxable account. If we’re in the midst of a bear market, the timing wouldn’t be ideal. But in this case, it wouldn’t matter because you would simultaneously move $20,000 from bonds to stocks within your retirement account. Result: Your stock exposure remains the same, you have sold $20,000 in bonds—and you have the cash you need.
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