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Q

I understand it’s not recommended that you use muni bonds in IRAs because taxes on traditional IRAs are already tax deferred. But I’ve been doing some out-of-the-box thinking about alternative IRA investments and wondered whether, if I did use muni bonds in a  traditional IRA, the bond interest would be taxed since the bonds are already tax exempt?

A

James A. Klotz responds:

As you mentioned, tax-exempt bonds are not normally considered appropriate investments for tax-deferred retirement accounts such as traditional IRAs or 401Ks. This is primarily because all distributions from your IRA are subject to taxation regardless of the source, and tax-free bond yields are historically lower than those of
taxable securities.

Many investors, however, have taken advantage of the recently introduced Build America Bonds (BABs) program that allows the issuance of taxable municipal bonds that enjoy a 35% federal government subsidy.

These BABs offer the same degree of safety as traditional tax-free bonds but provide significantly higher yields. Accordingly, they are ideal investments for tax-deferred retirement accounts.

The following link will take you to an article that discusses the BABs program in further detail: “Popularity of BABs Bodes Well for Tax-free Bonds.”