The Municipal Bond Tom Wants to Move into the IRA
Eleanor and Tom, both 58, file jointly. Investable assets are $1.1 million: $500,000 joint taxable, $400,000 in Tom's rollover IRA, and $200,000 in Eleanor's Roth IRA. Their marginal rate is 32% federal plus 5% state, and the 3.8% net investment income tax applies at the margin. Today the taxable account holds $250,000 in an in-state municipal bond fund yielding 3.1% (state-tax-exempt) and $250,000 in a total-market index fund; the rollover IRA also holds the total-market index; the Roth holds a small-cap growth fund. Tom wants to move the municipal fund into the IRA and buy investment-grade corporate bonds in the taxable account, arguing that 'munis yield less, so we are leaving money on the table.'
1. Evaluate Tom's proposal on an after-tax basis. Is the municipal fund actually the lower-yielding asset for them?
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Tom is comparing pre-tax yields. That is the error.
- The municipal fund yields 3.1%. Its interest is exempt from federal tax, exempt from state tax, and - importantly - municipal interest is excluded from net investment income, so the 3.8% NIIT does not apply to it. After-tax yield: 3.1%.
- A comparable investment-grade corporate fund yielding 4.6% is fully taxable at 32% federal + 5% state + 3.8% NIIT = 40.8%. After-tax yield: 4.6% × (1 − 0.408) = 4.6% × 0.592 = 2.72%.
Tax-equivalent yield of the muni: 3.1% ÷ 0.592 = 5.24%. A taxable bond would need to yield 5.24% to beat it.
The muni wins by roughly 38 basis points - about $950 a year on $250,000 - before adjusting for credit quality and duration. Tom's instinct is right that munis quote lower yields; he is missing that the comparison must be made on the marginal rate, including NIIT and state tax.
Caveats to state explicitly: the two funds are not identical risks. If the corporate fund is longer or lower quality, part of the 38 bp is compensation for risk, not tax alpha. And the muni advantage only exists because the taxable account is full - which is the subject of the next question.
2. Should they execute the swap Tom wants? Design the asset location they should actually hold.
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No - Tom has the right diagnosis and the wrong prescription.
Putting a municipal bond in an IRA destroys the exemption. Inside the IRA you should hold taxable bonds, because the IRA taxes everything as ordinary income on withdrawal and bond returns are ordinary anyway. Nothing is converted from capital-gain to ordinary treatment; the exemption is simply wasted.
Corrected location:
| Account | Hold |
|---|---|
| Taxable ($500k) | Broad equity index funds + emergency cash |
| Rollover IRA ($400k) | The bond allocation (taxable investment-grade) |
| Roth ($200k) | Highest expected-return sleeve (small-cap growth) |
Quantify why. Move $250,000 of bonds from taxable to the IRA:
- Annual interest at 4.6% = $11,500.
- Held in taxable, the tax is $11,500 × 40.8% = $4,692 per year.
- Held in the IRA, the current tax is zero and the future tax is ordinary - but the bond return was going to be ordinary anyway, so nothing is lost.
- Compounding ~$4,700 a year for 20 years is well over $100,000 of deferred capital.
The other half of the swap is worth more. Move $250,000 of equities out of the IRA and into taxable. Equities held in taxable get qualified dividend and long-term gain rates and, critically, a step-up in basis at death - potentially eliminating the entire embedded gain for heirs. Equities held in the IRA are eventually taxed at 32%+5% ordinary rates.
Before selling the muni: check the unrealized gain. If it is large, stage the sale across tax years rather than realizing it all at 40.8%. Keep enough cash in the taxable account for emergencies, since the IRA cannot be tapped for liquidity without tax.
3. Separately, they hold a legacy actively managed fund in the taxable account with a $60,000 unrealized loss. Tom wants to sell it and immediately buy a 'very similar' large-cap fund. What should you tell him?
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Wash-sale rules first.
- The loss is disallowed if he acquires a substantially identical security within 30 days before or after the sale - and the rule reaches all accounts, including IRAs.
- A wash sale into an IRA is worse than a normal wash sale: under Rev. Rul. 2008-5 the loss is permanently lost; the disallowed amount does not increase basis in the IRA.
- 'Very similar' is the problem word. Two large-cap funds tracking different indices (say S&P 500 versus Russell 1000) are generally treated as not substantially identical, but this is a facts-and-circumstances gray zone. The clean solutions are to buy a fund tracking a clearly different index, or to wait 31 days.
Is it worth doing?
- Tax value: $60,000 × 40.8% = $24,480 - but only if there are gains to offset.
- With no gains, the loss offsets only $3,000 of ordinary income per year. The remainder carries forward indefinitely, so it is still valuable, just slow.
- Better: pair the loss with the gain on the municipal fund sale in the same year. The two transactions together can make the location swap nearly tax-neutral.
Practical instruction: sell the legacy fund and buy a clearly different index fund the same day; do not let any account, including Eleanor's Roth, purchase the original fund within the 61-day window; and record the trade dates in the file.