Support our non-partisan non-profit newsroom 💜 Donate now
Ask Money

Don’t mix tax-exempts and tax shelters

Chris Farrell Apr 6, 2011

Question: I just turned 57 and plan on retiring in exactly 4 years. If I can get a 3.5% return on my 401K, IRA and brokerage account and combine it with my pension and SS payment, I will have an income of 90% of my present salary. What I want to know is if I change all the instruments in these accounts to tax free munis, how are the withdrawals treated? In other words, I would get tax free dividends paid into a tax deferred account, how is that taxed when I make a withdrawal? : Jonathan, Oakland, CA

Answer: There’s a saying in the personal finance industry: “Don’t put a tax shelter inside of a tax shelter.” It’s sound advice.

The interest on tax-exempt municipal securities is free from federal income tax, and sometimes from state and local government taxes. But if you put tax-exempts into a tax deferred retirement account you’ll give up the tax-free interest payments. When you withdraw the money you’ll pay your ordinary income tax rate on all of it–100%.

So, it doesn’t make sense to put tax-exempt securities into your IRAs or 401(k).

You could own tax-exempts in your brokerage account if it’s a taxable account, however. Tax-exempt securities are best held in taxable accounts and it’s usually a better investment for folks in the highest income brackets.

Right now, tax-exempt yields are unusually attractive relative to U.S. Treasury securities. The reason: The greater risks of owning tax-exempts considering all the turmoil in state and local government budgets. (Think Wisconsin, California and Illinois.)

The traditionally dull coupon-clipping muni market for the well-heeled retired is anything but staid these days.

There’s a lot happening in the world.  Through it all, Marketplace is here for you. 

You rely on Marketplace to break down the world’s events and tell you how it affects you in a fact-based, approachable way. We rely on your financial support to keep making that possible. 

Your donation today powers the independent journalism that you rely on. For just $5/month, you can help sustain Marketplace so we can keep reporting on the things that matter to you.