Question: My husband and I are currently maxing out each of our Roth IRA contributions each year. We are looking to put approximately $500 per month towards retirement savings and neither of our employers offer 401(k)’s. Do you have a suggestion as to where to put this monthly amount that will preferably be tax free? Cameron, Bozeman, MT
Answer: I have two suggestions for you to consider. The first is to put the money into the classic tax-exempt investment: Municipal bond mutual funds and ETFs.
It’s a troubled sector with so many state and local governments dealing with yawning budget deficits. Still, state government defaults are rare and so are local government bankruptcies. The bigger risk is widespread credit downgrades by the rating agencies.
I would seek out a measure of financial safety by sticking with high quality general obligation bonds backed by the taxing power of the issuer. And if you look into buying so-called revenue bonds–issues backed by fees–I’d stick with the debts of essential services, such as such as water and sewer treatment facilities. And even though you will give up some yield by buying a diversified portfolio stocked with bonds from outside your state you’ll also pick up an additional layer of financial safety. Diversification pays.
For individuals the financially smart way to buy tax-exempts is through mutual funds and ETFs.
That’s one tactic. Another idea that I like even more is to put money on a regular basis into a mix made up of a broad-based equity index fund and I-bonds. It’s an approach I frequently mention.
Yes, you’ll pay taxes on dividends and realized capital gains on the equity index fund every year. But the tax bill should be low since you won’t have a portfolio manager churning the portfolio. It’s a long term investment that you can tap at any time without penalty. You will pay Uncle Sam a long-term capital gains tax rate when you cash it in–assuming you’ve owned the investment for more than a year–but it’s still at a lower rate than ordinary income tax rates. The I-bond is a tax-sheltered default-free bond that protects your money against the ravages of inflation. You’ll pay ordinary income taxes on the gain when you cash it in.
What other suggestions do people have for them?
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