Mutual Funds and Retirement Savings

The tax law provides a variety of vehicles for retirement savings, including:

• IRAs (regular IRAs, Roth IRAs, SEP IRAs)

• 401k and 403b plans

• Plans such as SEPs and SIMPLEs designed for small businesses

Any of these plans can be set up to permit investments in mutual funds. (If the plan is set up by an employer, the employer decides whether to offer mutual funds as an investment choice, and if so, which ones.) Often there will be a choice of several mutual funds. In choosing a mutual fund investment for your retirement savings it’s helpful to understand the tax rules that apply here.

All earnings treated the same

For investments inside a retirement plan, all forms of earnings are treated the same way. Capital gains are treated the same as dividends. Municipal bond interest is treated the same as interest on a corporate bond.

• When the income goes in. The retirement plan doesn’t pay tax when it receives the earnings. This is true for all types of earnings except “unrelated business” income, a category most people never encounter. So all types of income are treated the same on the way in.
• When the income comes out. All income is treated the same when it comes out of the IRA or other retirement plan, too. In a Roth IRA, if you meet certain requirements, all distributions are tax-free — including earnings of every kind. In other retirement plans, distributions of all types of earnings are taxable as ordinary income.

Example: You have a traditional IRA and you choose to invest it in a mutual fund. Earnings from this fund include ordinary dividends, capital gain dividends and tax-free distributions. When you withdraw the earnings from the IRA you must treat the entire amount as ordinary income.

We can sum this up in a single sentence:

Inside an IRA or other retirement account, long-term capital gains, qualified dividends and exempt income are no better than ordinary income.

Municipal bond funds

These rules imply that you should never invest in a municipal bond fund within an IRA or other qualified retirement account. Because of their favorable tax treatment, municipal bonds pay a lower rate of interest than other bonds of comparable risk and duration. Yet the favorable tax treatment is lost within a retirement account, so you would receive a lower rate of earnings without a corresponding benefit. For this reason, municipal bond funds generally are not offered for these types of accounts, and should not be selected if available.