Bonds and The Roth IRA

As a conservative investor, you may look to bonds to collect interest income that grows purchasing power above the rate of inflation. Additionally, bonds may also be traded at a profit, when interest rates fall and the economic prospects for a particular issuer improve. In either case, smart tax planning is imperative to improve your total returns. The Roth IRA will shield regular interest income away from ordinary income taxes. Interestingly, a Roth IRA may be an ideal vehicle for both income and aggressive growth investments.

Roth IRA Tax Structure

U.S. Congress has integrated the Roth IRA into the tax code to encourage Americans to save for retirement. You fund your Roth IRA account with after-tax money. From there, investments within the Roth IRA grow on a tax-deferred basis. Tax-deferral means that you will not owe taxes on the investment income and capital gains that occur within your Roth. Through a broker, you may trade stocks, bonds and mutual funds for your Roth IRA. You may withdraw the total amount of your Roth IRA at age 59 ½ — without paying taxes on the sum.

Deposits and Withdrawals

You may withdraw your principal investment into the Roth IRA at any time – without a tax penalty. Withdrawals that include growth within the account, however, may be subject to a 10 percent additional tax penalty if made before the age of 59 1/2.

For example, you may have deposited $10,000 to buy bonds within your Roth IRA over the course of five years. After six years, your bonds have increased in value and made interest payments to take your Roth IRA balance to $11,000. After six years, you can sell bonds and withdraw your original $10,000 investment without paying taxes. If you take out the entire $11,000, you will be responsible for paying capital gains taxes and a 10 percent penalty tax on the $1,000 bond market profits.

Bond Interest Payments

Because of their regular interest payments, individual bonds and bond funds are ideal for Roth IRA accounts. Within a regular taxable account, your bond interest would be taxed as ordinary income. As of 2010, IRS ordinary income tax rates are at 10, 15, 25, 28, 33, and 35 percent, according to your income bracket.

Roth IRA Contribution Limits

The IRS limits the amount of annual contributions that you can make into Traditional and Roth IRA accounts. A Traditional IRA is funded with pre-tax money that grows on a tax-deferred basis. With a Traditional IRA, your money is taxed at ordinary income upon withdrawal. As of 2010, you are generally limited to $5,000 worth of annual contributions into Traditional and Roth IRA accounts, combined. You may put a total of $6,000 into these accounts, annually, if you are at least 50 years old.

The 401(k)

For tax savings, you may also consider buying into a bond fund through your 401(k) account. 401(k) plans feature $16,500 ($22,000 at age 50 and above) contribution limits, and tax-deferral. Your 401(k) balance is taxed as ordinary income upon withdrawal. Be advised that you could owe a 10 percent additional tax penalty, if you take any money out of your on 401(k) before age 59 ½.