Should You Hold Bonds in Taxable or Tax-Deferred Accounts?

As a financial planner, I work with many individuals approaching early retirement who want to stretch their savings while minimizing their tax burden. One of the most overlooked but powerful tactics for achieving this is asset location—strategically placing different types of investments across taxable and tax-deferred accounts to manage taxes, cash flow, and long-term growth.

Recently, I received a thoughtful question from a listener named Eric that perfectly illustrates the real-world tension between tax optimization and accessibility in retirement planning.

Tax Optimization vs. Accessibility

This is a fantastic question that highlights one of the core planning trade-offs in early retirement: Do you prioritize lower taxes or easier access to income?

When you hold taxable bonds (or bond funds) in a taxable brokerage account, the interest and non-qualified dividends are taxed at ordinary income rates—even if they’re reinvested. I refer to these accounts as being “taxable along the way.”

By contrast, putting bonds inside a tax-deferred account like a traditional IRA allows you to defer that ordinary income until you choose to withdraw it—giving you more control over when and how you pay taxes.

⚠️ But here's the catch: ordinary income from bonds in a taxable account can “crowd out” your standard deduction and lower tax brackets, leaving less room for strategies like Roth conversions.

Scenario Comparison: Mirrored vs. Optimized Asset Location

Let’s walk through a simplified example. Eric has a $2 million portfolio split evenly between:

• $1 million in a taxable brokerage account
• $1 million in a traditional IRA

Both approaches assume a 70% stock / 30% bond target allocation overall.

🧾 Scenario 1: Mirrored Allocation in Both Accounts

• Taxable Brokerage:

  • $700,000 in stocks

    • 90% qualified dividends at 1.3% = $8,190

  • $300,000 in bonds

    • 3.6% interest = $10,800

• Total Taxable Income: $19,900

  • Qualified Dividends: $8,190
  • Nonqualified Interest: $11,710
  • Only 41% of this income is taxed at favorable LTCG rates.

❗Nearly $12,000 of Eric’s standard deduction and/or low marginal tax brackets are used up by ordinary bond income before considering any other withdrawals.

🧮 Scenario 2: Optimized Asset Location

• Taxable Brokerage:

  • $1,000,000 in 100% US stocks

    • 90% qualified dividends = $11,700
    • 10% nonqualified = $1,300

• Traditional IRA:

  • 40% stocks / 60% bonds

• Total Taxable Investment Income: $13,000

  • 90% of income taxed at favorable rates

✅ This creates $7,000 less taxable income, including $10,410 less ordinary income - giving Eric more room to do Roth conversions, manage health subsidies, or draw income more flexibly.

✅ Pros of Scenario 2

• Lower current tax liability due to more income taxed as qualified dividends
• More control over taxable events in retirement (especially capital gains)
• Reduced RMDs in future years due to slower IRA growth
• Greater Roth conversion flexibility—use your tax bracket space intentionally

⚠️ Cons of Scenario 2

• Less liquidity: Accessing income from stocks may require selling shares
• Capital gains realization risk if you need to sell appreciated stock
• More complexity in execution (e.g., using Spec ID, monitoring brackets)

🧠 Strategies and Things to Consider

1. Use Specific Identification (Spec ID)

Choose which shares to sell to minimize capital gains

• Sell shares with the highest cost basis
• This may allow you to harvest gains at the 0% LTCG rate
• Often referred to as tax gain harvesting

2. Character Counts

(Thanks to Sean Mullaney for this concept)

• Interest = taxed at ordinary income rates
• Qualified dividends / LTCG = taxed at lower rates
• Asset location lets you control what type of income you generate

3. Watch Your MAGI

For ACA subsidies, both ordinary income and capital gains count toward MAGI.

Be intentional: too much income could reduce or eliminate your Premium Tax Credit (PTC).

🧭 Hybrid Strategy: You Don’t Need to Be a Purist

This doesn’t need to be an “all-or-nothing” decision.

You might:

• Hold some bonds in taxable for income stability
• Keep most bonds in tax-deferred to reduce taxable income and future RMDs
• Use Roth conversions strategically each year

The goal isn’t perfection—it’s alignment with your real-world cash flow needs, behavioral preferences, and tax reality.

💬 Final Thoughts

Asset location can be one of the most effective ways to fine-tune your retirement strategy—but it's not what makes or breaks your plan. If you're already saving intentionally, living below your means, and investing consistently, you're likely 90% of the way there.

Tax optimization lives in the top 10% of planning - may provide additional benefits, but not critical for success.

Start with flexibility, layer in efficiency, and make changes you can stick with. And if you’re not sure which route is right for you, it’s okay to take a hybrid approach.

🙋‍♂️ Have a Question?

Are you planning for early retirement and wondering how to make your money last? I’d love to hear your questions.

Join the conversation at local.choosefi.com/member — your question might inspire our next podcast episode or planning article.

And if you want more insights like this, explore the ChooseFI podcast, where we break down real-world strategies for financial independence, one decision at a time. 📈