Bonds

• A bond is essentially a loan you make, usually to a large company or government, be it local, state or federal. The amount of the loan is called its face value. In return, the bonding entity agrees to pay you annual interest, called a coupon, until the bond matures. So, if you purchase a bond with a face value of $2,000, a 4 percent coupon and an eight-year maturity period, you will receive $80 a year in interest for eight years, and, at the end of the period, you will walk away with your $2,000 intact.
  
  

Traditional IRAs

• Traditional IRAs allow you to deduct contributions and defer taxes until you take withdrawals, usually after you reach age 59 1/2. If you use a traditional IRA to purchase bonds, the interest they earn each year is not taxed as long as the money remains in your account. So, in the previous example, if your bond earned $640, and you received your $2,000 back when it matured, all $2,640 would return to your traditional IRA. Because your earnings are not taxed, you are free to re-invest 100 percent of your profits.
  
  

Roth IRAs

• Roth IRAs work differently: you do not get to deduct contributions, but qualified distributions are tax-free. If you were to use your Roth IRA contributions to purchase the aforementioned bond, your account would have $2,640 when the bond matured. Not only are you free to reinvest 100 percent of that amount, you do not owe income taxes on withdrawals you take once you turn 59 1/2. The bond's earnings are entirely tax-free. Over the life of a Roth IRA, these compounded earnings can create a sizable nest-egg.
  
  

IRA Custodians

• If you want to use a Roth or traditional IRA to purchase bonds, you need to open an account with an IRA custodian that offers them. Many different types of financial institutions can act as IRA custodians, including banks, credit unions, brokerage firms and mutual funds. Find a brokerage firm with bond offerings that you like; if you change your investment strategy later, after the bond matures, you can always make a tax- and penalty-free IRA transfer to a new custodian.
  
  

Considerations

• Certain types of bonds make more sense than others in an IRA. Municipal bonds, those issued by cities, villages or townships, offer tax-free returns for federal purposes and also for state taxes if you live in the state where the bond is issued. Because of the tax benefits, coupons are often lower. Consequently, purchasing municipal bonds in your IRA, particularly a Roth, may not be the best investment, since you'd be settling for a lower coupon with no real additional benefit.
  
  

IRA-Friendly Bonds

• You can buy zero-coupon bonds for less than face value, but redeem them for full face value when they mature. In the meantime, you must pay annual taxes on the bond's appreciation. Similarly, an inflation-indexed Treasury does not pay out until it matures, yet you are taxed annually on its appreciation. Both of these bond securities are ideal holdings for an IRA, because assets inside an IRA are not taxed, anyway.