The Best Way to Invest Your IRA

Opening an IRA can put money back in your pocket. But once you've opened your account, what should you do with it?

For many, the hurdle of getting an IRA account open in the first place is the hardest thing to overcome. As the end of the year approaches, however, your desire to cut your taxes may help you get over that hurdle. After all, making a deductible IRA contribution can add $1,400 or more to your tax refund.

Yet IRA investors face a more daunting task once their accounts are open: how to invest so that they make the most money. Picking the right mix of investments for your IRA can save you thousands over your lifetime.

The growth-vs.-tax trade-off
After you get your initial tax deduction, the primary benefit of traditional IRAs is that they provide tax-deferred growth. No matter how much income your IRA investments earn, and no matter how often you trade within your IRA, you don't have to pay any taxes until you take money out of the account.

So at first glance, you'd think the best strategy would be to pick the best growth prospects for your IRA. Certainly, loading up your IRA portfolio with stocks like Halliburton (NYSE: HAL  ) , Crocs (Nasdaq: CROX  ) , and NYSE Euronext (NYSE: NYX  ) would have boosted your retirement savings in a hurry. And in an IRA, you don't have to worry about taxes on steady dividend payers like Merck (NYSE: MRK  ) , Coca-Cola (NYSE: KO  ) , or Bank of America (NYSE: BAC  ) .

But as The Motley Fool's retirement expert Robert Brokamp has examined in his Rule Your Retirement newsletter, most investors should think about more than just getting their IRAs as big as possible. Including more conservative investments in your IRA may not help them grow as quickly, but it can have a big impact on how much you pay in taxes.

Favored status for stocks
Under current tax law, stocks get much better tax treatment than many other investments. The top rate for qualified stock dividends is 15%. That's also the most you can pay on capital gains for investments you own longer than a year. In contrast, you'll pay up to 35% on other income, such as interest from bonds or CDs.

The main drawback of IRAs is that you lose that 15% rate for your stocks. Everything you take out of your IRA gets taxed at your ordinary rate. So if you put all your stocks in your IRA and leave all your bonds in a taxable account, you'll get hit twice: You'll pay your ordinary rate every year on the interest from your bonds, and you'll pay the ordinary rate again when you start taking distributions after you retire. The example below shows how this works, assuming you invest for five years and then take everything out of your IRA when you retire in the fifth year.

Year

Year-End IRA Value

Year-End Taxable Account Value (pre-tax)

Taxes Paid on Taxable Account

Taxes Paid on IRA

Total Year-End Portfolio Value (after-tax)

1

$11,000

$10,500

($175)

$0

$21,325

2

$12,100

$10,841

($181)

$0

$22,761

3

$13,310

$11,194

($187)

$0

$24,317

4

$14,641

$11,557

($193)

$0

$26,006

5

$16,105

$11,933

($199)

($2,137)

$25,702

Assumes start with $10,000 each in stocks and bonds, with all stocks in IRA. 10% stock return, 5% bond return, 35% tax on IRA distributions and interest. Numbers may not add due to rounding.

But say you buy some bonds in your IRA and some stocks in your taxable account. By sheltering the high-tax bonds while paying lower taxes on your stocks, you actually come out ahead, even if you sell everything when you retire. Here's how the math works out.

Year

Year-End IRA Value

Year-End Taxable Account Value

Taxes Paid on Taxable Account

Taxes Paid on IRA

Total Year-End Portfolio Value

1

$10,750

$10,750

($106)

$0

$21,394

2

$11,563

$11,450

($111)

$0

$22,902

3

$12,443

$12,206

($116)

$0

$24,534

4

$13,398

$13,025

($121)

$0

$26,302

5

$14,434

$13,910

($467)

($1,552)

$26,324

Assumes start with $10,000 each in stocks and bonds, distributed 50/50 in IRA and taxable account. 10% stock return composed of 2.5% dividends and 7.5% capital gains, 5% bond return, 35% tax on IRA distributions and interest. Numbers may not add due to rounding.

This might not seem like much of a difference. But examples with a longer time frame show even more savings.

The key is that with stocks, you decide when you pay capital gains. So why not put all your stocks into a taxable account? The main reason is that you'll probably want to buy and sell some stocks over time. If you keep your stock trading within your IRA while keeping good buy-and-hold investments (like stock index funds) in a taxable account, you'll avoid paying tax as your portfolio turns over.

When you're investing for your IRA, don't automatically shoot for the moon by putting everything into stocks. By taking your taxable investments into account, you can find a balance that will help you cut your taxes and end up with more at retirement.

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