Investing Smart in IRAs

IRAs offer stock investors three great benefits: No capital gains taxes, no taxes on dividends, and more choices for their investments. The fourth benefit goes to all procrastinators. You can still make your contribution for last year as long as it is postmarked no later than April 15.

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By Tom Jacobs (TMF Tom9)
April 11, 2002

Monday is April 15, so whether you already have an IRA or are going to open one,  please make your year 2001 contribution right now. Right now! No checking the refrigerator or watching Survivor: Marquesas (where I've decided to retire). And, yes, even though it's now 2002, you can make your 2001 contribution until Tax Day.

We love IRAs because we want everyone to have a comfortable retirement, and they are especially attractive to investors with the time and interest necessary for investing in individual stocks. IRAs offer you four unique advantages not only over a regular investment account, but also even over 401(k) plans. If you are new to IRAs, take a brief 60 seconds to become familiar with these great savings plans.

No taxes
When you sell an individual stock in an IRA -- whether traditional or Roth, Education (now known as the Coverdell ESA), or all the other types -- you incur no capital gains tax liability. You, like some of us, may have had significant gains during the bull market leading up to March 2001, but didn't sell because you would  incur capital gains tax liability. With an IRA, it's not an issue. You still need to base your sell decision on other factors -- quality of the business, estimate of future returns, better places to put your money -- but you don't have to be deterred by the prospect of coughing up your gains to Uncle Sam.  

We are not saying that an IRA is a good place to become a day trader, or a short-term trader, either. We generally advise selecting excellent businesses at attractive valuations and holding them for five years or more, for the simple reason that the longer you hold, the more likely a stock price reflects a business' creation of value. But if you do want to sell, an IRA lets you take out capital gains as a consideration.

The flip side is that you don't get to deduct capital losses from sales in an IRA or carry them forward. Hey, it can't all be Skittles and beer.

Dividends not taxed
One argument against dividend-paying stocks is that a shareholder pays twice: First, your company pays taxes on net income, and then you pay taxes on the portion of net income your company distributes to you as dividends. But if you find a company with a good business and is priced attractively, you can take advantage of the compounding of its full dividend payments by buying its stock in your IRA. They won't be taxed. If you need to find some high-dividend stocks, check out our special feature in The Motley Fool Select.

True, many people, including noted investor Philip Fisher, have questioned the quality of any management that pays out income in dividends rather than investing in its business to create value for shareholders. There are arguments both ways. But if you decide that any dividend-paying stocks are for you, they likely belong in your IRA. 

More flexibility than a 401(k)
If you are fortunate to have an employer who sponsors a 401(k) or 403(b) retirement plan, you may not have enough money to make both your maximum 401(k) plan contribution ($10,500 for 2001; $11,000 in 2002) and your maximum IRA contribution ($2,000 for a single person in 2001 and $3,000 in 2002 for a traditional or Roth).

There are two great advantages to making your 401(k) plan contribution. First, if you make the maximum contribution that your employer will match, you are receiving an immediate return of whatever percent your employer contributes. The federal government matches federal civilian employee contributions to its 401(k) plan -- called the TSP (Thrift Savings Plan) -- dollar for dollar when you contribute 5% of your income. That's a walloping 100% immediate return, so make sure you contribute at least 5%.

It usually pays to contribute beyond your employer match, too, because your contribution to a 401(k) plan secures an immediate return by reducing your taxable income. Let's say you are in the 27% tax bracket, and contribute 5% of your $40,000 a year salary to your 401(k). All things equal, that reduces your taxable -- phenomenal. So, even if your company doesn't match at all, there are strong reasons for maxing out your income to $38,000, and you pay $540 a year less in taxes (27% of $2,000). That is an immediate 27% return 401(k) contribution.

But investors in individual stocks gain a benefit in an IRA that they almost certainly do not in their 401(k): more investment options. We hope that your 401(k) provider offers a low-expense broad market stock index fund, but it may not. It may limit you to one fund company's poor-performing funds, load funds, or a selection of funds that just don't meet your needs (sector funds, international funds, etc.). Your company may restrict you or require you to make certain investments in company stock, and rarely are you allowed to invest in individual stocks beyond your company in your 401(k).

More choices in IRAs
The IRA offers more options. You can set up an IRA with your discount broker and easily invest in individual stocks. And whether you prefer to stick with an index fund or pick another stock fund, your broker almost certainly will be deee-lighted to set up an IRA for you. Be sure to check both your broker's and mutual fund's annual fees, if any, for the IRA. No fees are best.

So for the investor with the initiative -- time and effort -- to invest in individual stocks, it may make sense to first contribute to your 401(k) enough to get the full employee match (free money!), then make your maximum IRA contribution, and then take whatever money you can and contribute up to your maximum to the 401(k).

One side note: Some of you are astutely noting that in my example of the tax reasons for contributing to your 401(k) plan beyond the amount your employer matches, most people won't invest that $540 tax savings and are likely to spend it on something that may have no return. To fully realize the tax benefits from your 401(k) contribution beyond your employer match, you need to invest the tax savings by setting aside that amount and using it to make your IRA contribution or a heftier 401(k) contribution, or putting it into your regular investment account. It isn't savings unless it's money you save.

Even available to the terminally lazy
Another thing: Your contribution, like your tax return, need only be postmarked by April 15. So, if you're worried that your IRA contribution check has to clear by April 15 and that you are too late, no way. Just get it in the mail by Monday.

There you have four excellent reasons to make your year 2001 IRA contribution right now, and for contributing every year from now on.

Best Foolish wishes to all.

Tom Jacobs (TMF Tom9) is jealous of his 25-year-old niece and all the years of Roth IRA contributions she has ahead of her. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.