OUR TAKE

Tax Benefits of Retirement Accounts

	Email this page Format for printing Reuse/Reprint
	Related Links How to Pick the Best Mutual Funds Perfect Your Portfolio: Asset Allocation Online Seminar IRA Center
	Discussion Boards The Motley Fool Take

By Robert Brokamp (TMF Bro)
May 19, 2003

Uncle Sam wants you to save for your golden years. To encourage you to do so, he has created employer-sponsored retirement accounts (such as 401(k)s) and individual retirement accounts (IRAs) that offer tax benefits as incentives to invest.

Depending on your situation and the type of account you choose, your contributions to these accounts might be tax-deductible. But it gets better: You don't pay taxes on the income and capital gains generated by the investments in the accounts until you retire (or not at all, in the case of the Roth IRA). Fewer taxes leave more money to grow through the years. This is powerful stuff. Taking full advantage of these accounts is a no-brainer.

However, some brains are required to decide which investments to put in retirement accounts. Here are some considerations:

• Keep income-producing investments in retirement accounts. Investment income (such as interest from bonds or dividends from stocks) is taxed at a higher rate than long-term capital gains (profits made from buying and selling an investment held for longer than a year). So, it often makes sense to keep investments such as bonds, REITs, and high-yield stocks in your retirement accounts.
  
  
• What's in your retirement plan at work? While the ideal is to put the most potentially taxing investments in your retirement accounts, the reality is that the options available in your retirement plan at work often dictate which investments go where.

For example, it doesn't make sense to keep the fixed-income portion of your overall portfolio in your 401(k) if your only fixed-income choice is a lousy bond fund. You'll have to take some time to evaluate the options in your plan. Since most of these options are mutual funds, check out How to Pick the Best Mutual Funds. And speaking of mutual funds...

• Evaluate the tax-efficiency of your funds. You can also get help analyzing mutual funds at Morningstar.com. One of the stats provided for most funds is the "Tax Analysis," which can be found under the "Returns" tab once you locate a fund's profile. This reports how much of the fund's returns would have been diminished by taxes. For example, the humongous Fidelity Magellan fund posted a 10-year average annual return of 8.69%. However, after taxes the fund's return drops to 6.33% -- more than two percentage points.

Compare that to a tax-efficient index fund such as the also-gigantic Vanguard 500 Index fund, which posted a 10-year average annual return of 9.59% before taxes and 8.76% after taxes -- a loss of less than one percentage point. So, if you wanted to own two funds but weren't sure which one to add to your IRA, look to the Tax Analysis or the annual turnover, which measures how often investments are bought and sold in a fund, triggering taxes.

As for how your assets should be split amount income-producing investments, index funds, REITs, and other investments, that's a question we'll be answering in our newest online seminar, Perfect Your Portfolio: Asset Allocation for Long-Term Wealth.

The Motley Fool is investors writing for investors. To view a writer's current stock holdings, check out his or her online personal profile.