Finding the best investments takes skill and effort. Once you've done all the legwork to seek them out, though, make sure that you put them where they'll do you the most good.
Where matters as much as what
To maximize your profits, you need to figure out how to fit your investments among the different accounts you have, each of which plays a vital role in your overall financial plan. For instance:
- If you're saving for retirement, then you may have a 401(k) or similar employer-sponsored plan account at work, along with traditional and Roth IRAs. With most 401(k)s, you'll have limited choices about where to put your money, but you can invest in just about anything you want in your IRA. With traditional 401(k)s and IRAs, you'll have to pay tax when you take withdrawals; a Roth, on the other hand, gives you tax-free treatment.
- Putting money aside for your kids' college education? 529 plans and Coverdell ESAs both have tax advantages, but again, 529 plans come with limited investment choices, depending on which plan you choose. ESAs give you the same flexibility as IRAs, but with a maximum contribution of just $2,000, you're unlikely to cover Junior's bills with an ESA even if you start early.
- Regular taxable accounts have no investment restrictions at all. You can buy whatever you want, but you'll have to pay tax on your investment income along the way, and when you sell, you'll face another tax hit.
In all likelihood, you'll want a combination of several different types of accounts to meet all your financial needs. So how do you decide which investments are best for each account? The right decision involves making sure you pay no more in taxes than you have to.
High-income securities love IRAs
Unless you're hyper-aggressive and have a very long time horizon, every portfolio should have some fixed-income securities. For a basic bond investment, the ETF iShares Barclays TIPS Bond (NYSE: TIP ) gives you inflation protection and the creditworthiness of the U.S. government. With Treasury yields at very low rates, the corporate bond ETFs iShares iBoxx Investment Grade (NYSE: LQD ) and SPDR Barclays High Yield Bond (NYSE: JNK ) generate more income, although they're also subject to greater default risk from their bonds' issuers.
In a taxable account, most fixed-income securities, including these funds, generate income that's taxed at your highest ordinary rate. A traditional IRA, though, lets you defer that tax until you take the money out, typically after you retire and hopefully pay tax at a lower rate.
Your best stocks belong in a Roth
On the other hand, you'll definitely want to invest in stocks for their growth potential. For instance, Texas Instruments (NYSE: TXN ) has been around for decades, but it's still making decisions that will lead to future growth, including its recent initiative to move out of low-margin mobile phone radio chips in favor of high-end mobile processors. Similarly, Chesapeake Energy (NYSE: CHK ) is a top player in the natural gas industry and stands poised to produce big returns when demand increases and gas prices start to rise.
Putting these stocks in a traditional IRA gives you a huge disadvantage. Currently, investors pay a maximum of 15% on dividends and long-term capital gains on stocks. But any money in an IRA gets taxed at your regular rate, up to 35%, regardless of whether it came from income on stocks.
Instead, put top stocks like these in a Roth, where you'll avoid taxes entirely. Can't do a Roth? At the very least, keep long-term buy-and-hold stocks in a taxable account to take advantage of those lower tax rates.
Use IRAs for trading
Even if you're typically a buy-and-hold investor, you'll likely see trading opportunities from time to time. For example, dollar bulls have ridden currency ETFs PowerShares DB US Dollar Index Bullish (NYSE: UUP ) and UltraShort Euro ProShares (NYSE: EUO ) higher so far this year, and if you think the dollar's strength will continue, those ETFs could go higher still. But you don't necessarily want to count on that uptrend lasting a year or longer.
Since gains on short-term investments get taxed at your highest rate, put investments you intend to trade in your IRA. That way, you can buy and sell whenever the time is right without worrying about taxes. It also saves you the paperwork of accounting for buys and sells on your tax return.
Keep your eye on the ball
Unfortunately, these rules of thumb may change soon. Tax laws are in flux right now, with many expecting Congress to raise tax rates from their current levels.
But the general rule still holds: With a combination of tax-favored and regular accounts, maximize your tax savings with IRAs and 401(k)s while also taking advantage of low tax rates on taxable accounts. That way, you'll keep as much money in your pocket as possible.
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