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With April 15 just around the corner, you'll want to pull out all the stops to find ways to cut your tax bill. With that in mind, we asked three of our Foolish contributors to weigh in on some common questions about investing in IRAs.
Why do you like IRAs?
Robert Brokamp, lead analyst, Motley Fool Rule Your Retirement: Besides the tax advantages, they're a great way to segregate money for long-term purposes. We all try to restrain our spending, but we've all also occasionally spent more than we should have, partially because the money was sitting there, waiting around in our checking accounts. If you move some of that money to an IRA, you've put it in "Time Out" -- for decades. You have to make an effort to spend it -- something most of us wouldn't even think of, except during emergencies.
John Rosevear, Fool contributor: I like IRAs because:
- I can invest in almost anything I might want, in a tax-favored way.
- Low-fee options are widely available.
- Human-nature-transcending features such as auto-deduct/automatic contribution programs are widely available.
Dan Caplinger, Fool contributor: IRAs are a great way to track your progress toward retirement. While you might see balances in other accounts rise and fall with spending and saving patterns, it's easy to max out an IRA and watch it reflect your saving and investing habits over the years.
What do you like better: traditional or Roth IRAs?
Brokamp: You can't help but like Roth IRAs, where you get tax-free growth after paying taxes on the contributions at rates we likely won't see again for decades. As the saying goes, you pay taxes on the seed, but reap the harvest tax-free.
There's also the neat little trick of being able to withdraw the contributions (but not earnings) tax- and penalty-free, if you need it. Of course, this shouldn't be done lightly. But if you need the money for a home, college, or a garden-variety emergency, it's available with no short-term consequences. (Long-term, of course, you'll have less money in retirement.)
Rosevear: I like both traditionals and Roths, in different ways. The traditional gives you the tax deduction, which can be helpful for some. A Roth's principal-withdrawal feature, on the other hand, makes it easier to overcome the "well, I might NEED this money" objection. Both give you shelter from the tax consequences of investments with income streams.
Caplinger: I like the Roth, because in essence, it lets you put more money away. Sure, if you put the same amount of money in a Roth or a traditional IRA and invest them the same way, you'll end up with the same balance when you retire. But because you won't have to pay taxes on the Roth, that money's worth more to you in retirement.
What are some good investment ideas for IRAs right now, and why do they belong specifically in an IRA?
Brokamp: Use your IRA for investments that pay higher-than-average dividends or investment strategies that result in a lot of short-term gains. That includes stocks like Altria (NYSE: MO ) and Southern Company (NYSE: SO ) . If you invest in bonds yet aren't in retirement, use the funds in your IRA to avoid paying ordinary income taxes on the interest. Finally, IRAs are also good for Treasury inflation protected securities (TIPS), which not only pay federally taxable interest each year, but the inflation adjustment (known as phantom income) is also taxable each year.
Rosevear: Those who've read my articles lately already know what I'm going to say here: IRAs are a great place for fat dividend stocks! Cash dividends are taxable, even if reinvested. The way to maximize a dividend-investing strategy is to avoid those taxes. Three stocks I own in an IRA include Teppco Partners (NYSE: TPP ) , France Telecom (NYSE: FTE ) , and BP (NYSE: BP ) -- all of them have dividend yields of 8% or more.
Roths, of course, are an excellent place to put hot growth stocks, as you'll never ever have to pay taxes on the gains.
Caplinger: I especially like putting investments in IRAs that don't qualify for lower tax rates on dividends. That includes REITs like Vornado Realty (NYSE: VNO ) and energy royalty trusts like San Juan Basin (NYSE: SJT ) . In addition, bonds and other fixed-income plays also do well in IRAs.
How should your IRA fit into your overall asset allocation?
Brokamp: While saving for retirement, use your IRA for investments that would otherwise generate taxable ordinary income, dividends, or capital gains each and every year. This changes a bit in retirement. Then, keep dividend-paying investments out of IRAs since qualified dividends are taxed at lower rates than ordinary income. Use your IRA for investments that produce income or gains that you reinvest and plan to hold on to for many years.
Rosevear: An IRA's tax advantages are great for dividend stocks, interest streams from taxable bonds, etc., and Roths are especially great for big-growth holdings as noted. But in many cases, deciding what to hold in an IRA should come after you see what the best options are in your workplace savings plan. In other words, decide on an allocation, see how best to fit whatever's available in your 401(k) into it, and then use your IRA to fill out the rest.
Caplinger: I like to use my IRA to help rebalance my portfolio, because that way I don't have to pay taxes on the rebalancing trades. So I'll keep a mix of stocks, bonds, and cash in my IRA -- and while it won't necessarily match my overall asset allocation, it has enough of all three types of investments that I can rebalance when I need to.
Want to learn more about IRAs? We've got some great resources: