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As the year comes to a close, it's time to start thinking about what you can do to make your investments work as hard as they can for you. With all the different types of accounts you can use to save, though, sometimes it matters just as much which account you use to invest as it does what investments you choose to make with your money.
For instance, most investors have access to tax-favored retirement accounts like IRAs. With all the flexibility that a regular brokerage account offers, IRAs give you the freedom to invest in a wide variety of different investments, from stocks and bonds to real estate and even certain gold coins and other precious metals. Given all those choices, though, figuring out exactly what you should put into your IRA can be really tricky.
Breaking it down
In determining which investments belong in your IRA, the first thing you need to know is what type of IRA you own. Contributing to a traditional IRA gives you a current tax deduction, and your investments grow on a tax-deferred basis within the IRA until you decide to take withdrawals from the account. All withdrawals get taxed as ordinary income, however, and if you take money out before you reach age 59 1/2, you may have to pay an additional 10% penalty.
Roth IRAs, on the other hand, have a different set of tradeoffs. With a Roth, you don't get an upfront tax deduction on the money you contribute. However, as long as you meet certain qualifications, you'll never have to pay income tax on money from a Roth, both while you keep it within the IRA as well as after you choose to withdraw the money in retirement.
Find the right stocks
What that means for your investing is that to make the most of the opportunities your IRAs offer, you need to tailor your investments to the type of IRA you have.
Traditional IRAs work best with assets that produce a lot of taxable income. That makes them ideal places for conservative dividend-paying stocks like Chevron (NYSE: CVX ) and Johnson & Johnson (NYSE: JNJ ) -- stocks you don't expect to experience huge growth in the future but which deliver a steady stream of slowly growing dividend income over the years. You'll eventually pay tax on those gains, but years of deferral will let you make maximum use of the IRA's benefits.
On the other hand, Roth IRAs give you the best bang for your buck with investments you expect to skyrocket in value. So if you look for investments that provide the sort of returns that Green Mountain Coffee Roasters (Nasdaq: GMCR ) and Southwestern Energy (NYSE: SWN ) have given shareholders in the past -- or if you think that gold can continue its meteoric rise and propel shares of companies like Barrick Gold (NYSE: ABX ) to new highs -- then you should look to use your Roth to turn all those potential gains into a tax-free windfall.
With some investments, both types of IRAs work equally well. For instance, if you make frequent trades on some stocks, the key is to be able to sell without paying high taxes on short-term gains. Finally, either IRA works well with stocks you plan to trade on a fairly regular basis. So using an IRA to scoop up shares of recovery stocks like MGM Mirage (NYSE: MGM ) or Citigroup (NYSE: C ) back in March would've been the right move if you expected to get out as soon as you had reaped your profits. In a regular account, you're faced with the dilemma of either paying higher taxes on gains if you sell now or potentially losing those paper profits if you hold for another few months.
In organizing your investments, it's critical to put everything in the right place. To make the most of tax-favored accounts, you need the right stocks in your IRAs. Although only hindsight will tell you where the best place would have been for a particular stock, making your best guess can make a big difference in your eventual tax bill.
If both bonds and stocks are overpriced right now, where should you put your money? Alex Dumortier has the right answer for your portfolio.