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Smart investors use every tool they have to protect their hard-earned money. When it comes to retirement savings, there's no better place to save than a tax-favored account like an IRA. But once you have money in your IRA, how can you make sure you take maximum advantage of the benefits it offers?
The most important part of your portfolio
For many investors, your IRA represents the biggest pot of investable money you have. Your home may be the most valuable asset you own, but as we've all learned all too well in recent years, you can't count on your home to grow in value -- and it can be difficult even to access the equity you have in your home, assuming you're fortunate enough to have any equity at the moment.
Your IRA, on the other hand, typically owns investments like stocks and bonds -- investments you can buy and sell when opportunities present themselves. Not only can you make annual contributions of $5,000 to an IRA throughout your lifetime, you also have the chance to roll over any money from your 401(k) into an IRA when you change jobs or retire. Those big lump sums from company retirement plans can really add up over time.
That's why it's so important to invest your IRA well. And one of the best ways to take maximum advantage of the power of IRAs is to buy investments that pay big dividends.
A taxing proposition
Dividend stocks are great for investors. They pay steady, predictable streams of income you can use either to pay living expenses or to reinvest. The companies that pay those dividends are necessarily more focused on their shareholders, because they have to make the effort to generate those dividend payments every quarter. That forces them to be more accountable than companies that simply hang onto their cash.
You might think, then, that any high-yielding dividend investment would be great for an IRA. The tax laws, however, are trickier than that. And more importantly, you only want the best dividend stocks you can find.
Staying (tax) smart
One example of how tax laws can bite you is in energy-related investments. Master limited partnerships (MLPs) pay dividends based on production levels on the energy-producing properties they own, and those dividend distributions are often substantial. Linn Energy (Nasdaq: LINE ) , for instance, pays an 8% dividend and has maintained a strong dividend for more than four years. Kinder Morgan (NYSE: KMP ) has raised its dividend 11 times since 2006 and now yields 6.3%. That kind of income is appealing.
But owning energy partnerships in an IRA can expose you to unusual tax rules. Without getting too far into the details, some of the income MLPs generate can create tax liability even within an IRA. And while some MLPs maintain stable dividends, others, such as Terra Nitrogen, have dividend payments that bounce around a lot. That makes it harder to count on the income they generate.
Also, holding foreign dividend stocks in an IRA can cause you to lose out on a valuable tax benefit. For instance, Canadian royalty trust Penn West Energy (NYSE: PWE ) has a current yield above 8%. But U.S. investors pay 15% withholding tax on those distributions, and within an IRA, you can't use the foreign tax credit to recover that money.
How can you avoid those potential pitfalls? Plenty of promising stocks let you maximize the tax protection your IRA gives you without running afoul of any arcane tax laws.
Real estate investment trusts are one great example. Chimera Investment (NYSE: CIM ) , for instance, has turned a high-risk portfolio of residential mortgage loans and mortgage-backed securities into enough profits to generate a 17.6% dividend yield -- none of which you'll pay tax on within an IRA. Realty Income (NYSE: O ) has a much lower yield of around 5%, but the retail-oriented REIT has boasted 51 increases in its dividend over the past 15 years.
On the other hand, many regular companies also work well in IRAs. If you like the healthy cash flow that small-town telcos Frontier Communications (NYSE: FTR ) and Windstream (Nasdaq: WIN ) use to support dividend yields in the 8% to 10% range, then why pay big taxes on those distributions? Hold those stocks in your IRA and stiff-arm the IRS until you retire.
An IRA is a valuable tool that you can't afford to waste. By holding great dividend stocks in your IRA, you can take maximum advantage of the tax protection your retirement accounts give you.
Want more great dividend stock ideas? These five dividend stocks are making retirees rich.
Fool contributor Dan Caplinger is always looking for stocks that pay you back. He owns shares of Chimera Investment. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy never stops paying dividends.