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6 Great Buys for Your IRA

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When it comes to investing for the long haul and giving the Internal Revenue Service a stiff arm, there's nothing like an IRA to get the job done. But setting up an IRA is only half the battle. You also need to know how to invest with your IRA money -- and which investments make the most sense to hold within your retirement account.

The big benefits of IRAs
If you've never opened an IRA, you've been missing out on one of the most useful ways to save toward your retirement. The combination of features that an IRA gives you makes them a valuable weapon in your investing arsenal.

With traditional IRAs, you get benefits both now and later. Right now, most taxpayers get to deduct the money they contribute to a traditional IRA on their current-year tax returns. In fact, as long as you open an IRA by the tax filing deadline -- this year, April 18, thanks to a holiday on the more typical April 15 -- you can allocate your contribution to last year and claim the deduction on the return you're about to file. Depending on your age and tax bracket, that can save you hundreds or even thousands in taxes right away.

The real benefits, though, come in future years. From now for as long as you keep your IRA open, you don't have to pay immediate income tax on the income you earn on the investments you make in your IRA. As your account value increases over time, that can save you even more each and every year that you hold your account open.

Choose the right stocks
There's a trade-off for the benefits of a traditional IRA. When you withdraw money from your account, you have to pay tax on that money. Even worse, you have to treat those withdrawals as ordinary income, even if some of the profits actually came in capital gains or dividends -- items that would typically qualify for a lower tax rate outside a retirement account.

Because of that drawback, it's important to put the right stocks inside a traditional IRA. Apple (Nasdaq: AAPL  ) , for instance, has been a great growth stock that has turned many investors into millionaires over the years. But in an IRA, what would have been capital gains taxed at 15% will turn into ordinary income that will carry taxes of as much as 35%. That's a big haircut.

To make the most of tax deferral without losing preferential treatment on profits, the ideal IRA investment is one that produces a whole lot of regular income that doesn't qualify for lower tax rates.

The REIT stuff
One category of investments that fits the bill is the real estate investment trust. REITs give investors access to real estate related investments, but because of their pass-through nature, they typically don't pay dividends that qualify for lower tax rates. And with American Capital Agency (Nasdaq: AGNC  ) , Cypress Sharpridge (NYSE: CYS  ) , and Chimera Investment (NYSE: CIM  ) all paying in excess of 15% right now, they're strong candidates for a traditional IRA.

But you shouldn't let the tax tail wag the dog. REITs can be dangerous investments, especially mortgage REITs like the three mentioned above. With mortgage REITs, if interest rates turn against you, then dividend yields could plummet and your capital could be at risk. But given that your IRA is likely to be only a part of your overall portfolio, making sure that any REIT exposure you do have ends up in a traditional IRA makes sense.

Getting your income fix
In addition to REITs, other fixed-income investments like bonds pay interest that's fully taxable at your highest ordinary rate. That makes them good candidates for an IRA as well.

For instance, if you intend to take advantage of the relatively attractive rates that high-yielding junk bonds offer, then iShares iBoxx High Yield Corporate Bond (NYSE: HYG  ) or SPDR Barclays High Yield Bond (NYSE: JNK  ) give you an easy way to build a diversified portfolio of such securities. But hold them outside an IRA, and you'll pay tax each and every year on the income they pay. With trailing yields of as much as 8%, that could add up to a big tax bill. Keeping them in an IRA, on the other hand, lets you avoid that hassle.

The same holds true for inflation-protected bonds that the ETF iShares Barclays TIPS Bond (NYSE: TIP  ) owns. TIPS can be a tax nightmare, since you have to account for interest that you earned but never actually received. An IRA lets you ignore those considerations.

Get started today
If you haven't set up an IRA yet, do it now. With two months left before the tax filing deadline, you have plenty of time. But April will be here before you know it -- and the sooner you get signed up, the sooner you'll be able to get your money working harder for you.

Have a Roth IRA? Watch for Dan's Wednesday column, where he'll discuss great investments specifically tailored for Roths. And be sure to tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.

High-yielding dividend stocks like REITs are valuable for any investor. Find the best ones in the Fool's free special report, "13 High-Yielding Stocks to Buy Today."

Fool contributor Dan Caplinger got a big haircut over the weekend. He owns shares of Chimera. The Fool owns shares of and has written puts on Apple, which is a Motley Fool Stock Advisor pick. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy tells you what we're buying.


Read/Post Comments (11) | Recommend This Article (30)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 14, 2011, at 2:38 PM, Henry3Dogg wrote:

    "Because of that drawback, it's important to put the right stocks inside a traditional IRA. Apple (Nasdaq: AAPL), for instance, has been a great growth stock that has turned many investors into millionaires over the years. But in an IRA, what would have been capital gains taxed at 15% will turn into ordinary income that will carry taxes of as much as 35%. That's a big haircut."

    This comment is not rational.

    If you are in the position of holding stocks both inside and outside an IRA, then the argument may suggest keeping AAPL outside, and something else with an equally high, none GC return, inside, but even that isn't clear, even if you can find such a thing.

    Bluntly the IRA gives you tax free geometric growth, whereas tax on what goes in, or comes out at the end, is a one off percentage.

    The advantage of untaxed geometric growth is so great, that your argument is totally irrelevant for anyone who is more than 5 years from retirement.

  • Report this Comment On February 14, 2011, at 5:22 PM, TMFGalagan wrote:

    @Henry3Dogg -

    To be clear, the IRA only gives you tax-free geometric growth until you withdraw the money. Outside an IRA, you can get the same "tax-free" growth simply by holding the shares rather than selling them.

    Granted, if you're planning to be an active trader, I understand your point. But the tax savings is far from irrelevant for some, especially long-term buy-and-hold investors who plan to hang onto their stocks for a nice long time.

    best,

    dan (TMF Galagan)

  • Report this Comment On February 14, 2011, at 7:08 PM, Borbality wrote:

    I chose to open a Roth IRA. I'm 26 and the savings from deducting 5,000 will pale in comparison to being able to withdraw tax free in retirement, I think.

  • Report this Comment On February 14, 2011, at 7:29 PM, stan8331 wrote:

    I would have liked to see discussion of the relative benefits of Roth vs. Traditional IRA here. If the IRA were one's only retirement investment there's a good argument to be made for either choice. However, a large percentage of people have some sort of 401K or other employer-based retirement plan, and most of those will provide taxable income during retirement.

    For anyone who has a taxable retirement plan other than an IRA, I think the argument shifts dramatically in favor of the Roth. In that scenario the Roth can provide important tax-treatment diversification by offering protection from the effects of tax law changes and/or increases during retirement, and it also provides considerably greater flexibility since there are no required distributions.

    Another factor often overlooked is that for anyone who starts investing early in life and is fairly successful, the conventional wisdom that income in retirement will be lower than that received before retirement may not hold true. If that happened to be the case, taxable retirement income would look even less attractive versus tax-free Roth distributions.

  • Report this Comment On February 14, 2011, at 9:27 PM, TMFGalagan wrote:

    @stan8331 -

    Stay tuned; on Wednesday, I'll talk about investments for Roth IRAs and discuss some of the pros and cons of Roths and traditional IRAs.

    best,

    dan (TMF Galagan)

  • Report this Comment On February 14, 2011, at 10:28 PM, retireewannabee wrote:

    I'm with you, Stan. Compare and contrast would have been good.

    I started a 401k 20 years ago or so and started a Roth last year when my job was eliminated. couldn't contribute to 401k and had no match so nest egg had to sit anyway.

    Creating future tax free income made a lot of sense. I'll keep making token injections into Roth while I await the ability to contribute to 401k again. then I'll work out the cash flow so I can get the employer match and contribute to Roth.

  • Report this Comment On February 15, 2011, at 10:13 AM, cmstripling wrote:

    @Borbality, I'm in the same position, age wise, and opted for a Roth 401k (my employer doesn't match on account of our defined contribution pension) so I don't have the low end contribution limits. Going to open Roth IRA in a few weeks.

    If I'm not in a higher tax bracket in 30 years I'll be greatly disappointed in myself.

  • Report this Comment On February 16, 2011, at 11:43 AM, bikertodd wrote:

    I'm looking to transfer funds from an existing Roth IRA and set up a new Roth IRA and go with a REIT either NLY CIM or AGNC . Can these be put into a Roth or does it have to be a traditional IRA. Thanks for any insight

  • Report this Comment On February 16, 2011, at 2:07 PM, idiotdetector wrote:

    The author is obviously untrained and unskilled in the investment process, like everyone else associated with Motley Fool

    What kind of moron would advise these VERY risky investments for an IRA? When they go belly up, you cant get a tax deduction. Motley Fool is a disaster. If you listen to these rookies, you will lose it all.

  • Report this Comment On February 16, 2011, at 6:02 PM, mountain8 wrote:

    I would love to see an article on withdrawing from my investment accounts (TOD, IRA, and ROTH, I have all). How might I determine in what order I should liquidate and draw, which account first and second. When to begin drawing. what kind of paperwork/documents I'm going to need for the GOV. I hope to leave the Roth untouched to pass to my son. All I find is how and why to invest in either, not how to spend them at retirement in the most efficient, effective manner.

  • Report this Comment On March 05, 2011, at 7:53 PM, imthafool wrote:

    @ cmstripling, I think you hit the nail on the head. The determination between Roth and Traditional should be based on what you believe your income will be when you withdrawal. I personally opted for a traditional knowing that I will get pinched in taxes later on. For me my gross puts me in a higher tax bracket now but my pension for retirement will be just enough to sustain my quality of life... so for me the tax break I get now far overshadows the hit that I will take later. ATB

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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