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.
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