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With tax time drawing to a close, you have less than a week left to make your 2010 contribution to your IRA. Yet whether you're still thinking about opening your first IRA or have had a retirement account for years, you may still have the obvious follow-up question: what's the best way to invest the money inside your IRA?
Why IRAs make sense
To answer that question, you first have to deal with another issue: which type of IRA you have. Depending on whether you choose a traditional IRA or a Roth IRA -- or both -- the best investments to put inside your retirement account could be vastly different.
Traditional IRAs are particularly popular at this time of year because they represent one of the few ways that you can do something now that will cut your tax bill on the return that you're about to file. Because you can designate IRA contributions you make on or before this year's April 18 tax deadline back to the 2010 tax year, a traditional IRA lets you claim a deduction of up to $5,000 -- or $6,000 if you're age 50 or older -- on your 2010 tax return. That can easily lead to valuable four-figure tax savings. The trade-off for that current tax savings is that when you retire, you have to pay tax on the money you withdraw from a traditional IRA.
On the other hand, Roth IRAs don't give you an upfront deduction, so you won't see any savings this April. What Roths do give you, though, is completely tax-free treatment on your contributions and their earnings when you take money out of your IRA after you retire. So if you think tax rates are going to go up from where they are now, then a Roth IRA makes a lot of sense -- because essentially, you get to lock in your current tax rate right now and never worry about paying tax again.
For most investors, a combination of both traditional and Roth IRAs makes a lot of sense. Getting a deduction now is very valuable, but it's also useful in retirement to have a pool of money you can draw from without worrying about tax liability.
The right investments for your IRA
To make the most of your IRAs, you should tailor your investments to take advantage of their strengths while avoiding their weaknesses. Let's break it down by type of account.
For traditional IRAs, the biggest investment benefit is the tax deferral they bring. But when you take your money out, you have to pay tax at your regular rate -- even if the income would otherwise have qualified for lower tax rates on dividends or capital gains.
To make the most of tax deferral, you'll want to put your highest-yielding investments in a traditional IRA -- particularly those that don't qualify for lower dividend tax rates. In the current low interest rate environment, mortgage REITs Annaly Capital (NYSE: NLY ) and Anworth Mortgage Asset (NYSE: ANH ) with their double-digit dividends are ideal candidates. High-yielding junk bond ETFs SPDR Barclays High Yield Bond (NYSE: JNK ) and iShares iBoxx High Yield Corporate (NYSE: HYG ) also fit the bill.
For Roth IRAs, the best investments differ because Roths have other advantages. The best thing about the Roth is its potentially unlimited tax free growth, so ideally, you want to put stocks with the highest growth potential in your Roth.
With that in mind, Apple (Nasdaq: AAPL ) , Netflix (Nasdaq: NFLX ) , and priceline.com (Nasdaq: PCLN ) are each runaway leaders in their respective industries. They certainly don't have as much growth potential as they did before their big gains in recent years, but many believe they still have plenty of room to run.
Be smart about your retirement
Of course, other factors also come into play in choosing investments for your retirement accounts. Your overall investment portfolio should have plenty of diversification, so if all your money is tied up in retirement accounts, don't just gravitate to one particular type of investment. But if you have multiple investing options, including retirement accounts and regular taxable accounts, steering your IRAs toward these types of investments and putting others in your taxable account can be the best move.
If you've already funded your IRA, then congratulations -- you've made a great first move. With the right investments, your IRA should serve you well for years to come.
Learn all the basics of financial planning with our 13 Steps to Investing Foolishly. It'll get you on track to a great financial plan in no time.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.