With a relatively favorable resolution to the portion of the fiscal cliff dealing with scheduled tax increases, the vast majority of taxpayers will see little or no change in their overall income tax liability. But no one wants to pay any more tax than you absolutely have to.
One smart way to cut your overall tax bill is to take maximum advantage of tax-favored accounts like IRAs and 401(k)s. But it's not enough just to have those accounts in your investing arsenal; you also have to use them to their full capacity. Simply by paying attention to how you allocate assets among various types of accounts, you'll go a long way toward getting your tax bill as low as it will go.
The pros and cons of IRAs
Most investors understand that IRAs and 401(k) accounts offer great tax breaks. Traditional IRAs give you an up-front deduction when you contribute money initially, and then any income that investments within the IRA generate is tax-deferred as long as that money stays inside your retirement account.
But traditional IRAs and 401(k)s don't let you off the IRS hook forever. Once you start taking withdrawals from your account, you'll have to include those withdrawals as income and pay taxes on it. Worse still, those withdrawals are all taxed at your maximum ordinary income rate -- regardless of where that income came from.
Where to put your investments
Therefore, in order to make the best use of the IRA tax rules, you have to make sure you put the right investments in your IRA. If you follow a standard asset allocation strategy that includes several different types of investments, then you can minimize your current and future tax bill by following these simple guidelines.
1. If it generates ordinary income, put it in an IRA.
With new tax rates running as high as 43.4%, any investment whose income doesn't qualify for special treatment as dividends or capital gains has the highest priority to be in an IRA. That includes not only obvious items like taxable bonds and bank CDs but also less obvious investments that you may not realize get taxed at ordinary income rates.
For instance, dividend investors love the income that mortgage REITs Annaly Capital (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) produce, but what many don't realize is that those payouts generally don't qualify for the lower dividend-tax rates. With yields of 12% to 16%, you could pay between 5% and 7% of the value of your shares each year in taxes alone. But by putting them in an IRA, you can save that amount, and then hopefully qualify for a lower rate when you take the money out after you retire.
2. Keep low-income buy-and-hold stocks in taxable accounts.
On the other hand, if you have an investment that doesn't generate any taxable income at all, it can often bring you better results in a taxable account. For instance, Netflix (NASDAQ:NFLX) doesn't pay a dividend, with all of its current potential coming from long-term capital gains. If you're planning to invest in Netflix for the long haul in the belief that its content deals and international growth will pay off, then you'll potentially pay less in taxes holding the shares in a taxable account than you would in an IRA. That's because outside the IRA, you're entitled to a 15% to 20% maximum rate on long-term capital gains.
3. Master limited partnerships do best in taxable accounts.
Certain income-producing investments don't do well in IRAs because of special rules governing their taxation. MLPs have become extremely popular because of their high yields. Pipeline companies Kinder Morgan Energy Partners (NYSE:KMP) and Enterprise Products Partners (NYSE:EPD), for instance, yield between 5% to 6%, and some of that income doesn't get taxed immediately.
Putting MLPs in an IRA rarely makes sense, though, because getting too much MLP income in an IRA can actually lead to the disastrous result of having to pay tax on that income even though it's inside the IRA. That's one reason some investors choose to buy exchange-traded vehicles that invest in MLPs, but if you intend to hold on to MLP units for a long time, the better bet is often simply to keep them in taxable accounts.
Be tax smart
You only have a limited amount of IRA money to invest. Make sure you get the biggest tax savings you can from it by investing your IRA in highly taxed assets. That way, you'll end up with more and the IRS with less in the long run.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends Enterprise Products Partners and Netflix. The Motley Fool owns shares of Annaly Capital and Netflix. 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 Motley Fool has a disclosure policy.