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Why This Smart Investment Gets No Respect

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Millions of Americans have realized how important it is to save for their own financial future. But when it comes to taking maximum advantage of all the tools at their disposal, most of them ignore a smart investment that can be crucial in getting them to their long-term goals.

A survey last week from financial services firm TIAA-CREF looked at how Americans are using IRAs as part of their overall investing strategies to save for retirement. The results were frightening, as 80% of those surveyed said that they're not contributing at all to an IRA, up from 76% last year. Even worse, nearly half of the survey's respondents didn't even understand what an IRA really is or how it could help them with their retirement savings.

The key elements of a smart investment
To make the most of your limited investment resources, you have to take maximum advantage of the opportunities at your disposal. To make the smartest investments you can, you need to consider several factors:

  • Solid return potential. The best investments deliver outstanding returns to their shareholders because the underlying businesses that generate those returns have solid fundamentals and lucrative growth prospects to keep profits coming in well into the future.
  • High current income. Investments that produce substantial income is extremely valuable right now, because most of the traditional go-to income-producing investments are doing a woefully inadequate job of delivering their usual payout levels. High-yielding stocks and other investments are getting a lot of investor attention and seeing share prices rise as a result.
  • Favorable tax treatment. With Uncle Sam taking a larger portion of your earnings in the form of taxes, taking advantage of the tax benefits that certain investments offer has gotten more valuable in 2013. If current trends are a sign of things to come, higher future tax rates could make tax considerations even more important in judging a smart investment.
  • Good value. Even the best investments won't produce the returns you need if they're already too expensive. To maximize your returns, you have to discover good investments before the crowd has already bid their prices up. Otherwise, you'll miss out on the lion's share of a stock's long-term returns.

It's a rare investment that meets all four of these criteria. For instance, Chimera Investment (NYSE: CIM  ) and Two Harbors Investment (NYSE: TWO  ) have tapped into the lucrative returns available from leveraged investments in mortgage-backed securities, which they and their peers use to generate massive dividend yields. The same is true of Ares Capital (NASDAQ: ARCC  ) , which helps closely held businesses finance their current operations and future growth and which pays out dividends approaching 9% over the past 12 months. But the payouts from both of those types of investments generally don't qualify for lower tax rates on qualified dividend income, leaving taxpayers carrying a huge burden.

Even traditional stocks that do enjoy favorable dividend treatment can leave investors suffering. Rural-telecom stocks Windstream (NASDAQ: WIN  ) and Frontier Communications (NASDAQ: FTR  ) offer high levels of current income, with their dividend yields at or above the 10% mark right now, and even though their dividends generally qualify for the lower maximum rate on dividend income of 15% to 20%, that's still high enough to take a big bite out of after-tax returns.

How IRAs make investments smarter
But IRAs can help you take what would otherwise be a less-than-perfect investment and make it look a lot smarter. With the tax deferral that IRAs offer, high taxes on substantial income disappear at least until you start taking money out of your IRA at retirement. For Roth IRAs, you never have to worry about paying tax on that income.

Of course, an IRA by itself can't make a bad investment better. Concerns about weak growth prospects for Frontier and Windstream won't go away just because you hold shares in an IRA, and if mortgage REITs eventually suffer from worsening conditions in the bond market, then IRA holders won't fare any better than regular investors.

But what IRAs can do with good investments clearly makes them worth pursuing. Even if 80% of the public doesn't give IRAs any respect, that shouldn't stop you from reaping the benefits in your investing strategy.

When it comes to dividend yields, you won't find many higher than Frontier Communications. While its juicy dividend is tempting, every Frontier investor has to understand that it's not a sure thing. A huge acquisition has transformed the company forever. Will the move bear fruit, or are investors destined for another disappointing dividend cut? In this premium research report on Frontier Communications, we walk you through all of the key opportunities and threats facing the company. Get your copy today by clicking here.


Read/Post Comments (2) | Recommend This Article (8)

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 March 31, 2013, at 3:10 PM, nat0101 wrote:

    Think about it in every type of investment you get taxed at least once - even IRA and Roth IRA. So really how exactly is the Govt helping - what by not taxing you twice? When you put in the money and when you take out the money. IRA when you take out then you get taxed in you saving account for holding it and then you get taxed in what you by (total 3x tax ) Roth taxed when you put in the money then taxed again in your savings account or earned income and taxed again in the uses of your money such as taxes on the item you purchase.

    I wonder what the world record is for getting taxed here in the USA? Anyone know the record for how many times the same dollar gets taxed.

  • Report this Comment On August 20, 2013, at 5:26 PM, DavidBressler wrote:

    I love your perspective on using dividend investments in an IRA to maximize your returns (after tax) and make time work for your audience.

    Key line: IRA's don't make bad investments better. Very true.

    How should you maximize investing returns in a company with a powerful dividend? In my opinion reinvest the dividend. Most every brokerage has an option to do this at this point, and what it does for you is create an ever increasing income from your investment dollars to keep up with inflation.

    And, if you're lucky/smart enough to start saving early, you can create an income stream that never requires you to touch the principle. Leaving your principle there for "emergency".

    I have shared a (free) blueprint for retirement investing (sign up at http://ElephantsPaycheck.com) using dividends and reinvesting, including a unique way of tracking your investments and planning based on cash flow (paycheck) rather than principle (pile o' money).

    If you'd like to read a post about changing you perspective to one of income rather than principle, have a look at today's post: http://elephantspaycheck.com/401k-rollover/no-translation-ne...

    Enjoy,

    db

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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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10/24/2014 3:59 PM
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