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Tax season is here again, and with time ticking away, many Americans will take advantage of the last-minute tax break that contributing to an IRA offers. Because you have until April 15 to make a contribution for the previous tax year, IRAs are popular at tax time. But even after you open an account, you face another big question: how to choose the best investments possible so that your IRA will grow. Here are a few tips for picking the best stocks for your new IRA.
1. Make the most of the IRA's tax benefits.
If you want an immediate tax deduction for your retirement contributions, you'll want to pick a traditional IRA. As long as you fall under certain income limits that vary depending on your filing status and whether you have access to an employer-sponsored retirement plan at work, you'll be able to deduct your IRA contribution on the returns you're about to file. As far as picking stocks is concerned, the key element of the traditional IRA is that any dividends or capital gains won't be subject to tax until you make withdrawals in retirement. That's different from regular accounts, where you pay taxes on dividends when they're paid, and you owe capital gains tax when you sell shares at a profit.
Photo credit: Flickr/Donkey Hotey.
As a result, traditional IRAs make great choices for stocks with high dividends -- especially those that don't qualify for preferential dividend tax rates. For instance, real-estate investment trust dividends are typically taxed at your full ordinary income tax rate, but if you hold them within an IRA, you won't pay anything as long as the money stays in your account. The same is true for other income-oriented investments, including bonds, bond mutual funds and ETFs, and business development companies. The higher the yield, the greater the savings from holding those stocks in an IRA versus a regular taxable account.
2. If an upfront deduction isn't your goal, a Roth IRA can have long-term benefits -- and is good for different stocks.
Roth IRAs differ from traditional IRAs in two main ways. They don't give you an upfront tax deduction; you have to use after-tax money in order to fund a Roth IRA. But in exchange, you don't just get tax-deferred growth of your retirement savings -- you get tax-free treatment.
That makes high-growth stocks a no-brainer for your Roth IRA. In a traditional IRA, high-growth stocks can actually end up costing you more in taxes than they would in a regular taxable account, because when you withdraw money from a traditional IRA in retirement, you pay ordinary income tax rates on the withdrawal -- even if those profits came from capital gains that would typically enjoy a lower tax rate. In a Roth, on the other hand, you won't pay any tax on those big gainers.
Photo: iamsummersblog.com.
To understand the full value of a Roth, consider this example: Three investors buy 1,000 shares of a stock that costs $5 per share, one in a taxable account, the second in a traditional IRA, and the third in a Roth IRA. Over the course of 30 years, the stock's value climbs to $500 per share. Assume that everyone is in the 25% tax bracket and that tax rates don't change in the interim.
All three investors will have accounts worth $500,000 30 years from now. If the taxable-account investor sells those shares, capital gains of $495,000 will get taxed at the lower 15% tax rate on long-term gains, costing $74,250 in taxes. The investor will end up with $425,750. If the traditional IRA investor withdraws the full $500,000 at retirement, then the tax will be 25% of that amount or $125,000, leaving $375,000 remaining. But the Roth IRA investor will have full access to the $500,000, thanks to the tax-free nature of the account.
Regardless of whether you pick a Roth or a traditional IRA, though, keep that April 15 deadline in mind. What you can save by doing so will make it worth your while.
