Individual Retirement Accounts receive special tax treatment that gives them the ability to supercharge your investment returns. The most important of these advantages is that -- unlike money invested using a regular brokerage account -- you don't incur taxes on the capital gains and dividends you accrue from investments in an IRA until and/or unless funds are withdrawn from the account. So, if you're not taking advantage of these tax-advantaged accounts, you're likely leaving money on the table. Proper asset location can improve your after-tax returns on investment by up to 0.75% per year.
Here are three strategies that you can use to take the best advantage of the IRA's special tax benefits.
Let's define some terms first
Before we get into strategy, let's step back and define the different broad categories of investment accounts you might have access to.
- Tax-deferred: Money that goes into these accounts is not counted by the IRS as taxable income in the year you contribute it. You pay no income tax on it -- until you go to withdraw the funds later, at which point you'll pay income tax on the distributions, at whatever tax rate you're paying at that time. These accounts don't incur taxes on capital gains or dividends. Examples include traditional IRAs and 401(k) plans.
- Tax-exempt: Your holdings in a tax-exempt account will not incur any additional taxes once the contributions are made. No income tax on distributions, no capital gains tax, and no dividend tax. Examples include Roth IRAs, Roth 401(k)s and Health Savings Accounts (if distributions are for qualified medical expenses).
- Taxable: For investments held in taxable accounts, you will incur taxes on capital gains and dividends. This is the category that includes your normal brokerage account.
Now, on with the strategies.
Strategy 1: Use your IRA for tax-inefficient investments
The simplest strategy is to include any tax-inefficient investments in your tax-deferred and tax-exempt accounts.
Some examples of tax-inefficient investments include:
- Bonds and bond funds;
- High-dividend stocks;
- Actively managed mutual funds with high turnover;
- Real estate investment trusts;
- Physical gold and physical gold ETFs (which are taxed as collectibles).
The corollary to this is that highly tax-efficient investments are better off in taxable brokerage accounts. Some examples of investments that you'll want to allocate to a taxable account rather than an IRA include:
- Municipal bonds and municipal bond funds;
- Stocks that don't pay a dividend (and probably won't for a very long time if ever);
- Stock index funds.
Strategy 2: Higher expected returns go in tax-free accounts
Since you will never pay taxes on the growth of those investments you hold in a tax-free account like a Roth IRA, that's where you'll want to put those assets with the highest growth potential.
The other advantage of putting growth investments in Roth IRAs is that they don't have required minimum distributions. By keeping assets with lower expected returns in your tax-deferred accounts, you reduce the size of your required minimum distributions (RMDs), giving you greater control over your income in retirement. And you may be able to use that control over timing to further save money on your tax bills.
Some assets with high expected returns, like growth stocks, are also relatively tax efficient. That can create a conflict -- should you follow strategy No. 1 or No. 2 with them? In these cases, you'll need to consider your overall asset allocation and the funds available in your various accounts to determine the best locations for your various high-expected-return assets.
Strategy 3: Keep volatile assets outside of tax-exempt accounts
Keeping volatile assets in tax-deferred and taxable accounts can be a useful strategy for investors who pay close and consistent attention to their holdings. There are a few things investors can do if they keep more volatile assets outside of Roth accounts.
The first is tax-loss harvesting. If your investments in taxable accounts have decreased in value, you can sell them and deduct the losses against your capital gains. You can also deduct a limited amount from your income taxes each year and carry forward any balance. You'll need to be aware of wash-sale rules, however, which apply to investments across all of your accounts.
Second, more volatile assets provide more opportunities to convert tax-deferred accounts into tax-free accounts. Performing a Roth conversion when the value of your assets in a traditional IRA is low could result in a lower tax bill than if you wait to withdraw funds in retirement.
Again, this can conflict with the other strategies. Higher volatility is correlated with higher expected returns. But for someone who is more active about managing their investments, it can be an effective strategy. For those who would rather take a more passive approach to their investments, there's not much to gain from keeping volatile assets outside of tax-free accounts.
Make the most of your options
By using these investment strategies, you could end up with more money to spend in retirement and paying less to Uncle Sam. If you're maxing out your retirement accounts, it pays to pay attention to which assets you're investing in which ones.