IRA plans can be excellent ways to save for retirement, but there are some investments to avoid holding in them if you want to take full advantage their tax advantages. Two that come immediately to mind are tax-exempt municipal bonds and high-yielding stocks from foreign countries with dividend withholding taxes.
Tax-exempt municipal bonds
While these types of bonds can make great investments if you have a high income and hold them in a taxable account, investors holding them in IRAs miss out on a key benefit. As their name implies, tax-exempt municipal bonds avoid federal income tax (except in certain cases involving alternative minimum tax), but holding them in an IRA defeats the purpose of this tax exemption.
In a traditional IRA. the primary benefit is that you don't have to pay taxes on gains until you make withdrawals, which only become required after age 70 1/2. But tax-exempt municipal bonds mean you wouldn't have to pay taxes on the interest anyway. As a result, there's an opportunity cost associated with holding them in your IRA, as they would crowd out otherwise taxable investment income. It's also important to note that because IRA withdrawals are taxed at ordinary income tax rates, holding tax-free municipal bonds in an IRA would result in taxes on interest from these tax-exempt bonds.
Additionally, tax-exempt municipal bonds trade at valuations assuming the buyer will be using the tax-exempt status. To calculate whether a tax-exempt municipal bond is more or less attractive than a taxable bond, investors use this formula for calculating tax-equivalent yield:
Tax equivalent yield = Tax-exempt yield / (1- Tax Rate)
But having a 0% tax rate, which would be the case in an IRA, means you are getting a lower tax-equivalent yield than the market typically prices tax-exempt bonds for. This, in turn, means that putting tax-exempt bonds in an IRA causes you to overpay on a tax-equivalent yield basis more often than not.
If you're interested in municipal bonds for the safety they provide rather than tax-exempt status, you may want to look at taxable municipal bonds for your IRA. Since interest from these bonds is taxable to investors holding these bonds in taxable accounts, they generally carry higher yields to make up for the difference. But for IRA investors, the bonds are tax-advantaged anyway, making them a way to get more yield than tax-exempt bonds but with similar risk.
Exceptions: While putting tax-exempt bonds in your IRA to earn interest is rarely a good idea, putting them in your IRA may work if you're investing in them for capital appreciation. Since the increase in the bond's value is not tax-exempt in taxable accounts, an IRA could help you save on taxes here.
However, the same applies to taxable bonds, and if you're looking for capital appreciation it can still help to collect a larger yield while you wait.
Certain foreign stocks
International diversification can help in building a retirement portfolio, but not taking the right steps can mean missing out on some dividends. While dividends from U.S. companies are tax-advantaged in IRA accounts, most dividends from foreign countries are hit with a dividend withholding tax.
Some countries, such as the United Kingdom, have no dividend withholding tax, but others can run as high as 35%, as is the case with Switzerland. In many cases, the listed dividend withholding tax rates are reduced through tax treaties, making dividend withholding tax rates for U.S. holders, including those holding shares in IRA accounts, closer to 15%. At this point, you can decide whether it's worth giving up 15% of your dividend to gain exposure to a specific stock.
However, getting this rate is not always easy. Switzerland, for example, withholds 35% anyway since it can't tell whether the person holding the shares qualifies for the 15% rate. To get the difference back, you must file the right forms, which simply isn't worth the time and expense for most small investors.
Other countries that do the same thing include Germany, Ireland, France, and Spain. Filing the right forms with these countries can reduce foreign dividends withheld. But even after filing these forms, a dividend withholding tax of 15% or more will usually apply.
I encourage examining your options for more than just tax purposes, but if you're still looking for ways to avoid foreign dividend withholding tax, there are options. Dividends from the United Kingdom don't have a dividend withholding tax, and dividends from Canada avoid the dividend withholding tax if the shares are held in a qualified retirement account. Both of these countries have several major banks that may interest financial investors looking for dividends.
If you're interested in investing in foreign dividend stocks, it may be worth doing so in a taxable account, since most investors would be able to claim a foreign tax credit for dividend taxes withheld. However, it would result in taxation of any capital gains that result.
Exceptions: Just because part of the dividend will be withheld doesn't mean you should avoid the investment altogether. If, after doing your own research, it still provides the best income opportunity after tax, then it could be worth buying anyway.
Additionally, it can be worth buying these shares for capital appreciation. Since capital appreciation isn't withheld, you can still get tax-advantaged treatment for gains.
Picking your investments
IRAs offer special tax savings for retirees -- and if this article has you wanting to open one, then check out this Fool section where you can learn more about IRAs and figure out which one is right for you. But even with their built-in benefits, it's important to know how to fully take advantage of them. When it comes to tax-exempt municipal bonds and certain foreign dividend stocks, IRA investors should take a second look to make sure they're getting the maximum tax-equivalent yield available to them.
Alexander MacLennan is not a tax professional. Always consult a reputable tax professional before making any investment decisions.
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