By now, I hope most of you have seen the wisdom of setting up an IRA of some kind. Whether it's a traditional pre-tax IRA, a Roth IRA, or a rollover IRA you funded with an old 401(k) balance, there should be no doubt that a well-tended IRA is an excellent wealth-building machine over the long haul.
While the different types of IRAs matter -- and the idea of converting your non-Roth IRAs to Roths deserves some consideration -- there's a larger question that many folks miss: What should you hold in an IRA?
Or put another way, how can you use your IRA(s) to lower your overall tax bill?
Tax-aware asset allocation isn't just for tax nerds
"Tax-aware asset allocation" is a dorky name for a simple idea: If you think of all of your different investment accounts as one big portfolio -- and you should -- then it makes sense to put the things that generate the most tax liability into the tax-sheltered accounts.
What are those things? Below I've separated some common investments into more-or-less tax-favored categories. To be clear, you can hold any of these in an IRA or a taxable account -- it's up to you. But separating them out roughly along these lines could save you big bucks at tax time.
Put these in your IRA
These investments typically generate the highest levels of tax liability. Your IRA -- or, where applicable, your 401(k) -- is the ideal place for them:
Junk bond or "high yield" funds: Mutual funds that hold bonds from issuers with lower credit ratings -- a quick look at Fidelity High Income Fund's (SPHIX) recent holdings showed it owned bonds issued by Chesapeake Energy
(NYSE:CHK)and Huntsman (NYSE:HUN), for instance -- have two tax strikes against them: The interest those bonds pay is taxable as "ordinary income," and high turnover -- which creates a big liability that's passed on to shareholders -- is common. Hide these puppies in your IRA.
Stocks you're planning to sell soon after purchase: If you hold a stock for a year or less, you pay tax on the gains at your "ordinary income" rate. Hold it longer and you get the much more favorable 15% maximum capital gains rate. Hoping for a quick pop on a small cap like Pacer International
(NASDAQ:PACR)? Do it in your IRA (or better yet, forget the quick pop and just hold that one).
- Corporate bonds and higher-grade bond funds: Turnover is typically less of an issue with "investment-grade" bond funds, but that yield is still taxable as ordinary income.
- Stock funds with high turnover: Many (but not all -- shop around) actively managed stock funds have high turnover, creating big, taxable capital gains distributions that get passed on to shareholders. Your IRA or 401(k) is the best place for these.
These investments, on the other hand, have some tax advantages that make them well-suited for your taxable account:
- Treasuries: You'll still pay federal taxes at "ordinary income" rates on those yields, but unlike other bonds, Treasury yields are exempt from state income taxes.
Master Limited Partnerships: These oft-misunderstood babies -- companies like Enterprise Products Partners
(NYSE:EPD)and Alliance Resource Partners (NASDAQ:ARLP)-- are some of my favorite investments. Briefly, they're usually companies that develop and own energy infrastructure -- and under a special provision of the tax laws, they're allowed to be set up as partnerships, which lowers their cost of capital. Like a REIT, they're "pass-through entities": Most of their cash gets passed out to their owners -- that's us. That usually means a big yield; 7% or 8% is common. But wait, it gets better: Because of some other complicated tax provisions, you typically pay taxes on only a portion of that yield.
- Index funds: Low turnover, low tax liability. Plain and simple.
Long-term stock holdings: Think Apple
(NASDAQ:AAPL)will be able to sustain its success until Steve Jobs hits 100? Looking forward to a day when there's a Chipotle Mexican Grill (NYSE:CMG)on every street corner in the world? Park those in your taxable account. As long as you hold for longer than a year, you'll pay taxes on your gains at the lower capital gains rate when you sell.
- Municipal bonds: They're free of federal taxes, and they might be free of state taxes, too, if you live in the place that issued them. Keep 'em in a taxable account.
Again, where you actually hold what investment will depend on your personal situation. But planning your investments with a tax strategy in mind is one approach that many people miss -- and that's too bad, because it can make a big difference to your bottom line over time.
Fool contributor John Rosevear owns shares of Apple and Enterprise Products Partners. Chesapeake Energy is a Motley Fool Inside Value selection. Chipotle Mexican Grill is a Motley Fool Rule Breakers pick and a Motley Fool Hidden Gems recommendation. Apple is a Motley Fool Stock Advisor recommendation. Alliance Resource Partners and Enterprise Products Partners are Motley Fool Income Investor picks. The Fool owns shares of Chesapeake Energy and Chipotle Mexican Grill. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a tax-savvy disclosure policy.