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.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter: @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.