In addition to a tax deduction now (traditional IRA) or tax-free income in retirement (Roth IRA), the other major tax benefit of IRA investing is tax-deferred compounding. In other words, when your investments pay dividends, or when you sell investments at a profit, you won't have to pay dividend or capital gains taxes each year.
For this reason, putting your highest-dividend stocks in your IRA is the best way to maximize its long-term potential. When you're paying taxes on your dividends each year, it leaves you with less money to reinvest, and it can have a significant impact on your returns over time.
This is especially true for stocks that don't qualify for qualified dividend tax treatment, such as REITs and foreign stocks, whose distributions are generally treated as ordinary income.
On the other hand, non-dividend stocks you plan to hold for the long term make the most sense to hold in your taxable accounts, as you don't pay taxes on capital gains until you sell.
To illustrate the importance of placing your highest-paying investments in tax-advantaged accounts, consider this hypothetical and simplified example.
Let's say that you have $3,000 to invest in two stocks, one in your traditional IRA and the other in a taxable brokerage account. One of the stocks is a high-yield dividend stock that pays a 5% ordinary (not qualified) dividend, and the other is Berkshire Hathaway, which doesn't pay a dividend.
For simplicity, we'll assume that both stocks deliver 10% total returns over the long run. The dividend stock pays a 5% yield and increases in price by 5% per year, while Berkshire's gain is all in its stock price. We'll also assume you're in the 22% tax bracket and have a 20-year time horizon.
If you keep the dividend payer in your traditional IRA and Berkshire in your taxable account, the value of both investments after 20 years would be roughly $20,180. Selling Berkshire would result in a $17,180 long-term capital gain, which at the current applicable 15% rate would lower your total sale proceeds to $16,400. Selling the dividend stock and withdrawing the money would result in 22% income tax on the entire amount, resulting in proceeds of $15,740. Between the two, you'd have $32,140.
Now, let's say you did the opposite and held the dividend stock in a taxable account and Berkshire in your IRA. Your Berkshire investment would have grown to $20,180 and its sale and withdrawal would be taxable as ordinary income, so you'd have $15,740. However, your dividends paid by the other stock would be taxable every year, reducing your annualized return. After 20 years, the investment would grow to $16,510. I'll spare you the mathematics of 20 years of reinvested dividends, but when you sold the stock, you paid capital gains on the profit. In all, your proceeds upon the sale would be $15,370. The total between the two investments would be $31,110.
Here's the point: By not allocating your investments into the correct accounts, you'd be robbing yourself of more than $1,000 in profits. Sure, this is a simplified example, but this illustrates the importance of using your IRA in the best possible way.
Maximize your returns
IRAs can be an excellent way to lower your taxes either now or in retirement, but to truly max out the value of your IRA, it's important to fill it with the kind of investments that take full advantage of the tax-free compounding power. As you've seen, holding the right kind of stocks in your IRA can make a big difference over the long run.