5 of the Best IRA Investments

Some assets are better off than others inside of traditional or Roth IRAs

It’s not how much you make that ultimately matters in wealth accumulation, but how much you keep, and the amount of your gains that get lost to taxes are a major factor in your realized returns.

IRA investments
Source: Lendingmemo

Thankfully, you don’t have to be a millionaire with an army of lawyers to effective game the tax code. Even the basic tools available to every American taxpayer, such as IRAs and Roth IRAs, can be wildly effective in lowering your tax burden and compounding your wealth at a much faster rate.

But as wonderful as an IRA or Roth IRA can be as a tax-free accumulation vehicle, we’re limited to contributions of just $5,500 per person per year ($6,500 if you are aged 50 or older). And worse, your ability to contribute to a Roth IRA gets phased out at higher income levels. So, if you’re aggressively saving for retirement, you’re going to have a large portion of your savings invested outside of an IRA or Roth IRA and subject to the ravages of taxation.

This means we have to pick and choose which investments we put in our IRA or Roth IRA. And choosing poorly here can make a big difference to the lifestyle you can afford in retirement.

Ideally, you should prioritize for your IRA or Roth IRA any investment that gets a large chunk of its total return from current income. And specifically, it should be current income that does not benefit from special tax rates, such as qualified dividends taxed at the preferential 15% and 20% rates.

So with no more ado, let’s jump into the five best IRA investments … and then we’ll quickly hit a few things you really shouldn’t put in an IRA.

IRA Investments: Business Development Companies (BDCs)

IRA Investments: Business Development Companies (BDCs)Business development companies (BDCs) are an interesting niche of the market. They essentially do what banks used to do back in the good ol’ days before the 2008 crisis: lend money to up-and-coming businesses.

The tax code gives a nice bonus to BDCs. To encourage them to provide funds to capital-starved young businesses, all profits are tax-free at the corporate level … so long as they distribute at least 90% of it as dividends.

As BDCs are unable to retain much of their earnings for future growth, a large chunk of the total returns to investors comes from the dividend. Many BDCs yields well in excess of 10%. That alone would make them an ideal IRA investment.

But that’s not where the story ends.

The taxability of BDC dividends will vary from company to company, but the dividend will generally be some combination of lower-taxed “qualified” dividends, higher-taxed unqualified dividends and tax-deferred return of capital. Typically, the biggest chunk of the dividend is considered non-qualified and taxed as ordinary income, making BDCs woefully tax-inefficient. This makes them particularly well suited for an IRA or Roth Ira.

I’m a fan of BDCs under the right conditions, and I made a BDC my pick in this year’s Best Stocks for 2015 contest. Prospect Capital (PSEC) trades at a deep discount to book value and pays a fantastic 14% dividend yield. Thus far, the stock has had a rough 2015, but I expect it to finish the year strongly. I also consider it an outstanding IRA investment … and happen to own it in my own IRA.

IRA Investments: Equity REITs

Realty Income NYSE:OAlong the same lines, we have equity REITs.

Equity REITs have one of the simplest business models out there. They buy or develop real estate, lease it out and collect the rent. As with BDCs, REITs pay no taxes at the entity level … so long as they pay out 90% of their income in the form of dividends.

Although REITs are considered to be long-term growth vehicles, they also get a high percentage of their total return as income. But as far as tax treatment goes, REITs tend to get punished even harder than BDCs. In any given year, some portion of a REITs dividend may be classified as capital gains distribution or as a tax-free return of capital. But the lion’s share of the payout will generally be a non-qualified dividend taxed as ordinary income.

One REIT that I hold in my IRA that I am unlikely ever to sell is “the monthly dividend company,” Realty Income (O). Realty Income has paid 540 consecutive monthly dividends and has increased its dividend for 71 consecutive quarters. At current prices, it yields 4.7%.

IRA Investments: Mortgage REITs

mortgage reitEven less tax efficient than equity REITs would be their cousins, mortgage REITs.

Like equity REITs, mortgage REITs (or just mREITs) avoid taxation at the company level so long as they distribute 90% of their profits as dividends. But mREITs are even more dependent on their dividends for their total returns than equity trusts, as there is virtually no long-term growth component. Equity REITs hold properties that are presumed to rise in value over time. Mortgage REITs hold mortgages … while are eventually paid off or refinanced.

Many mortgage REITs, including blue chips like Annaly Capital (NLY), pay dividends well in excess of 10%. And virtually all of it is going to be taxed as regular income. This makes a mortgage REIT a very obvious choice as an IRA investment.

Mortgage REITs have been slammed in 2015 by fears that a Fed rate hike would raise borrowing costs and crimp profitability, and today many mortgage REITs trade for just 80% to 90% of book value. At these prices, they would seem to be a low-risk bargain.

IRA Investments: Bonds

Corporate Bonds bond fundsPersonally, I think you would have to be crazy to own bonds at today’s yields. I am about as close to a “bond bull” as you are likely to find these days because I believe that long-term yields will stay low for a long time to come.

But that’s hardly a rousing endorsement. At current yields, you’re locking in returns of, at best, 2.2% in 10-year Treasuries, and high-quality corporate bonds don’t yield much better. In my view, you’re much better off trying your luck with high-quality dividend-paying stocks.

Nevertheless, some investors crave the safety and predictability of bonds. And if you are going to invest in bonds, then by all means, you should protect your modest income stream by placing them in an IRA.

Bond interest is taxed as ordinary income, and bonds get virtually all of their returns in the form of current income if held to maturity. This makes them an extraordinarily tax inefficient investment … and a perfect IRA investment.

IRA Investments: Precious Metals

Gold prices
Source: Flickr

And finally, we get to precious metals.

I don’t consider previous metals an “investment,” per se. In my view, you keep a few gold coins around for the same reason you keep a gun: as “insurance” in the event that things really got bad. (Yes, my true Texas colors are starting to come out.) So, I personally would never keep a position in gold or any other precious metal in an IRA. In the event I actually needed gold, I would want it physically in hand.

But I also realize that my views a little eccentric here. Plenty of investors consider precious metals a viable asset class and allocate a portion of their portfolio to it in the form of a metal-backed ETF such as the SPDR Gold Trust (GLD) or the iShares Silver Trust (SLV).

If you are one of those investors, keep your precious metals investment in an IRA. Metals are considered “collectibles” for tax purposes, and gains are taxed at a 28% tax rate rather than the usual 20% capital gains rate.

And now, a quick look at what you should avoid using as IRA investments …

What You SHOULDN’T Put in Your IRA

NaturalGasPipeline185
Source: iStockphoto

Most obviously, this would include tax-free securities like municipal bonds. Any investor stupid enough to waste precious IRA funds on tax-free muni bonds probably shouldn’t have those funds in the first place.

The same is true of MLPs and other “special” stocks that create tax complications. Because MLPs can generate unrelated business taxable income (“UBTI”), they can create bizarre tax situations in which your IRA has to file its own tax return and pay taxes. And looking at the bigger picture, given that most MLP distributions are indefinitely tax-deferred, there is no benefit to placing them in an IRA or Roth IRA.

Casting the net a little wider, I would say the same about tax-efficient index mutual funds or ETFs you intend to hold for the long-term.

There’s just no point. Portfolio turnover is minimal in index funds, so they generate very little in taxable income other than the dividend yield, which these days amounts to all of 2%. Plus, once you sell the funds to pay for your retirement expenses, you’re going to be paying ordinary income tax rates on the full amount of the funds withdrawn from an IRA, whereas you’d be paying the long-term capital gains tax rate on just your capital gains on a taxable mutual fund or ETF investment. (You wouldn’t pay taxes on monies withdrawn from a Roth IRA, but my point stands.)

Charles Lewis Sizemore, CFA, is the chief investment officer of investment firm Sizemore Capital Management. As of this writing, he was long PSEC and O. Click here to receive his FREE weekly e-letter covering top market insights, trends and the best stocks and ETFs to profit from today’s best global value plays.

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