Whether you want him to be or not, Uncle Sam is one of your most important partners in your retirement planning. The taxes you pay have a major impact on your effective returns … and in some cases might make the difference between retiring comfortably or just barely getting by. That’s why it pays to know what investments should go in different retirement vehicles, such as a 401k, IRA or Roth IRA.
Not all investment gains are taxed equally. Some are taxed at preferential rates — or allowed to defer taxes indefinitely — while others will cost you so much of your current income, you might mistake them for a vindictive ex-wife.
So, as important as asset allocation, it’s all for naught if you don’t take tax allocation into account.
If you’re like most Americans, your retirement savings are a mixture of tax-deferred IRA and 401k money, and good, old-fashioned taxable bank and brokerage accounts. Today, we’re going talk about how best to arrange your investments within those types of accounts in order to lower your tax bill.
Obviously, non-interest-bearing cash generates no taxable income and should therefore be held in a taxable account. The same holds true for low-turnover, buy-and-hold stock index funds. There’s no reason to burn valuable tax-free dollars on something that’s not going to generate taxable gains.
Your IRA dollars should be reserved for the highly taxed stuff. So with no further ado, here are 10 investments you should always try to hold in an IRA if possible.
Investments to Hold in an IRA: Bonds
I’ll start with the most obvious asset class: fixed income.
I don’t get wildly excited about bonds these days because, frankly, they just don’t yield enough to warrant much of an investment. But bonds still have their place. They help to stabilize a portfolio and reduce volatility. And though they don’t pay what they used to, they do provide current income.
Unfortunately, virtually all of your return from debt comes from the coupon payment, which is fully taxable as ordinary income at your marginal tax rate. (The one exception being tax-free municipal bonds, of course.)
It’s bad enough that you’re earning a lousy yield from the bonds. Having to pay as much as 39.6% of it in taxes (the highest marginal rate) is insult to injury. So, to the extent you can, try to hold your taxable bonds in your IRA account.
Investments to Hold in an IRA: Closed-End Funds
Along the same lines, closed-end funds (CEFs) should be held in an IRA.
For the uninitiated, CEFs are a type of mutual fund that trades on an exchange. At first glance, then, they would seem a lot like exchange-traded funds (ETFs), but they are very different and should be thought of as distinct asset classes.
While many investors use ETFs as long-term buy-and-hold vehicles, they’re designed to be tradeable. The creation-and-redemption function helps their prices stay tethered to the fund’s net asset value. Closed-end funds, on the other hand, go public with a fixed number of units, and that number never changes. Thus, CEFs can often trade at significant premiums or discounts to their NAVs.
Also, most CEFs are designed to throw off a lot of income, even using leverage to boost yields. Taxable CEFs can yield anywhere from 7% to 10% or even more in some cases. Anything that generates that much taxable income should be held in an IRA.
There is one exception, of course. Just as tax-free municipal bonds should be held outside of an IRA, the same is true of tax-free municipal CEFs, which can yield 5% or more. There’s no reason to burn precious IRA dollars on something that’s already tax free.
Investments to Hold in an IRA: REITs
Congress may be full of bumbling imbeciles, but once in a while they get something right. That certainly is the case with real estate investment trusts (REITs), which they created in 1960. In the decades that have passed, REITs have become a mainstay in the retirement portfolios of millions of investors.
It’s easy to understand why. Sure, they give regular investors access to real estate that would normally be available only to the wealthy. But really, it all comes down to income.
REITs are exempt from federal corporate income tax so long as they pay out at least 90% of their profits as dividends. When you can avoid dishing out 35% of your income to the tax man, that leaves a lot more to pay dividends … which real estate investment trusts do in spades.
Unfortunately, REIT dividends are often not considered “qualified,” meaning they are generally taxed at higher rates. So, to the extent you can, it makes sense to hold your REITs in an IRA.
Investments to Hold in an IRA: Business Development Companies
Business development companies (BDCs) can be thought of as close cousins to REITs. Just as Congress created the REIT structure to encourage everyday investors to invest in real estate, they created BDCs to allow them to invest in non-public companies that would normally be the domain of venture capital or private equity companies.
In fact, BDCs are often referred to as “publicly traded private equity.”
However, unlike an investment in a traditional private equity — which can require minimum investments of tens of millions of dollars — a business development company can be bought just like any other stock in a brokerage account or IRA.
BDCs and REITs have similar tax treatment in that both are exempt from federal taxation so long as they distribute at least 90% of their net income as dividends. Not surprisingly, BDCs are some of the highest-yielding stocks on the market, with some yielding well more than 10%.
As with REITs, BDC dividends are not always taxed as qualified dividends. Most of their dividends tend to be ordinary income and taxed at your marginal tax rate. So, if these are definitely best held in an IRA.
Investments to Hold in an IRA: Alternative Investments
“Alternative investments” is something of a blanket term that can mean different things to different people.
To me, an alternative is anything other than the traditional asset classes of stocks, bonds or cash. But for many of my high-net-worth clients, this will generally mean hedge funds.
Due to the lousy yields on offer in the bond market, I’ve been using market-neutral hedge funds for accredited-investor clients. While volatility tends to be low, this usually comes at the cost of higher portfolio turnover, which is extremely tax-inefficient.
That makes them an obvious choice for an IRA.
You really should do your homework here, however, because certain assets can create tax headaches. Some funds generate unrelated business taxable income (UBTI), which can result in you having to file a tax return on behalf of your IRA. However, you can sometimes avoid this by buying the offshore version of the fund for your IRA.
Before you do this, make sure you discuss this with your financial adviser or with the fund’s general partner because every scenario is a little different. But as a general rule, a fund that is “tax safe” for an offshore investor will also be “tax safe” for a rollover IRA investor.
Investments to Hold in an IRA: Gold
I’ll be straight with you: I hate gold.
It’s pretty, and my wife likes to wear it. But I consider it a lousy long-term investment.
That said, gold has a lot of fans. It’s successfully survived the test of time, and it has consistently been a good inflation hedge.
If you insist on owning gold (or any precious metal), I recommend in physical form and keep them in a bank safe deposit box or in a home safe, ideally off the books. After all, if this is zero-hedge insurance for the post-zombie-apocalypse world, it’s best not to advertise to the world that you own it.
But if you are bound and determined to hold it as a financial asset, such as via the SPDR Gold Trust ETF (NYSEARCA:GLD), you should absolutely own it in an IRA. Precious metals, whether held as coins or held through an ETF, are taxed at the unfavorable “collectibles” capital gains rate of 28%.
Your typical online broker is not going to let you own gold coins in an IRA, but it can be done. There are plenty of self-directed IRA custodian that specialize in holding gold and other collectibles.
Investments to Hold in an IRA: High-Dividend Stocks
Stocks have proven to be great long-term investments over the decades. But these days, you’re not earnings a lot of current income on an index fund. The SPDR S&P 500 ETF Trust (NYSEARCA:SPY) yields a pitiful 1.9%.
Many investors choose to build income portfolios using utility, telecom, tobacco and other high-yielding stocks, many of which sport yields of 5% or more.
All of that is great, and I do plenty of it myself. But to the extent I can, I try to do so via my IRA, and I recommend you do the same. Even if you’re paying the qualified dividend tax rate of 15% to 20%, you’re still giving one of every five dividend dollars to the tax man.
Do yourself a favor and keep the higher-yielding stocks in your IRA. Use your taxable dollars for low-yield, low-turnover index funds.
Investments to Hold in an IRA: Momentum Stocks
An object in motion tends to stay in motion. That’s the basic idea behind momentum investing, and it works. Stocks that have outperformed of late tend to continue outperforming.
Of course, the party does eventually end. Momentum stocks eventually lose their momentum, at which point you sell and move on. So, momentum strategies tend to have a relatively high turnover, meaning they generate a lot of short-term capital gains subject to tax.
For this reason, I’d advise you to keep an open mind and consider running any momentum-based strategies in your IRA account.
A lot of investors tend to shy away from running aggressive strategies in their IRA for fear of losing money. Well, this is my thinking: If a strategy is too risky for your IRA, why invest in it at all? It’s probably a lousy strategy for your taxable money too.
If your strategy is worth doing at all, it’s worth doing in an IRA.
Investments to Hold in an IRA: Land Held for Speculation
As a general rule, any investments you make in rental real estate should be made with free-and-clear taxable money.
To start, most of your profit will be offset by non-cash depreciation expenses, so it makes little sense to burn precious IRA dollars to buy a building that already has fantastic tax breaks built in. Additionally, your IRA can’t take on a mortgage, as IRAs aren’t allowed to borrow. So, as a general rule, real estate should be held outside an IRA.
One exception is raw land.
If you’re buying raw land with the intent of flipping it, you might as well do it in your IRA and avoid the capital gains taxes.
This may or may not be practical depending on the cost of the land, and holding land in an IRA isn’t as straightforward as holding other assets such as stocks or bonds. But if you have IRA dollars to spare, using them for a well-researched land speculation is a sensible move.
Investments to Hold in an IRA: Actively Managed Mutual Funds
I’ve repeated multiple times that low-turnover index mutual funds should be held in a taxable account. They generate virtually no taxable income (other than the modest dividends), effectively deferring taxes until you sell. So, there is no point in putting already tax-deferred investments in a tax-deferred account.
Actively managed mutual funds are a very different story, however. Even if you buy and hold an active mutual fund, you can still be on the hook for a boat load of taxes due to capital gains distributions. It’s not uncommon for an equity mutual fund to have portfolio turnover of well over 100%.
Now, we could have an entirely different conversation about whether active mutual funds have any value at all or whether investors should just stick with index funds. But that’s a different story for a different day. Right now, we’re just talking about tax consequences. And the fact is that active funds tend to be pretty tax inefficient.
If you invest in actively managed mutual funds, do yourself a favor and do so via an IRA account.
Charles Sizemore is the principal of Sizemore Capital, a wealth management firm in Dallas, Texas.