Tax Efficient Investing with IRAs
Individual retirement accounts, which you’re probably more familiar with as “IRAs,” are usually used as long-term savings solutions and most often hold things like stock funds.
However, bonds can be just as important to retirement planning, and that becomes even more apparent as you inch closer to retirement.
Before we go too much further, let’s take a moment to consider how IRAs work. If you’re 49 or younger, a traditional IRA lets you contribute either $5,500 or your taxable compensation for the year, whichever is greater (according to the 2016 rules). If you’re 50 or older, then you can contribute up to $6,500 each year to the account.
The contributions you make to your IRA account may be tax deductible, but that will depend on your actual income. You don’t have to pay taxes on interest or capital gains that are earned within the IRA, either. Instead, you’ll pay taxes on your distributions once you start pulling cash from the IRA account.
The same contribution limits are established for Roth IRAs. It is important to note that contribution limits to both traditional IRAs and Roth IRAs cannot exceed $5,500 if you’re under 50, or $6,500 for who are 50 and older.
Contributions to Roth IRAs are not tax deductible, but interest and capital gains within Roth IRAs are not taxable while they’re held in the account or when you withdraw income and capital gains from your Roth IRA.
Tax Efficient Investing by Splitting Assets
It’s crucial that you follow the right IRA investment strategy.
To do that, you’ll need to merge your IRA with your investment plan, rather than setting it apart as a separate entity unique to itself.
What that means, in short, is that the account doesn’t have to be fully diversified on its own, and can be used to house investments that have a greater potential for generating taxable income, or to help distribute your capital gains.
By ensuring that different accounts hold different investments diversified by tax treatment will ensure that you can add value during the accumulation phase and allows you to defer taxes or even eliminate them completely (such as through a Roth IRA). You also benefit from more diversification during the distribution phase.
Because IRAs are tax-deferred, they are often recommended to hold bonds. That allows you to defer the taxes due on income generated by bonds, which you would have to pay if they were held in taxable accounts. That would lead to a huge hit to your return.
Look at it this way. A conventional investment that yields 4% actually only generates 3% yield if you’re in the 25% tax bracket, and because of this, bonds (and any other higher-than-average income generating investment) are great fits for IRA accounts.
Additionally, remember that splitting your assets into multiple accounts doesn’t mean that you have more than one investment portfolio. Think of each account as a separate folder, but still contained within the same drawer of your filing cabinet (your portfolio).
As a simple example, suppose you had two accounts – one with bonds, and one with stocks. Rather than having two portfolios, one built completely out of stocks and the other of bonds, you actually only have one portfolio that is equally split between the two.
Municipal Bonds Should Not Be Held in Your IRA
While bonds are great fits for IRAs, that doesn’t apply in all cases. For instance, municipal bonds should not be placed in your IRA. This is because they are not taxable in any way (their primary draw), and that means they have a much lower yield than taxable bonds.
You actually gain no benefit from keeping municipal bonds in your IRA. Instead, keep them in a regular account.
In the End
While planning for taxes is a key consideration in developing an investment strategy, it’s actually more important to consider the bigger picture.
You’ll need to factor in things like your personal risk tolerance, your time horizon, your investment objectives and more.