3 Investments You Should Avoid In Your IRA | personal financing
Saving for retirement with an IRA is a great way to save on taxes and speed your way toward your financial goals. But not every investment will make the most of the tax benefits that an IRA offers. Here are three investments that are best kept in a regular brokerage account.
1. Municipal bonds
Municipal bonds, or “monies,” are debt instruments issued by municipalities. The advantage of investing in money is that interest payments are exempt from federal income tax. Additionally, if you purchase bonds from the municipalities in your home state, they are generally exempt from state income taxes as well.
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Since municipal interest payments are already tax deductible, you don’t gain much benefit from keeping them in an IRA. Munis usually pay lower interest rates because of the tax benefits they offer, so you would be better off buying a different type of bond for your IRA with lower tax benefits than munis and higher interest payments.
If you want to invest in municipal bonds, you must keep them in a taxable account. You should also do a quick analysis to see if your tax savings are enough to make the low interest rate worthwhile.
2. Mastering Limited Partnerships
Master Limited Partnerships, or MLPs, are another investment with built-in tax benefits. Because they are structured as a partnership, the cash flow and profits are distributed directly to the owners, called unitholders, so they don’t pay any corporate income taxes.
Furthermore, there are tax advantages for unit holders. Since most MLPs are able to claim significant deductions on their taxes, the actual earnings are much less than the cash flow. As a result, unit owners receive a significantly deferred cash flow for taxes each quarter.
Since MLP already provides deferred tax benefits, there is no reason to use an IRA to defer taxes on it if you can purchase units in a taxable brokerage account. Additionally, by keeping the MLPs in a taxable account, your heirs may be able to take advantage of the increased cost basis upon your death. This will eliminate a significant portion of the tax obligations involved in investing in MLPs.
3. Foreign dividend payers
Foreign stocks can provide a great way to diversify your retirement savings, but you may not get full tax benefits if you hold large dividend-paying foreign stocks in an IRA account.
While local IRA dividends are not taxed, you will still see tax removed from dividends paid by most foreign companies. These are taxes paid to the company’s local government.
The United States has a law under which you can get tax refunds: the Foreign Tax Credit. This way, you will not pay taxes in both the US and the foreign country. But you cannot claim this credit if you keep the dividend payers in an IRA. Therefore, you end up receiving no interest on the dividend tax by keeping it in the IRA.
The United States has some treaties with foreign governments to exempt shares held in retirement accounts from foreign taxes. For example, shares of Canadian corporations will not withhold taxes on their dividend payments in the IRA.
What should you invest in?
While you can still buy muni bonds, MLPs, and foreign dividend payers in your IRA, you simply won’t get the most out of the tax benefits that a retirement account provides. In order to maximize the benefit of an IRA, you will want to purchase investments that do not have any special tax advantages.
Even better, you may find an opportunity to hold investments that will produce a significant tax liability if you keep them in a standard brokerage account. For example, high-yield REITs and bonds can produce large tax bills each year, and may produce better after-tax returns within your IRA.
It pays to learn the basics of how your investments are taxed and the benefits of keeping them within an IRA. This will allow you to make smarter decisions about what to invest in and where to keep those investments in order to maximize the balance of your portfolio.
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