Which Investments Belong In an IRA?

People frequently want investment recommendations. Less often do they concern themselves with which investments belong in which types of accounts. This is known as “asset location,” for those of you who like financial jargon. Investments generally grow faster in IRAs because Uncle Sam is keeping his hands off your earnings each year. Eventually, you pay the taxes when you withdraw the money, but there’s a good chance you’ll be in a lower tax bracket then. Nevertheless, some investments are better suited for taxable accounts (non-IRA). Today, we will look at the best and worst IRA investments.

Worst IRA Investments (in terms of tax efficiency)

  1. Municipal Bonds – These are already income tax-free (in most cases). Why would you screw that up by putting them in an IRA where the growth will all be taxable when withdrawn?
  2. Annuities – These already grow tax-deferred, so an IRA annuity only makes sense if you are buying for features other than tax benefits (e.g., guaranteed income riders). Still, it’s generally better to use after-tax funds (if you have them) to purchase annuities.
  3. Gold – Precious metals do not pay any dividends, so holding them in a taxable account does not create taxable income. When you sell them in a taxable account, you can take advantage of any capital losses or gains, which will be taxed at a maximum of 28% (a special cap gains rate that only applies to collectibles).
  4. Physical Real Estate – Some people just love real estate. However, I believe physical real estate should be owned outside of your IRA. Reasons include:
  • Owning property in an IRA negates all the familiar tax benefits of owning real estate such as the deductions for property taxes, mortgage interest, and depreciation.
  • There’s an extensive list of prohibited transactions. You and your relatives cannot occupy or work on the property, so forget free rent or “sweat equity.” You will also need a property manager since you personally cannot provide services like finding tenants if your IRA is the owner of the property. Every dollar you spend on the property must come from the IRA. So you need to have extra cash sitting in the account in case of unforeseen repairs.
  • It’s difficult to finance real estate owned by an IRA. So expect to pay cash. If you do manage to get a loan, you can be hit with a tax when you sell the property known as Unrelated Business Taxable Income (UBTI).

Owning investment real estate typically works much better outside a retirement account, where you can borrow at low interest rates, enjoy the tax deductions, and benefit from long-term capital-gains rates when you sell.

Best IRA Investments (in terms of tax efficiency)

  1. Bonds – It makes sense to hold bonds in your IRA because they make regular interest payments, which would be taxed at your full “ordinary” income tax rate. This is particularly true of high-yield or junk bonds, which pay higher interest.
  2. REITs – Real Estate investment trusts pay regular distributions that are taxed as ordinary income, so it makes sense to defer the taxes on these investments by holding them in your IRA. Similar to stock dividends, distributions from a REIT are not guaranteed and can be changed or eliminated at any time. Additionally, they are speculative in nature so an investor needs to make sure they are suitable based on their investment objectives and risk tolerance.
  3. Stocks – The case for stocks is less compelling because their dividends and capital gains already get preferential tax treatment (less than ordinary income rates). However, stocks belong in your IRA because long-term investing (for retirement) relies heavily on stocks for their historically superior performance over bonds or cash as well as for diversification. In fact, you should put your most aggressive, and most long-term stock holdings in your ROTH IRA, if you have one.

Final Thought: Which account holds your investments is less important than saving the money in the first place and investing it in a well-diversified portfolio. Once you have those two items taken care of, you can worry about asset location. ????

Have a great week.

DISCLOSURE:  The purpose of this article is to educate the reader on the potential tax consequences of various investments and account titling.  An investor should also consider all the material differences between investments such risks, costs and expenses, liquidity, safety, guarantees or insurance, fluctuations of principal or return, and uncertainty of future dividends. The objectives of the investor also play a central role and must be considered before an investment is deemed suitable.  As such, nothing stated in this article should be considered a recommendation.