When building your retirement portfolio, you may have some assets spread across a 401(k), a taxable account, and an IRA. The types of accounts you use to invest in each type of asset can have a significant impact on your after-tax returns.
If you use a traditional IRA in your retirement planning, you should consider prioritizing the following three types of investments in that account.
REITs, or real estate investment trusts, pay 90% of their taxable income as dividends to shareholders. Due to their business structure, they do not have to pay corporate taxes on those profits. Unfortunately, that means shareholders have to pay regular income taxes on REIT dividends instead of the lower qualified dividend tax rate.
However, if you hold your REIT shares in an IRA, you won’t owe any taxes on those dividends. Of course, you will eventually pay income taxes when you take distributions from your IRA, but you should be able to pay a lower tax rate on distributions in retirement than if you paid income taxes on dividends while working.
You can get the same benefits in a Roth account, but Roth is more suitable for assets with the highest expected return. REITs generally offer intermediate expected returns. If you’re investing in a REIT that you think has high total return potential, consider a Roth instead.
2. Corporate bonds
Corporate bonds suffer from the same tax problem as REITs. Interest payments on those bonds are taxed at your regular income tax rate if you keep them in a taxable account. You can protect yourself from that tax burden by keeping them in a tax-sheltered account like an IRA.
Again, the idea is that your income tax rate is lower during retirement than your marginal tax rate during your working years. Also, the expected total return on bonds is typically lower than other asset classes like stocks, so you may not want to prioritize them in a Roth account. That said, junk bonds (so known for their higher risk of default) can produce a high total return, and investors may also want to consider holding them in a Roth account.
3. Supplements to your 401(k)
While a 401(k) is a great retirement account with many advantages, a drawback to most 401(k) plans is a limited number of investment options. That can leave some holes in your portfolio, and you can probably fill them using an IRA. IRAs give investors much more freedom to choose their own investments.
An example of an area where your 401(k) may be lacking is in inflation-protected assets, such as TIPS. In fact, an IRA is a great place for TIPS because the adjustments in TIPS are taxed as income every year, whereas an IRA will allow you to defer those adjustments.
Another situation may be that the offers of funds in your 401(k) for a certain asset class are simply much more expensive than others. If you can find a fund with a low expense ratio, you can buy it in your IRA and put more money into your 401(k) in less expensive options.
Taking the time to consider where you invest in certain assets based on the options you have and the tax treatment of each will help you produce better after-tax returns without taking on any additional risk.
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