3 investments to avoid in your IRA |  Smart Switch: Personal Finance

3 investments to avoid in your IRA | Smart Switch: Personal Finance

(Adam Levy)

Saving for retirement using an IRA is a great way to save on taxes and speed your way toward your financial goals. But not all investments will take full advantage of the tax advantages an IRA offers. Here are three investments that are best kept in a regular brokerage account.

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1. Municipal Bonds

Municipal bonds, or “munis,” are debt instruments issued by municipalities. The advantage of investing in munis is that interest payments are exempt from federal income tax. Also, if you buy bonds from municipalities in your home state, they are also generally exempt from state income taxes.

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Since municipal interest payments are already tax-free, you won’t get much benefit from keeping them in an IRA. Munis generally pay lower interest rates because of the tax advantages they offer, so you may be better off purchasing a different type of bond for your IRA with less tax advantages than Munis and higher interest payments.

If you want to invest in municipal bonds, you must hold them in a taxable account. You should also do a quick analysis of whether your tax savings are enough to make the lower interest rate worthwhile.

2. Master limited companies

Master limited partnerships, or MLPs, are another investment with built-in tax advantages. Since they are structured as a partnership, the cash flow and profits are distributed directly to the owners, called unit owners, so they do not pay corporate income taxes.

There are tax advantages for share holders on top of that. Since most MLPs can claim substantial deductions on their taxes, the actual earnings are much lower than the cash flows. As a result, unit holders receive a significant stream of tax-deferred cash flows each quarter.

Since an MLP already provides tax-deferred benefits, there is no reason to use an IRA to defer taxes on them if you could otherwise purchase units in a taxable brokerage account. Also, by having MLP units in a taxable account, your heirs can take advantage of the cost increase based on your death. That would eliminate a large part of the tax liability 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 receive all of the tax advantages if you have foreign stocks with large dividend payments in your IRA.

While domestic dividends are not taxed on an IRA, you will still see taxes eliminated on dividends paid by most foreign companies. Those are taxes paid to the local government of the company.

The US has a law by which you can recover those tax payments: the foreign tax credit. That way, you won’t pay taxes both in the US and in the foreign country. But you can’t claim that credit if you have those dividend payers in an IRA. Therefore, you end up receiving no tax benefits on dividends by keeping them in an IRA.

The United States has some treaties with foreign governments to exempt stocks held in retirement accounts from foreign taxes. For example, shares of Canadian companies will not have taxes withheld on their dividend payments into an IRA.

What should you invest in?

While you can still buy municipal bonds, MLPs, and foreign dividend payers in your IRA, you simply won’t take full advantage of the tax advantages the retirement account offers. To maximize the utility of an IRA, you’ll want to buy investments that don’t have any special tax advantages.

Better yet, you may find the opportunity to own investments that would incur a significant tax liability if held in a standard brokerage account. For example, REITs and high-yield bonds can produce significant tax bills each year and can produce better after-tax returns within your IRA.

It’s worth learning the basics of how your investments are taxed and the benefits of keeping them in an IRA. That will allow you to make smarter decisions about what you invest in and where you keep those investments to maximize your portfolio balance.

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