In November 1789, Benjamin Franklin lamented in a letter to a friend that there were only two certainties in life: death and taxes. Sure enough, Franklin died less than six months later, after having paid a considerable share of taxes to the newly established republic he helped found.
Though taxes are an inescapable part of modern life, Congress will occasionally enact relief measures to help ease the burden of taxation and to incentivize certain behaviors. One such law, the Taxpayer Relief Act of 1997, introduced the Roth IRA — a highly tax-advantaged savings vehicle that middle-class Americans could use to prepare for retirement.
The greatest savings account in America?
Unlike a traditional individual retirement account (IRA) where savers contributed pre-tax dollars, got access to tax-deferred growth, and then faced taxation upon withdrawals in retirement, taxpayers saving in a Roth IRA would contribute after-tax dollars upfront. In exchange, Roth funds would be permanently sheltered from federal income tax — allowing savers to enjoy both tax-free growth and tax-exempt withdrawals.
This extraordinary quirk makes the Roth IRA an excellent place to shelter what would otherwise be tax-inefficient investments, since interest, rent, capital gains, and dividend income earned by Roth holdings are all untaxed. Below are some great assets to hold in a Roth IRA.
Dividends paid by publicly traded companies are already tax-favored, as qualified dividends are subject to lower long-term capital gains tax rates — a maximum of 23.8%, inclusive of the 3.8% net investment income surtax.
However, that's a far cry from 0%, and it puts a drag on the performance of investors who reinvest their dividends to enhance portfolio returns. If you choose to hold dividend stocks in a Roth IRA instead, you can DRIP away — participate in a dividend reinvestment program — without having to pay Uncle Sam first.
Real Estate Investment Trusts (REITs)
Because REITs are required by law to distribute at least 90% of their annual income to shareholders, many of them sport hefty yields and are appealing to investors who seek consistent portfolio income. Unfortunately, REIT distributions are usually taxed as ordinary income, which can be subject to rates as high as 40.8%, after including the 3.8% surtax.
On the other hand, if you buy REITs with the money already inside your Roth IRA, you can spend or reinvest this income without owing a cent in tax.
If you've ever held mutual funds or ETFs in a taxable account, you may have noticed that you owed taxes on capital gains even when you didn't personally sell your shares — that's because you're also taxed on sales made by the fund.
High-turnover funds — those that frequently buy, sell, and replace their holdings — are less tax-efficient than buy-and-hold funds that sell or rebalance their investments infrequently. This is because each sale on the fund level triggers a tax consequence that is often passed onto individual shareholders. And the higher turnover the fund, the more likely you are to be hit by those taxes, which can seriously eat into your returns.
Of course, when you hold high-turnover mutual funds in your Roth IRA, you won't have to worry about taxes at all — whether you or the fund made the sale. Save your taxable brokerage account for tax-optimized, low-turnover funds, like Vanguard's Total Stock Market Index Fund, Admiral Shares (NASDAQMUTFUND: VTSAX) instead.
The tax code is generous toward investors, subjecting most capital income to long-term capital gains tax rates — but only if you hold an investment for a year or more. Anything you sell for a profit with a holding period of less than a year will trigger far less-favorable short-term capital gains taxes, which are equivalent to ordinary income rates.
Luckily, you can use that fact to your advantage by buying investments you plan to sell within a year in your Roth IRA — and avoid taxes on the earnings altogether. Meanwhile, it's a good idea to allocate the portion of your portfolio held in taxable accounts to long-term holdings, so that your wealth can be invested as tax-optimally as possible.
Good investing isn't just about earning a high rate of return. It's also about optimizing your portfolio so that you get to keep as much of what you earn as possible, making a thoughtful tax strategy an important component of any robust investment policy. Using a Roth IRA to hold investments with otherwise high tax burdens is a great way to start — and can seriously pay off.
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