Saving for retirement using an IRA is a great way to save on taxes and accelerate your path toward your financial goals. But not every investment will make the most of the tax advantages offered by an IRA. Here are three investments you’re better off keeping in a regular brokerage account.
1. Municipal bonds
Municipal bonds, or “munis,” are debt instruments issued by municipalities. The advantage of investing in munis is that the interest payments are exempt from federal income tax. Plus, if you purchase bonds from municipalities in your home state, they’re generally exempt from state income taxes as well.
Since muni interest payments are exempt from taxes already, you’re not gaining much advantage from holding them in an IRA. Munis typically pay lower interest rates because of the tax advantages they offer, so you’d be better off buying a different type of bond for your IRA with fewer tax advantages than munis and higher interest payments.
If you want to invest in municipal bonds, you should 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 partnerships
Master limited partnerships, or MLPs, are another investment with built-in tax advantages. Since they’re structured as a partnership, cash flow and profits are distributed directly to owners, called unit holders, so they don’t pay any corporate income taxes.
There are tax advantages for unit holders on top of that. Since most MLPs are able to claim substantial deductions on their taxes, the actual profits are far lower than cash flows. As a result, unit holders receive a significantly tax-deferred stream of cash flows every quarter.
Since an MLP already provides deferred tax benefits, there’s no reason to use an IRA to defer taxes on them if you could otherwise buy units in a taxable brokerage account. Additionally, by holding MLP units in a taxable account, your heirs may be able to take advantage of the step-up in cost basis upon your death. That would eliminate a big chunk 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 might not receive full tax advantages if you hold foreign stocks with big dividend payments in your IRA.
While domestic dividends aren’t taxed in an IRA, you’ll still see taxes removed from dividends paid by most foreign companies. Those are taxes paid to the company’s home government.
The U.S. has a law whereby you can recoup those tax payments: the foreign tax credit. That way, you’re not paying taxes in both the U.S. and the foreign country. But you can’t claim that credit if you hold those dividend payers in an IRA. So, you end up receiving no benefit on dividend taxation by holding them in an IRA.
The U.S. has some treaties with foreign governments to exempt shares held in retirement accounts from foreign taxes. For example, shares of Canadian companies won’t withhold taxes on their dividend payments in an 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 be getting the most out of the tax advantages offered by the retirement account. In order 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 an opportunity to hold investments that would produce a significant tax liability if you held them in a standard brokerage account. For example, REITs and high-yield bonds can produce significant tax bills each year, and may produce better after-tax returns inside your IRA.
It pays to learn the basics of how your investments are taxed and the benefits of holding them inside an IRA. That will allow you to make smarter decisions about what you invest in and where you hold those investments in order to maximize your portfolio balance.
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