3 Investments to Avoid in Your IRA | Smart Change: Personal Finance

(Adam Levy)

Saving for retirement using an IRA is a great way to save on taxes and accelerate your path to your financial goals. But not all investments will make the most of the tax advantages offered by an IRA. Here are three investments that are best kept in a regular brokerage account.

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1. Municipal associations

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

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Since common interest payments are already tax-free, you’re not gaining much benefit from keeping them in an IRA. Municipalities typically pay lower interest rates due to the tax benefits they offer, so you’d be better off buying a different type of bond for your IRA with fewer tax benefits than municipalities and higher interest payments.

If you want to invest in municipal bonds, you should keep them in a taxable account. You should also do a quick analysis to see if your tax savings are sufficient to make the lowest interest rate worthwhile.

2. Master in limited partnership

Limited partnerships, or MLPs, are another investment with integrated tax benefits. Since they are structured as a partnership, the cash flow and profits are distributed directly to the owners, called the unitholders, so they pay no corporate income tax.

There are also tax benefits for unitholders. Since most MLPs are able to claim substantial tax deductions, actual profits are far less than cash flows. As a result, unitholders receive significantly tax deferred cash flow 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. Additionally, by holding the MLP units in a taxable account, your heirs may be able to take advantage of the increased cost base at the time of your death. This would eliminate a large chunk of the tax liability involved in investing in MLPs.

3. Foreign taxpayers

Foreign stocks can provide a great way to diversify your retirement savings, but you may not receive all the tax benefits if you hold foreign stocks with high dividend payments in your IRA.

Although domestic dividends are not taxed in an IRA, you will still see taxes removed from dividends paid by most foreign companies. Those are the taxes paid to the house government of the company.

The United States has a law under which you can recover those tax payments: the foreign tax credit. That way, you don’t pay taxes both in the US and abroad. But you can’t claim that credit if you hold those dividend payers in an IRA. So, you end up receiving no dividend tax benefit by keeping them in an IRA.

The United States has some treaties with foreign governments to exempt shares held in retirement accounts from foreign taxes. For example, shares of Canadian companies do not withhold tax on dividend payments in an IRA.

What should you invest in?

While you can still buy foreign muni bonds, MLPs, and dividend payers in your IRA, you simply won’t get the most out of the tax benefits your retirement account offers. In order to maximize the usefulness of an IRA, we recommend that you purchase investments that do not have special tax advantages.

Better yet, you may find the opportunity to hold investments that would produce 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 can produce better after-tax returns within the IRA.

It pays to learn the basics of how your investments are taxed and the benefits of keeping them within an IRA. This 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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