It’s not how much you make that ultimately matters in wealth accumulation but how much you keep, and the amount of your gains that get lost to taxes are a major factor in your realized returns.
Thankfully, you don’t have to be a millionaire with an army of lawyers to effective game the tax code. Even the basic tools available to every American taxpayer, such as IRAs and Roth IRAs, can be wildly effective in lowering your tax burden and compounding your wealth at a much faster rate.
But as wonderful as an IRA or Roth IRA can be as a tax-free accumulation vehicle, we’re limited to contributions of just $5,500 per person per year ($6,500 if you are aged 50 or older). And worse, your ability to contribute to a Roth IRA gets phased out at higher income levels. So, if you’re aggressively saving for retirement, you’re going to have a large portion of your savings invested outside of an IRA or Roth IRA and subject to ravages of taxation.
This means we have to pick and choose which investments we put in our IRA or Roth IRA. And choosing poorly here can make a big difference to the lifestyle you can afford in retirement.
What Not to Buy in an IRA
Let’s start with what you shouldn’t put in an IRA or Roth IRA. Most obviously, this would include tax-free securities like municipal bonds. Any investor stupid enough to waste precious IRA funds on tax-free muni bonds should be taken out back and shot. Or at least sterilized.
The same is true of MLPs and other “special†stocks that create tax complications. Because MLPs can generate unrelated business taxable income (“UBTIâ€), they can create bizarre tax situations in which your IRA has to file its own tax return and pay taxes. And looking at the bigger picture, given that most MLP distributions are indefinitely tax deferred, there is no benefit to placing them in an IRA or Roth IRA. You’re effectively wasting precious IRA dollars.
Casting the net a little wider, I would say the same about tax-efficient index mutual funds or ETFs you intend to hold for the long-term.
There’s just no point in putting them in an IRA. Portfolio turnover is minimal in index funds, so they generate very little in taxable income other than the dividend yield, which these days amounts to all of 2%. Plus, once you sell the funds to pay for your retirement expenses, you’re going to be paying ordinary income tax rates on the full amount of the funds withdrawn from an IRA, whereas you’d be paying the long-term capital gains tax rate on just your capital gains on a taxable mutual fund or ETF investment. (You wouldn’t pay taxes on monies withdrawn from a Roth IRA, but my point stands.)
