A guest post today – Let me introduce you to a simple concept, one that is overlooked by most IRA owners and unfortunately even many financial advisors. Not all investments are taxed the same way by IRS. Therefore, if you understand how different investments are taxed, you can use that information to pay the lowest taxes by using the correct investments in your IRA and the correct investments outside of your IRA.
Here are the basics. Some investments are taxed at 0%. These would be tax-free bonds and of course you would never place these in your IRA because when distributing them from your IRA, you would pay tax at your full rate, let’s say 30% for the purpose of this post. The next investment would be individual stocks. As long as you hold them for more than a year, the dividends you receive and the profit on your appreciation is taxed at 15% (for most taxpayers). However, if you had that same stock in your IRA, eventually, when you distribute the principal and dividends, you would pay tax at 30%. Therefore, it is foolish to hold stocks that will qualify for long-term capital gains treatment in your IRA. It is best to hold that type of investment outside of your IRA to take advantage of the very favorable tax treatment.
Alternatively, it’s likely that many investors buy mutual funds rather than individual stocks. Let’s assume the mutual fund is a growth mutual fund. Morningstar reports that the average growth mutual fund has a turnover rate of 100% annually. This means that the average stock in the fund is held for six months and any profits would not qualify for long-term capital gains treatment (which requires holding a stock for at least six months). If this mutual fund is held outside of your IRA, you pay your share of tax each year even if you make no withdrawals. So if the fund is generating the majority of its profits as short-term capital gains, you will pay tax on these at your regular income tax rate. In other words, if you earn $60,000 a year, and the fund generates $3,000 in short-term gains, that $3,000 is added on top of your income and taxed at the top rate applicable to you. Again, let’s say this is 30%. If you will be paying the same rate of tax later when you withdrawal these funds from an IRA, it certainly makes sense to hold such an investment inside an IRA so that you benefit from the years of tax deferred growth.
So let’s summarize so far. Assets that qualify for long-term capital gains treatment and are taxed for most people at 15% should not be placed in an IRA. Those investments would typically be individual stocks held for more than a year and index mutual funds which hold their shares on average for four years. Those investments that should be held in an IRA are those on which you would owe tax at your regular ordinary rates and therefore you gain by the tax-deferral of an IRA (or tax-free growth in the case of a Roth IRA).
So let’s take a look at the math so you can see the incredible difference by holding the right investments in the right places. For simplicity, let’s assume your IRA has one investment, shares of IBM.
Initial investment $50,000
Hypothetical growth rate of shares: 5% annually
Hypothetical Dividend: 3% annually
Investment made at age 40, liquidated at age 70
Taxpayer tax rate during holding period 30%
|Held inside an IRA||Held Outside an IRA|
|Value at end of 30 years||216,097||216,097|
|Tax paid on Dividends||0||31,392|
|Tax Paid Upon sale (and withdrawal from IRA) at end of term||81,221||24,915|
|Total Tax Paid||81,221||56,307|
It is quite important to have the right securities inside and outside your IRA based on the way the security is taxed. Show this post to your financial advisor and if he scratches his head, find another advisor.