This post shows how placing investments in the right “pots” can save a small investor $100,000 in a lifetime. This savings accrues from taking advantage how IRS taxes different investments at different rates and for different holding periods. Knowing these arbitrary IRA rules will save you more than you may believe.
Avoid In IRAs
All funds or assets withdrawn from a traditional IRA are taxed at ordinary income rates, up to 39.6% in 2013. Therefore, it makes little sense to place tax-saving investments (to be defined momentarily) in an IRA since they will lose their tax saving benefit upon withdrawal. Most obviously, one would never place a tax-free bond in an IRA or any type of retirement plan (e.g. 401k, pension, profit sharing, etc.) because it will be taxed when removed. The difference of income tax rates in this case, 0% for the municipal bond and as high as 39.6% for anything taken from an IRA, is huge.
As to annuities, annuity agents and annuity issuers will argue they have a place in an IRA for reasons other than their tax deferral (such as lifetime guaranteed income and death benefits and guaranteed income riders in the case of variable annuities). That may be the case, however, this author recommends that if you have 2 pots of money, one that is tax sheltered such as an IRA and one pot that is not sheltered, buy the annuity in the non-sheltered pot. There are better ways to employ tax-sheltered money.
A more subtle but no less important choice, is which stocks or mutual funds to place in an IRA.
Put Long Hold Stocks Into IRAs
Knowing how income tax rates apply to stock holding periods determine which stocks to own in or out of an IRA. If you have stocks that you will hold for many years, then it is very foolish to own these in an IRA. Stocks held for many years, when sold, will qualify for long-term capital gains rates, the lowest of income tax rates (15% for most people, 20% for those in the highest tax brackets). If we assume $50,000 of stock that is held for 30 years and sold, that appreciates 5% annually and pays a 3% annual dividend based on the stock year-end value, the difference in tax is as follows:
Tax paid over 30 years if held outside IRA, all at 15% : $38,319
Tax paid at end of 30 years when stock and dividends withdrawn, all at 39%: $116,723
(To keep the analysis simple, I have assumed that the dividends were not reinvested and earned 0% and have also not given credit for earnings that would have been earned on the annual taxes not paid if the stock were held in the IRA. However, even if these factors were incorporated, they would have a small impact in favor of the IRA. The calculation spreadsheet is here).
So we see that on a modest amount of stock, $50,000 worth, over 30 years, one pays 3 times as much tax by making the incorrect decision to hold the stock inside the IRA.
Alternatively, if you have investments in volatile stocks such as technology stocks or pink-sheet stocks that you plan to trade frequently (i.e. hold for less than 1 year), this is best done in an IRA. If you trade these stocks outside of an IRA, your profits will be short-term i.e. less than one-year holding period and therefore, you will pay the high ordinary income tax rate on profit (up to 39.6%). You will do no worse if you do this trading inside an IRA because the eventual income tax rate will be the same. But here’s the good part. When you do this trading inside an IRA, it is all tax-deferred until you are age 70 1/2 whereas such trading outside of an IRA would cause you to pay additional tax every year. The avoidance of the annual tax and the compounding that will accrue within the IRA will bring you significantly ahead.
The Right Mutual Funds for IRAs
As to mutual funds, it is critical to understand the nature of the mutual funds you buy or own as different funds are taxed at different income tax rates. Index funds, such as an S&P 500 index fund, does very little trading. The average stock within an index fund is held for four years. Therefore, when it is sold, the gain qualifies as a long-term capital gain taxable at a maximum income tax rate of 15% (for most investors). Additionally, the average stock in an S&P 500 index fund also pays a respectable dividend. These dividends also meet the standards for “qualifying dividends” and are also taxed at a maximum income tax rate of 15%. Therefore, one would be you terribly foolish if they understand income tax rates to put in index fund inside an IRA. To do so would be taking income preferably taxed at 15% and eventually exposing it to tax that could be as high as 39.6%.
The mutual funds that should be held inside an IRA are growth, technology and appreciation funds which commonly have turnover rates in excess of 100% annually. Doing so will avoid a nasty and expensive annual 1099.
As you see, a basic understanding of income tax rates and how they’re apply to different investments and their holding periods is critical to reducing how much IRS gets from you over a lifetime. Shockingly, the difference in taxes could easily be over $100,000 for someone with $100,000 of investments.
You Pay More Taxes Than NecessaryAnd we guarantee your CPA has never told you The problem with paying taxes is that most people overpay. So if you are concerned about having enough in retirement, you must stop overpaying taxes. I know you think your CPA takes care of this for you. WRONG. I AM a CPA (retired) and I can tell you that 90% of CPAs do nothing more than enter your information into the little boxes on the tax return but NEVER tell you how to pay less next year. Why? Many of them simply do not know what we can show you. In ten minutes.
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