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How to Invest IRA Accounts

Last update on: Nov 09 2017

IRAs seemed so simple when they were started. Make the maximum contribution; invest the money until retirement; and then take money over time to pay for retirement.

Managing IRAs, however, requires more thought if one wants to maximize after-tax retirement income. One issue that is not considered enough is which investments are best held in these tax-deferred accounts. Most investors own both taxable and tax-deferred accounts. Some also own tax-free accounts, such as Roth IRAs. Switching the investments between the accounts can change the amount of after-tax income available for retirement.

Here are the key factors that influence the results:

  • Earnings compound free of taxes in IRAs and other tax-deferred accounts. The longer the returns are allowed to compound in the deferred account, the greater will be the wealth that accumulates.
  • When earnings and pre-tax contributions are distributed from a deferred account, they are taxed as ordinary income. It doesn’t matter how the distributions would have been taxed if they had not been in the account. The distributions are taxed at the taxpayer’s ordinary tax rate.
  • Under current law, long-term capital gains and qualified dividends are taxed at a maximum 15% tax rate. For taxpayers in the lowest tax brackets, they are taxed at lower rates. Short-term capital gains (imposed on assets held for one year or less) are taxed at ordinary income tax rates. Capital gains are not taxed until the asset is disposed of.
  • Investment returns in a Roth IRA compound tax deferred. In addition, qualified distributions from a Roth IRA are tax free.
  • Stocks and other investments that tend to generate long-term capital gains have higher long-term returns than do bonds and other investments that pay interest.
  • Losses incurred in IRAs and other tax-deferred accounts rarely are deductible. Losses in taxable accounts are deductible dollar for dollar against capital gains, and up to $3,000 of excess losses each year can be deducted against other types of income. Additional excess capital losses are carried forward to future years and used in the same way.

Taxes clearly matter and should be a factor in deciding which investments to own in each account. The greater the gap between one’s ordinary income tax rate and the long-term capital gains rate, the more important the decision is. The maximum ordinary income tax rate is 35%, and the maximum capital gains rate is 15%.

A stereotypical investor will hold stocks and equity mutual funds for the long term. The mutual funds will have low annual distributions that are subject to taxes. For this investor, the best advice is the conventional advice. Hold in a taxable account investments that already are tax-advantaged, such as stocks, equity mutual funds, and real estate. Gains from these investments will be taxed at the maximum 15% long-term capital gains rate. If the investor incurs losses in the taxable account, these can offset gains from other investments in the account or other income.

If these tax-advantaged investments instead were in a tax-deferred account, the investor would be converting tax-advantaged income into ordinary income. That is because distributions from an IRA are taxed as ordinary income. Long-term capital gains earned in the IRA would be taxed at a maximum 35% rate instead of 15%.

The conventional advice does not work for every investor. Suppose an investor owns stocks and equity mutual funds but rarely holds them for more than one year. Or the mutual funds do a lot of trading and distribute a lot of taxable gains each year. The gains earned by this type of investor would be taxed at ordinary income rates in a taxable account because they would be short-term gains. The investor could be better off holding those investments in tax-deferred accounts.

Interest, short-term gains, and nonqualified dividends will be taxed at ordinary income rates whether earned in a taxable account or distributed from a tax-deferred account. The difference is that in a tax-deferred account the income can compound and grow to a much larger amount before being taxed. That compounding advantage results in greater after-tax wealth if the income investments are held in a tax deferred account.

Here are some rules I have developed after modeling different investment policies and returns:

  • Stocks and equity mutual funds should be held in a taxable account unless at least 25% of the annual return from them is taxed at ordinary income tax rates.
  • Bonds and other investments that generate ordinary income should be held in tax deferred vehicles when possible. Also included in this category are high-yield bonds and most real estate investment trusts.
  • It is best to own the highest-returning investments in tax-free accounts such as Roth IRAs.
  • The greater the tax rate difference, the more important it is to get the allocation between the accounts correct.
  • The lower the difference in the rates of return between the different investments, the more important it is to get the allocation correct. When stock returns were greatly exceeding those of bonds in the bull market, the excess returns could make up for getting the account allocation wrong. If stocks earn only a few percentage points annually more than bonds, as many analysts expect for the next decade or so, it is more important to get the tax allocation correct.

Estate planning is worth considering. If a pension or other income sources will provide most of retirement income and the investments primarily are for emergencies or leaving an inheritance, hold the money in a taxable account. An IRA is included in the estate and potentially subject to estate taxes. In addition, heirs must include IRA distributions in ordinary income. With an inherited taxable account, on the other hand, the tax basis of the assets can be increased to current fair market value by the heirs. They can be sold immediately for no taxable gain.

This analysis is based on current tax law. The budget most recently passed by Congress anticipates that the 15% tax rates on long-term capital gains and qualified dividends will be allowed to expire after 2010. The long-term capital gains rate would return to 20%, and dividends would be taxed as ordinary income.

If that happens, it still would be advantageous for a tax-advantaged investor to follow these guidelines. A meaningful gap would exist between the long-term capital gains rate and the top ordinary income rate, and the taxes could be deferred in taxable accounts until assets are sold or funds distribute gains. In addition, losses could offset gains. The real effect of the change would be to reduce the after-tax wealth of all investors. My studies after the 2003 tax cuts showed that the tax cuts had the effect of allowing a nest egg to last a year or two longer. Reversing the tax cuts will deplete most nest eggs faster.



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