What Type of Investments Are Best For An IRA?

The question often comes up – what types of investments are best for my IRA?

Of course, any investment that you make in a tax-deferred fashion is a good one, at least in theory.  But there are other investments that make the most sense for your IRA versus other vehicles… and some investments that make more sense in other kinds of investment accounts, where possible.

Listed below are a couple of considerations to take into account when considering taxation of your IRA and non-IRA investments.

Bonds and other interest-bearing vehicles

Given the nature of the IRA – deferring taxation on current income and growth, investments that would otherwise be taxed at ordinary income tax rates would be best for your IRA.

This includes the likes of interest-bearing investments, such as CDs or bonds.  Since, presumably, your tax rate when you begin taking distributions will be either the same or less than your rate before retirement, the deferral will provide for the interest to be taxed at either the same rate or lower, just later in your life.

Growth-oriented and dividend-paying investments

Growth-oriented stocks and investments that pay current dividends make more sense to be held in taxable accounts than in deferred accounts.  This is due to the fact that dividends and capital gains are (at least for now) taxed at much lower rates than ordinary income – which is the rate your distributions from the IRA will be taxed at.

The same would be true of other growth- and dividend-oriented investments such as real estate and commodities, for example.

Bottom Line

So in other words, if you have the ability, you should split your interest earning investments into your IRA, and growth- and dividend-oriented investments into taxable accounts.  This way, you won’t be subjecting lower-taxed items to a higher tax rate – if possible.

This doesn’t mean that you should ONLY invest in items that would be taxed at ordinary rates within your IRA.  This is known as letting the tax-tail wag the investment dog.  Tax planning should always be considered as you plan your investments, but appropriate diversification should always be your first consideration.

In addition, the deductibility of IRA (and 401(k)) contributions provides a benefit that should be weighed against the taxation concepts we’ve talked about above as well.  Again, the tax-tail shouldn’t wag the investment dog…

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

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2 Comments

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  • Adam –

    First of all – good for you! A Roth IRA is an excellent place to get started with investing. And your questions show that you’ve been doing some studying on the taxation matters – bravo!

    Roth IRA money, that is, any money contributed to a Roth IRA can always be withdrawn at any time for any reason, without tax or penalty. Growth on the other hand, whether from dividends, interest, or capital gains, must generally be left in the account until after you’ve reached age 59 1/2 (there are exceptions to this, but let’s not complicate things!).

    When you’ve reached age 59 1/2, you are free to withdraw the funds, including the growth, for any reason without tax or penalty.

    There is no tax on the account’s capital gains (per your questions) either as they are accrued in the account nor when you remove the funds from the account.

    Pretty great deal, right?

    Hope this answers your questions –

    jb

  • I’m new to investing, and just began a Roth IRA. Are dividends accrued in a Roth IRA subject to tax now or later? Will I need to pay capital gains now due to the fact that Roth contributions are subject to tax beforehand, or are the gains considered as growth within the IRA which is supposed to be tax sheltered? Also, since Roth distributions made after retirement age are supposed to be tax exempt, could these capital gains create some other tax burden?

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