When you are preparing for retirement, it is a good idea to open up an IRA, given that you can grow your money tax-free until retirement. However, you are limited by the amount of money that you can put into one of these accounts in a given year, and so if you plan on saving more money for retirement you will need to, unfortunately, put money in an account that is taxed at the normal rate.
Because of this, your strategies for the two accounts should be different. Tax-free accounts have the obvious advantage of being tax-free, but you can milk the greatest benefit from this tax-free account by doing the four following things.
First, avoid municipal bonds and municipal bond funds in your tax-free account. The simple reason for this is that municipal bonds are not taxed at the federal level, and if you buy a municipal bond from your home state, your bond income is completely tax-free. This is a great advantage, but if you want to buy municipal bonds, make sure you do so in a taxable account. Otherwise, you’re wasting your limited tax-sheltered resources.
Second, buy stock in companies that have a tax advantage. Companies such as limited partnerships (LPs), master limited partnerships (MLPs), and real estate investment trusts (REITs) can avoid paying taxes if they distribute a certain percentage of their profits to shareholders (it is usually pretty high). The government allows this because these dividends are taxed as ordinary income at the individual level, which is a higher tax rate than the capital gains rate for most individuals in the stock market.
These aren’t necessarily bad plays for your regular account, especially since they avoid double taxation (that is, taxation at the corporate level and then at the individual level). But why not take full advantage and pay no taxes by putting these stocks in your tax-free retirement account? Just be sure to research these companies carefully, don’t chase yield, and be aware that these companies can cut their dividends and see losses just like any other company.
Third, take profits in your retirement account and move money around, especially if commissions aren’t going to eat into your principal. When you have money in a normal account, you may want to avoid taking profits or switching from one company to a similar yet cheaper company because it isn’t worth doing if you have to pay taxes. However, this isn’t an issue in a tax-free retirement account. So if you see that a company trades at 15 times earnings and you own stock in a similar company that trades at 17 times earnings, you should make the switch in your retirement account. It may not be worth doing in your regular account — you’ll have to do a lot of math to figure it out, and the difference might not be worth your time and effort.
Finally, pick dividends over stock buybacks in your retirement account. A lot of companies have lately been eschewing dividends in lieu of buybacks because of a tax advantage. If you receive a dividend in a regular account, you need to pay capital gains on that income. But if the company buys back stock, that will presumably generate a gain in the share price, and you don’t have to pay taxes on it unless you sell your stock.
Furthermore, you sell stock only once, whereas you receive dividends once a quarter, once a month, or once a year. But despite this advantage, dividend-paying companies have a better mindset for long-term investors, and dividends are real, tangible benefits of an investment. A company can easily stop a buyback, and it can implement one just to drive up the stock price in the near term. But a dividend is something that management believes to be sustainable, and when you are looking for retirement stocks, you want sustainability.
Since there is no tax advantage for the buyback in your retirement portfolio, the clear winner is the dividend payer. Again, you should be careful when selecting dividend stocks. Make sure you know where the money is coming from and make sure that this is a sustainable source of income.
More from Personal Finance Cheat Sheet:
- How I Achieved a Near-Perfect Credit Score By Age 30
- Patience Rewarded? Retirement Account Balances Hit Record Highs
- When Should You Discuss Money Matters With Family?