Using an IRA to save for retirement is a terrific strategy to reduce your tax burden and move closer to your financial objectives. However, not every investment will benefit the most from an IRA’s tax advantages. The following three investments are ones you should retain in a standard brokerage account.
1. Municipal debt
Municipalities issue financial instruments known as “munis,” or municipal bonds. The tax-free status of interest payments is a benefit of investing in municipal obligations. Additionally, you won’t typically pay state income taxes on bonds you buy in your state of residence.
Holding muni interest payments in an IRA doesn’t offer any benefit because they are already tax-free. You would be better served investing in a different kind of bond for your IRA that offers less tax benefits than munis and pays higher interest rates because munis normally have lower interest rates due to the tax benefits they provide.
You should keep municipal bonds in a taxable account if you wish to invest in them. You should also quickly evaluate if your tax savings will be sufficient to justify the reduced interest rate.
2. Limited liability companies
MLPs, or master limited partnerships, are another type of investment with built-in tax benefits. As a partnership, they don’t pay corporation income taxes since cash flow and earnings are transferred directly to owners, known as unit holders.
Additionally, there are tax benefits for owners of units. The real earnings are far smaller than the cash flows since the majority of MLPs are able to deduct a sizable amount from their taxes. As a result, every quarter, unit owners get a stream of cash flows that are largely tax-deferred.
There is no need to utilize an IRA to delay taxes on MLPs as these investments already offer deferred tax benefits. Instead, you may purchase units in taxable brokerage accounts rather than using an IRA to do so. Additionally, your heirs might be able to benefit from the step-up in cost basis after your passing if you own MLP units in a taxable account. That would significantly reduce the tax obligation associated with investing in MLPs.
3. Foreign dividend payers
Foreign equities can be a terrific way to diversify your retirement funds, but if you own foreign stocks with large dividend payments in your IRA, you can’t obtain the full tax benefits.
Even while domestic dividends are not taxed in an IRA, most overseas corporations nevertheless take taxes from their dividend payments. These taxes are given to the national government of the business.
You can recover those tax payments thanks to a legislation in the United States called the international tax credit. In this manner, you avoid paying taxes in both the United States and the other nations. But if you hold such dividend payers in an IRA, you cannot claim the credit. Therefore, retaining dividends in an IRA has no tax benefits for you.
There are several treaties between the United States and other countries that exclude shares held in retirement accounts from paying international taxes. For instance, shares of Canadian corporations won’t have taxes deducted from dividend payments made to IRA holders.