Income Tax Rates Determine Investments to Put In Your IRA

Because IRS taxes different investments at different rates and for different holding periods, it makes a difference which investments you place in your IRA. Understanding income tax rates and taking advantage of these different rates can save you a boatload of cash.

Since everything that comes out of a traditional IRA is taxed at ordinary income rates, up to 35% in 2012, it makes little sense to place tax-saving investments 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 because it will be taxable when removed. The difference of income tax rates in this case, 0% for the municipal bond and as high as 35% for anything taken from an IRA, is huge. A more subtle choice is which stocks or mutual funds to place in an IRA and the choice can make a difference of thousands or tens of thousands of dollars over a lifetime.

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. And those rates have been lower than ordinary income rates for this author's entire lifetime. Currently, the capital gains rate is a maximum of 15% as compared to the maximum ordinary income rate of 35%. On the other hand, if you have some of your money allocated to trading volatile stocks such as technology stocks or pink-sheet stocks, 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. 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.

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%. 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 35%.

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.

Here's the 2013 update on appropriate IRA investments.