Which investments are best for tax-deferred account?
By Mary Beth Franklin
Maturity News Service
The key advantage of stashing money in a tax-deferred retirement account
isn't just that you'll pay less to the government this year, but that your investments
will compound faster than in a taxable account. The result is usually a larger retirement
nest egg even after the funds are taxed upon withdrawal.
In tax-deferred accounts such as a 401(k), a Simplified Employee Pension
(SEP) plan, Individual Retirement Account (IRA) or a Keogh plan for the self-employed,
dividends and interest income are not subject to tax until funds are withdrawn after
retirement. This means not only lower taxes in the current year but also a larger base in
each successive year for that year's growth. Hence, the overall accumulation is
Some types of investments work better than others in these accounts.
Here are some general Guidelines to consider when funding your tax-deferred retirement
One investment you should never put inside a tax-deferred account is tax-exempt bonds.
That's because the interest is already tax-free, which is why tax-exempts generally yield
less than comparable taxable bonds.
If you put tax-exempts inside a retirement account, the earnings will be
taxed as regular income when you withdraw them. The result would be to turn a tax-free
investment into a taxable one - and that's not a wise move.
Taxable bonds and bond mutual funds.
These investments are excellent candidates for inclusion in your tax-deferred retirement
The income from taxable bonds and bond mutual funds is subject to
federal and state taxes. By holding them in a qualified retirement plan you defer those
taxes until you withdraw them in retirement, when your tax bracket may be lower because
your annual income is reduced.
This tax deferral is particularly valuable for deep discount and zero
coupon bonds, which generate no current income but incur annual taxes.
Dividend-producing stocks and income mutual funds.
Like bonds, individual stocks and stock mutual funds whose returns come mostly from
dividends, not price appreciation, should be kept in tax-deferred retirement accounts.
Financial experts are divided on the wisdom of keeping these stocks in tax-deferred
Some say it is better to keep these stocks in taxable accounts because
most of their gain is from price appreciation, which you don't pay taxes on until you sell
the stock. When you do sell a growth stock, it is taxed at the capital gains rate, which
is often lower than a taxpayer's regular income tax rate.
The maximum capital gains tax is 28 percent, while personal tax rates
for upper-income taxpayers can go as high as 39.6 percent.
If growth stocks are held inside a retirement account, you might be
trading in a 28 percent capital gains tax for a higher tax rate, depending on your income
and tax bracket. You also lose the ability to offset capital gains with capital losses
when stock is held inside a retirement plan.
However, a 1995 study in the Journal of Investing says this strategy of
keeping growth stocks out of your retirement accounts works only if you buy and hold a
stock for a long time.
If you are an active trader, you may do better putting the stocks inside
your tax-deferred account. That way you'll be taxed only once when you withdraw the funds
rather than paying taxes on each transaction.
Higher turnover mutual funds.
Mutual funds investing in growth stocks may be good candidates for inclusion in your
tax-deferred retirement account. That's because these funds usually buy and sell a lot of
stocks each year.
By law, they are required to pass 98 percent of their net investment
earnings, including capital gains, on to their shareholders. Unless you keep them in a
tax-deferred account, you'll be taxed on these gains each year.
Consider interest rates.
Since tax-deferred retirement accounts have limits on how much you can contribute each
year, don't use up those quotas with low-yielding investments like money market funds. Why
protect something that is only earning 3 percent or 5 percent interest? Better to reserve
this valuable tax deferral for investments that warrant protection.
On the other hand, if yields were to rise significantly in the future,
it might make sense to shelter interest income from taxes with a tax-deferred account.
Whatever you invest in, the most important thing is to contribute as
much as possible to your tax-deferred account. Not only will you pay less on current
income and increase your future retirement income, but you may also reduce your taxable
income if your contribution qualifies for a tax deduction.