Saving on investment-related taxes may not be the first thing on your mind these days--after all, most investors haven't had many gains to speak of over the past year. And because many mutual funds have capital losses on their books, some won't have pay out taxable gains for years, even if the market recovers. (For more on this topic--and for a list of good funds with big tax-loss carryforwards--check out this article.) For that reason, you may be feeling lukewarm about sinking more money into an IRA, even as April 15, the deadline for making an IRA contribution for the 2008 tax year, fast approaches.
Still, saving within an IRA will likely reduce your long-term tax costs and, in turn, improve your take-home return. And if you make a deductible contribution to a traditional IRA, you'll be able to reduce your tax outlay right off the bat.
Individuals can contribute $5,000 annually to an IRA for 2008 and 2009, and those over 50 can contribute $6,000 in each year. It's worth noting that you can deduct your IRA contribution from your current income only if your income falls below a certain threshold. Roth IRA contributions, by contrast, are not tax-deductible, but qualified withdrawals will be tax-free, and the income limits are much higher than is the case for traditional deductible IRAs. (Individuals of all income levels can make a nondeductible contribution to a traditional IRA.) Use Morningstar's IRA Calculator to see what type of IRA you're eligible to contribute to. For some helpful IRA dos and dont's, check out this article, and this piece provides some guidance on whether it makes sense to convert a traditional IRA to a Roth.
You can put almost any type of investment within an IRA wrapper, but if you're trying to pick between competing ideas, it's only sensible that you'd put the one that might cause the biggest tax headaches in your IRA and save more tax-efficient investments for your taxable account. Here are some issues to consider as you decide what to put in your IRA.
Stocks or Bonds: Which Are Better?
Conventional wisdom holds that investors should hold bonds in tax-protected vehicles like IRAs and stocks in their taxable accounts. Intuitively, that makes sense. After all, bonds throw off a lot of taxable income, which is taxed at rates as high as 35% (and that could head even higher if President Obama gets his way). Meanwhile, stocks typically generate much less income, and that dividend income is taxed at a much lower rate--generally 15%. (Long-term capital gains from stocks enjoy the same rate.)
In this instance, however, the conventional wisdom has limitations. Stocks generally produce higher returns than bonds, and thanks to the magic of compounding, the differences in performance really add up over time. That's why the return from stocks can generate a much higher tax burden than bonds over the long haul.
Thus, if you're a long way from retirement (one study from T. Rowe Price suggested 15 years or more), it might make more sense to hold stocks in your IRA. Conversely, if you're relatively close to retiring, you're probably better off investing your IRA in bonds.
Christopher Davis does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.