Individual Retirement Accounts are long-term, tax-advantaged savings accounts. Essentially, IRAs function very much like regular investment accounts, as they can hold stocks, bonds, mutual funds and other common investments. However, because the tax treatment of IRA investments is different, some investments are more advantageous than others when bought in an IRA. Additionally, the Internal Revenue Service restricts the purchase of certain investments in IRA.
IRA Features
When you contribute to an IRA, you can take a tax deduction for the amount of the contribution. Your contributions and earnings grow tax-deferred within an IRA, meaning you do not have to report the annual gains or losses in your account on your tax return. However, as your IRA is funded with pretax dollars, distributions you take from the account are considered taxable, at ordinary income rates. This taxation cannot be avoided, since the IRS requires you to begin taking minimum distributions once you reach the age of 70 1/2.
Income Investments
Since you do not have to pay income tax on your IRA from year to year, one strategy for IRA investments is to purchase the bonds, mutual funds or other securities that pay the highest dividends and interest. Particularly if you are in a high tax bracket already, it makes sense to purchase high-interest, high-tax investments in an IRA, rather than in a taxable investment account. Although you will ultimately have to pay tax on these investments when you withdraw the money, you may be in a lower tax bracket when you retire. And in any event, you gain by paying tax in the future, rather than year to year.
Capital Gains
As of 2010, long-term capital gains, or those held for longer than one year, are taxed at a favorable rate of 15 percent. Ordinary income tax rates can go as high as 35 percent. As a result, a common investment strategy is to purchase securities more likely to generate capital gains, such as common stocks, outside of an IRA. This is a viable strategy, but there are other factors to consider as well. For example, growth stocks tend to outperform income investments over long time periods, and because an IRA is by definition a long-term account, your account value is likely to be higher over time using a growth strategy, rather than an income strategy. Additionally, if you trade stocks, or otherwise hold them for one year or less, you will be taxed at ordinary income rates anyway. In this instance, your portfolio could benefit by making your stock transactions in an IRA, as opposed to a taxable investment account.
Prohibited Transactions
Prohibited transactions in an IRA include borrowing from it, selling property to it, using it as collateral for a loan and buying personal property with IRA funds. Additionally, if you invest in collectibles in an IRA--including coins, stamps, gems, metals, rugs or artwork--the investment is considered a distribution by the IRS, subject to ordinary income tax and an additional 10 percent penalty, if you are under the age of 59 1/2. Investments and transactions such as these should not be used in your IRA.
Real Estate
Real estate is not strictly prohibited by the IRS in IRA accounts, but many IRA custodians refuse to allow real-estate transactions due to the increased paperwork responsibilities. If allowed, real estate must be for investment purposes and not for personal use.
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