3 Investments That Don't Belong in Your IRA

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Wendy Connick, The Motley Fool

Updated Sun, Dec 31, 2017, 7:36 AM

If you're regularly contributing money to an IRA, then you're making good progress toward a happy and well-off retirement. However, what you do with that money is just as important in determining how much you'll have saved up by the time you retire. Some types of investments just don't make sense in your IRA, so avoid the following options.

Prohibited investments

The IRS forbids you to hold certain types of assets inside an IRA. First, any type of collectible is banned -- that includes not only things like artwork and stamps, but also gemstones, gold bullion, and (bizarrely enough) alcoholic beverages. If you want to finance your retirement by selling off the contents of your wine cellar, you'll have to do it outside your IRA.

If you put IRA money into collectibles, that money is treated as though you had taken it out of the account; you'll have to pay income taxes on it, plus an early withdrawal penalty if you're younger than 59 1/2.

Second, you're not allowed to have a life insurance policy inside your IRA. You can certainly buy such a policy as a retirement investment, but not with tax-deferred money.

roll of hundred dollar bills in middle of bear trap

Image source: Getty Images.

There are also some investments that, though not forbidden from being parked in an IRA, are simply unsuitable for an IRA. You see, IRAs shield your investments from taxes on capital gains, dividends, and interest. Therefore it makes sense to load your IRA up with investments that will benefit from those valuable tax breaks. Meanwhile, the investments discussed below can go in a taxable brokerage account.

Municipal bonds

Putting municipal bonds in an IRA doesn't make a whole lot of sense. The big benefit that municipal bonds bring to the table is their tax advantage. The interest these bonds pay is exempt from federal taxes, and if you choose a municipal bond issued by your state of residence, the interest is also exempt from state taxes. However, interest paid by investments inside an IRA is already exempt from taxes, so putting a municipal bond in an IRA negates its advantages. And because municipal bonds typically pay lower interest than non-tax-exempt bonds, you'll be missing out on some of the interest you could be getting with another type of bond.

Tax-managed mutual funds

Mutual funds often conduct transactions that create tax bills for people who own shares of that fund. When dividends or interest are paid to the fund, you'll have to shoulder your share of the resulting tax burden. And if the fund manager sells some investments at a gain, you'll be hit with capital gains taxes, too.

Tax-managed mutual funds do their level best to reduce or eliminate the taxes generated by the fund. They'll typically choose stocks that don't pay dividends over ones that do (or at least make sure that any stocks they hold produce qualified dividends). They may try some tax loss harvesting, selling investments at a loss to balance out anything they sold at a gain during the year. And they'll often buy investments that are partially or fully tax-protected, such as Treasury securities and municipal bonds.

Putting a tax-managed mutual fund inside an IRA doesn't make sense for the same reason that municipal bonds are a poor IRA investment. The investments inside your IRA are already receiving favorable tax treatment, so there's no need to stock your account with any investment whose main selling point is its tax advantage.

So what should I put in my IRA?

An IRA is a great place to put any investment that would otherwise run up a steep tax bill for you. For example, REITs are a terrific way to dabble in real estate, but the law requires them to pay at least 90% of their annual taxable income to their shareholders in the form of dividends. And because dividends are taxable, this can result in a hefty tax bill -- but putting the REIT inside your IRA completely negates this particular disadvantage by protecting said dividends from taxation.

Treasury Inflation-Protected Securities (TIPS) are another great investment with a potentially hefty tax drawback. TIPS have a sort of built-in inflation insurance: When inflation goes up, so does the principal you invested in the security. However, these periodic increases in value are taxed at the ordinary income tax rate, not the more favorable long-term capital gains rate, during the year they occur. If inflation spikes, your TIPS will grow dramatically, but you might end up with quite a large tax bill as a result. However, keeping your TIPS in a tax-advantaged account such as an IRA protects you from these taxes.

Now that you know what makes sense -- and what doesn't -- inside your IRA, you can kick out any tax-advantaged investments and replace them with ones that need a little help keeping taxes under control. Putting those investments inside your IRA gives you the best of both worlds: a great investment that pays out substantial income without creating a substantial tax burden.

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