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Avoid Tax-Advantaged Investments in Your Retirement Account

Written by Samuel Taube
Posted September 22, 2019

I talk a lot about retirement accounts on this site. It’s hard not to when you write financial education articles for a living. I’ve told you how to sneakily open them, what to do with them during retirement, and how to take loans from retirement accounts (and why you really shouldn’t)...

In fact, I’m half-expecting somebody to call in one of these days and say, “Okay, Sam, we get it. We should put all our money in retirement accounts — just shut up about it for a minute.”

But you actually shouldn’t do that. In fact, there are a few tax-advantaged investments that can be more profitable if held outside of an IRA or 401(k). 

Below, we’re looking at three of them…

Municipal Bonds

If an investment is already tax-free, there isn’t much point in putting it in a tax-free account. 

With that in mind, municipal bonds (or “munis” for short) don’t belong in an IRA or 401(k). 

These debt obligations are issued by state and local governments, and their interest payments are exempt from federal taxation. 

Depending on where you live and where you buy your municipal bonds from, many pay interest that is exempt from state taxation as well. These include all munis issued by non-state U.S. territories like Puerto Rico and all munis issued by your home state (with the exception of Oklahoma, Utah, Iowa, Wisconsin, and Illinois).

It’s nice that the federal government and many state governments waive taxation of municipal bond income — but there’s a reason they do so. 

When you buy a municipal bond, you’re doing a good deed by providing infrastructure funding to state and local governments. However, you’re also making a relatively risky investment for a single-digit yield. 

After all, unlike the federal government, local governments can go bankrupt, and bankruptcy often means no more muni payments. Detroit, San Bernardino, and Puerto Rico have all gone bankrupt in the last decade. 

Munis do offer higher yields than, say, Treasury bonds, but they pay out less than many corporate bonds and dividend stocks with similar risk levels. 

In other words, the tax benefits of municipal bonds are a significant part of their value as investments, and those tax benefits are only realized when municipal bonds are held outside of an IRA or 401(k). 

Annuities

These products are built on a simple and appealing idea: You give an insurance company a lump sum of money — some or all of your retirement savings — and then they send you regular payments until you die.

The tax benefits of annuities are even more appealing. If you buy an annuity with post-tax money, then the principal portion of your annuity payments (which is equal to the lump sum paid for the annuity, divided by the IRS estimate of your life expectancy in years) is tax-free. 

As an example, if you buy an annuity for $100,000 and the IRS estimates that you have 20 years to live, then the first $5,000 worth of annuity payments are tax-free each year ($100,000 / 20 years = $5,000 tax-free per year). 

But notice the italicized phrase: Annuity payments are partially tax-free if you buy them with post-tax money

If you buy them with pre-tax money — like the balance of a traditional IRA or 401(k) — then the payments are entirely taxable. 

Many retirees, who are attracted to the guaranteed income provided by annuities, subject themselves to extra taxation by buying them within a traditional retirement account.  

Physical Real Estate 

Real estate investment trusts (REITs) are great investments to hold in an IRA or 401(k). These investments pay large, taxable dividends — and that can actually make them unwise to hold in taxable accounts. 

But when it comes to actual, physical real estate — like a house, an office building, or a plot of land — the inverse is true. You don’t want to hold physical real estate within a retirement account. 

As with the other assets we’ve discussed in this article, that’s largely because physical real estate already has tax benefits, like the mortgage interest deduction, and these are negated within IRAs and 401(k)s. 

You might think you’re always better off stashing more wealth in your IRA or 401(k), but as we’ve discussed today, that’s not always the case from a tax-planning perspective. Certain tax-advantaged investments are better off held outside of retirement accounts.  

Until next time,

Monica Savaglia

Samuel Taube

Samuel Taube brings years of experience researching ETFs, cryptocurrencies, muni bonds, value stocks, and more to Wealth Daily. He has been writing for investment newsletters since 2013 and has penned articles accurately predicting financial market reactions to Brexit, the election of Donald Trump, and more. Samuel holds a degree in economics from the University of Maryland, and his investment approach focuses on finding undervalued assets at every point in the business cycle and then reaping big returns when they recover. To learn more about Samuel, click here.

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