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I’m pretty sure you don’t like paying Uncle Sam.
Taxes are your enemy when it comes to investing. They’ll eat away at your returns if you are not strategic about your investment allocations. If you want to maximize your tax savings, a Roth IRA is going to be your best friend. A Roth IRA shelters your investments so you don’t have to pay any taxes on them.
Today, we are discussing the best Roth IRA investments you should have to avoid taxes.
What Are The Best Roth IRA Investments?
A Roth IRA is a special type of brokerage account that protects your investment from taxes. However, by keeping the especially tax-inefficient ones in your Roth IRA, you will be able to maximize your savings.
1. REITs
The first best Roth IRA investment I want to talk about is a REIT.
A real estate investment trust (REIT) fund is similar to an index fund but focuses only on real estate. A REIT fund is a basket full of companies that do business in real estate.
REITs and REIT funds are great investments for those who want exposure to income-producing assets but cannot afford to buy or manage real estate property on their own. They don’t offer much in terms of capital appreciation but offer high-yielding dividends. Dividend yields from REITs are often much higher than other stocks and index funds because they are required to pay at least 90% of their taxable income to shareholders.
Different types of REIT Funds
The two main types are equity and mortgage REITs.
Equity REITs
This is the most common. Equity REITs hold companies that own and manage real estate properties such as office buildings, apartment complexes, and shopping centers. Most of their income comes from rent, which then gets distributed back to investors.
Mortgage REITs
Mortgage REITs lend money to real estate owners and charge interest in return. It is a less common type of REIT and returns can fluctuate depending on interest rate increases or decreases by the FED. A large bulk of income is from interest generated from loaned money.
Why REITs cause you to pay taxes on your investments
Most REITs do not meet the legal definition of “qualified dividends,” therefore your dividends are going to be taxed as “non-qualified dividends.” This means that all dividends you receive are going to be taxed at your normal income tax bracket.
Dividends account for a large majority of capital growth that REITs provide. If your REITs are held in a regular brokerage account, the IRS is going to deduct a huge chunk of those dividends. To avoid this, you need to make sure all your REITs are in your Roth IRA account. In doing so, no deductions will be made and you will get to keep the full dividend.
Here are three REIT funds to check out from Vanguard, Fidelity, and Schwab.
2. Bonds or Bond Index Funds
The second best Roth IRA investment on today’s list are bonds or bond index funds.
Governments or companies can issue bonds to raise funding for large-scale projects. When you buy or invest in a bond, you lend your money to the entity and receive interest in return. When the bond “matures,” or expires, the entity gives you back the money you invested. It’s like something like a mortgage, but you are the one issuing it.
Bonds are low-volatile investments that can offer stability to your portfolio. They can be a great tool for risk-averse investors and those approaching their retirement date. But because bonds are low-yielding, make sure you actually need them before you invest in them. You might be settling for a lower return.
Just like a stock index fund, a bond index fund is just a variety of different bonds gathered into a single fund.
The risk with bonds is the possibility of credit default. For example, if the company that issued the bond went bankrupt and lost all its funding, its investors will not get their money back.
Bonds can be divided into two major categories depending on the level of risk.
Investment-grade bonds
These are the safest type of bonds with a rating of BBB- or higher. They are usually issued by the government or well-established companies. They have a low chance of credit default, but in turn, offer lower interest payouts.
Junk/High-yield/non-investment-grade bonds
These types of bonds are higher risk but offer higher interest payouts. They usually consist of smaller companies that have a higher chance of credit default, with a rating of BB+ or lower.
Why bonds are tax-inefficient
The only form of capital appreciation bonds offer is through interest payments. Different types of bonds and bond funds are taxed differently, but in general, they are taxed as ordinary income at the federal and state level.
Bonds themselves are already low-yielding investments. By getting hit with tax deductions on your interest payments, you are settling for even less of a return.
To avoid this, keep all your bonds and bond funds in your Roth IRA where no deductions will be made.
Now there are some exceptions to this – some bonds such as municipal bonds and U.S. Treasury bonds are tax-exempt. But for the rest, make sure you are using a Roth IRA.
Thinking of investing in a bond index fund? Here are three from Vanguard, Fidelity, and Schwab.
3. Actively managed mutual funds
The last “best Roth IRA investment” we are looking at today is actively managed mutual funds.
Here at InvestaMind, we never advise our readers to invest in actively mutual funds. They are expensive to invest in and often underperform the market. However, if you must invest in one, they are best kept in a Roth IRA.
Fund managers of actively managed mutual funds are constantly buying and selling stocks. Did you know that in 2019, the average turnover rate for these types of funds was 63%? All that buying and selling triggers short-term gain taxes that you, the investor, will have to pay.
If you must invest in these types of funds, make sure they are in a Roth IRA to avoid paying taxes on short-term capital gains.
At InvestaMind, we teach our readers to invest in index funds that are much more tax-efficient. Even more tax-efficient investments are ETFs.
Conclusion
The reason why we invest our money is to build wealth. To build wealth, you are going to want to avoid paying taxes as much as you legally can.
Keeping your tax-inefficient investments in your Roth IRA will give you the most bang for your buck because you shelter your investments from taxes.
Just remember, you can withdraw Roth IRA contributions at any time, but any capital appreciation you accumulate must be withdrawn after you turn 59 and a half years old. You will be hit with a penalty if you withdraw any earlier.
Thank you so much for reading today’s post, and I hope you learned something new!