When saving for retirement, one of the essentials is to open an Individual Retirement Account, more commonly referred to as an IRA. There are four different kinds of IRAs (traditional, Roth, SEP, and SIMPLE). There are unique requirements and rules that apply to each of these. You may or may not be able to fund your IRA with “before tax” dollars but none of the dividends, capital gains, interest or other income will be taxed until you retire and start to withdraw. This provides a huge tax advantage when held for many years. Now the question is what investments to select for an IRA.
What Investments Can You Select for an IRA?
According to Investopedia you can invest in “almost anything” which includes stocks and bonds, mutual funds and annuities, exchange-traded funds (ETFs), unit investment trusts (UITs) and real estate. But, as they note, there are 5 investments you cannot hold in your IRA.
Prohibited investments for an IRA include these:
- Life insurance (whole life, universal, term and variable policies are all excluded)
- Various derivative positions (many IRA custodians will not allow any but ratio spreads and naked call writing are specifically prohibited by the IRA)
- Antiques, collectibles, and artwork
- Real estate for personal use (you cannot buy your home with an IRA)
- The majority of coins (exceptions are these)
- American Eagle coins (proof and non-proof)
- American Gold Buffalo coins (non-proof)
- American Silver Eagle (proof and non-proof)
- Austrian Gold Philharmonics coins
- Canadian Maple Leaf coins
The bottom line is that while the investment stays in the IRA there are no taxes. If the investment is removed before you are fifty-nine and a half, there is a ten percent penalty before you pay any taxes. Because your well-chosen investment has been earning steadily for years and years without having any capital gains, dividends, or interest being taxed, your IRA-protected investments will do substantially better than the same investments that are not shielded from taxes.
What Investments Should You Select for an IRA?
Remember that an IRA is a retirement account. We just wrote about solid investments for retirement. The closer you are to retirement when you start your IRA the more you need to follow a conservative approach. The earlier you start, the more time you will have for somewhat riskier growth investments. The tax-deferred aspect of an IRA protects dividends from being taxed, which makes dividend stocks a must for part of your IRA. Likewise, earnings from high yielding bonds and CDs will also appreciate faster when they are not being taxed. That having been said, here are the basic investments to put in an IRA.
If you are going to have investments in an IRA for more than ten years and especially if you will leave investments there for twenty and thirty years, well-chosen stocks are the most likely to produce the best results. An investment in stocks averages a 10% return on investment when averaged out over many years. Most investment advisors recommend that a substantial part of your retirement savings be stocks and this includes what investments to select for an IRA. Then the question is what stocks do you choose and how to you manage your investment.
Managed Investments versus Self Directed Investments
If you already own stocks, have decided preferences based on your experience, and have the time to manage your own IRA investments this can work out well. Because this is money for retirement you should err on the conservative side but choose investments where the tax-deferred aspect of IRA works the best for you. This would be in solid stocks that provide a healthy dividend. Or, it works when you buy and sell over the short term and are able to avoid capital gains due to the IRA.
If you want an IRA and like the idea of stocks, but have absolutely no expertise or the time and inclination to learn, you will have someone pick and manage your stocks for you. You may or may not get a better rate of return than if you did it yourself and your IRA will be paying a fee. This, unfortunately, detracts from the benefit of the IRA.
Mutual funds fall into the managed investment category. Some outperform the market and some do not but all of them take a cut that reduces the appreciation of your investment.
What Investment to Select for an IRA
Besides stocks, bonds can be a good investment to select for an IRA and probably should represent an increasing proportion of your IRA, and other retirement savings as retirement approaches. Interest is not taxed so your nest egg will appreciate much faster.
Annuities have the benefit giving you a defined income stream once you retire. There is no guess work. You pay in over the years and then take out exactly what you expected afterward. The drawback, like with mutual funds and managed stocks is the management fee which can be substantial.
For many investors looking for what investments to put in an IRA, exchange traded funds or ETFs may be the best bet. And ETF is a mix of stocks that track the overall market like the S&P 500 simply a specific sector. Over the years ETFs have often outperformed investment managers and especially mutual funds. There are no costs outside of the cost of purchasing or selling shares.
UITs, Unit Investment Trusts, are also managed investments that may or may not outperform stocks or ETFs that you choose yourself and there are hefty management fees.
Real estate can be part of your IRA providing that it is not for personal use and does not provide “indirect benefits.” Any investment expenses must be paid by the IRA and any income must return to the IRA. This approach can work well or not so well. If you are knowledgeable about and experienced at real estate investments, this way to go can be smart. If you are a novice in real estate investing, stay away!
What Investments for Your IRA to Avoid
We mentioned that derivative investments are frowned upon by the IRS. Nevertheless, there are IRA custodians that will allow you to engage in highly leveraged derivative trading. First, of all this is the province of professionals and you will lose your shirt if you believe you can win at this game. Second, even if you are a professional derivative trader, this is your IRA, your retirement nest egg. Why not leave part of your assets safe from trading blunders and available at retirement even if everything else fails?