Things to Consider When Making Investment Choices in Your IRA

May 23, 2014

Individual retirement accounts (IRA’s) represent an accumulation of pretax funds. They can be funded from a 401–K or other qualified plan or from individual contributions through the years, but no tax is paid on the accumulation until funds are distributed out of the IRA. As a result, every distribution is treated as ordinary income to the recipient. This taxability makes some investment vehicles and strategies more appropriate for an IRA than for after tax accounts. Any distribution prior to age 59 ½ is subject to a 10% excise tax, except under certain restrictive situations. After attaining age 59 ½ withdrawals can be made from the IRA but in general, funds should be retained in the IRA for as long as possible so they grow on a tax free basis.

Once the owner attains age 70 ½, distributions must be made according to the required minimum distribution (RMD) tables. Now the taxman gets paid. In order to determine the RMD, the value of the account at the beginning of the year is divided by a factor from the tables based on your age. At age 70 the divisor is 27.4. For example, if the value of the account at the beginning of the year is $500,000.00, the RMD is $18,248.18. Each year after age 70 the divisor is reduced so more funds are required to be distributed to the IRA owner.

Technically, each IRA owner must receive their RMD in the year they attain age 70 ½ or by April 15 of the following year. As a practical matter the payment should be completed in the year the owner reaches that milestone, otherwise two years of distributions will be taxed the following year.

In terms of investing within the IRA, the benefit of having qualified dividends taxed at 15% is lost since all distributions are taxed as ordinary income, no matter the source of said income. In addition, the benefit of long term capital gains tax treatment is also lost. Therefore, IRA accounts are ideal for investments in high yielding preferred stock, REIT’s, fixed income securities and master limited partnerships (MLP’s). These partnership holdings should be organized in a corporate structure, instead of a direct partnership interest. The IRS has rules concerning the amount of unrelated business income (UBIT) that can be earned in a tax deferred account, which limit the amount of partnership income that can be received each year to $1,000 or less.

A note of caution. The investment in “fixed” assets should be carefully constructed during this period of historically low interest rates since each of the vehicles mentioned is subject to loss of value if/when interest rates increase. Therefore, a strategy of investing in short duration bonds and diversifying among the different classes of entities will smooth out the returns over the long run while the high current income stream consistently adds cash to the portfolio.

This strategy of investing the IRA assets in high yielding taxable entities is most effective when there is also an after tax account which can be invested more heavily in growth stock and dividend paying domestic corporate stock. This will allow the tax benefits to be fully utilized, while maintaining a balance between equities and fixed investments through utilization of the two entities.

Any one with philanthropic intentions may decide to wait until later in 2014, to take the portion of their distribution earmarked for charity. Until the end of last year, an IRA could distribute up to $100,000 to a qualified 501c3.charitable organization and not be subject to income tax on those funds. From a tax standpoint, this was the most efficient way to make donations to charity, and it is possible that Congress could resurrect this benefit, since many charities are urging reinstatement.