The Best Reason to Open an IRA
Mar 12th 2012 9:43AM
Updated Mar 12th 2012 1:00PM
If you ever want to retire, there's only one way to do it: Save some money on your own. With Social Security in danger, company pensions going by the wayside, and tax rates on the rise, it's more important than ever to boost your savings and to be smart about how you invest.
Opening a tax-favored retirement account like an IRA can be your most valuable tool in accomplishing that goal. Many people are aware of how IRAs can help you cut your taxes. But IRAs can also help you in ways that you may not know.
Later in this article, I'll reveal what could be the most important reason you should open or add to your IRA today. But first, let's make sure everyone's up to speed on the better-known benefits of IRAs.
The big two
If you ask most people why they like IRAs, they'll give you one of two answers:
- Contribute to a traditional IRA, and you can get a big tax break on your tax return this year.
- IRAs let your money grow tax-deferred from now until when you take it out after you retire. For Roth IRAs, that income is tax-free forever.
Those are simple reasons, but they're also extremely powerful. Contributing the $5,000 maximum to an IRA before the April 17 filing deadline can save you as much as $1,750 this year.
Yet even more valuable is the tax deferral that IRAs give you. Dividend investors who seek out the highest-yielding stocks they can find know all too well the big chunk of cash that the IRS takes from the income they receive, especially when those dividends don't qualify for lower tax rates. Mortgage REITs Annaly Capital (NYS: NLY) and Chimera (NYS: CIM) may be enjoying both year-to-date share-price gains and strong dividend yields due to low interest rates, but outside an IRA, you'll give up as much as 35% of those dividends to taxes -- and that doesn't even include what some states charge for their own taxes.
The tax problem that's getting worse and worse
But an even bigger problem that an IRA solves is having to deal with tax reporting requirements. This year, things are changing for investors. In addition to Schedule D, anyone who sold stocks, bonds, mutual funds, or other investments this year will have to complete the dreaded new Form 8949.
Form 8949 forces you to reconcile your gains and losses with figures your broker is now required to provide. If your broker's numbers are right, then everything's pretty simple. But if they're wrong, then you have to go through a complicated process of reporting corrections. Even worse, with brokers increasingly having to provide numbers directly to the IRS, any mismatches will raise red flags on your filing -- potentially triggering an audit.
IRA investors, however, don't have to worry about Form 8949. Any buying and selling inside your IRA has no tax impact at all.
Why you have to sell sometimes
Of course, long-term investors will argue that this is just another reason that long-term buy-and-hold investing makes sense. But often, despite your best intentions, holding on to a stock forever doesn't make sense.
One popular reason lately has been the increase in spinoff activity among big companies. Abbott Labs (NYS: ABT) , for instance, plans to split off its pharmaceutical segment from its other businesses, which will leave a company that has exposure to medical devices, diagnostic testing, and other health-care areas. ConocoPhillips (NYS: COP) will break into two pieces later this year, one holding refining and other downstream assets while the other focuses on exploration and production activity. And Rentech (ASE: RTK) already did a spinoff of its Rentech Nitrogen Partners subsidiary, which focuses entirely on its fertilizer business, to allow Rentech to represent itself as an alternative-energy company.
When these companies complete their spinoffs, investors have a choice to make. If you bought the stock because of one particularly promising piece of the business, then you're entirely justified selling off the other parts. On the other hand, if you liked the company because of its complete package, then you might keep both parts -- or you might decide the two halves no longer add up to as much as the whole was worth.
How IRAs help you
In an IRA, you're free to buy, sell, or hold whenever you want -- without worrying about gains or the complicated reporting requirements. That's getting to be an increasingly valuable advantage of IRAs for retirement investing.
We like to keep things easy when it comes to retirement investing. The Motley Fool's latest special report on retirement highlights three promising stock picks for retirement investors and includes more information on putting together a top portfolio. It's absolutely free but only for a limited time, so read it today while it's still available.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.
At the time this article was published Fool contributor Dan Caplinger is having a love-hate relationship with the IRS right now. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital and Abbott Labs. Motley Fool newsletter services have recommended buying shares of Abbott Labs and Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is simply the best.
Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.