Is it Better to Have Stocks or Bonds in an IRA?
Stocks have historically outshone bonds when it comes to wealth creation over time. Investors who hold stocks within an IRA can further take advantage of its tax deferral feature or, with Roth IRAs, elimination altogether of capital gains taxes upon withdrawal.
Investors should take their age, timeframe until retirement and benefits of diversification into account when allocating an IRA to stocks.
Stocks
For an IRA investment to provide consistent returns, select stocks from safe companies that pay dividends. That way, even if their share prices decline, your income remains secure – this has proven particularly true with Johnson & Johnson which sells medical devices and pharmaceuticals needed by people in both strong and weak economies – helping protect it against economic downturns in past times.
Trading stocks through a taxable brokerage account requires reporting any capital gains or interest income on your annual tax return, while holding them in an IRA allows them to be taxed as investment income only upon withdrawal from the account.
TIPS funds, or inflation-adjusted bond funds, can also be protected within an IRA account. While outside an IRA you’d pay taxes each year on the principal value, its growth would instead adjust with inflation in an IRA account – providing interest income without incurring additional taxes each year.
Bonds
Bonds provide investors with some protection when stocks decline, yet don’t always gain. Finding suitable bonds and bond funds to fit with their portfolio is the key for making sense out of investing with bonds within an IRA account.
Morningstar reports that bond funds held within an IRA are taxed much more efficiently than those held within a taxable account, due to interest being taxed at ordinary income rates rather than capital gains rates.
Municipal bond interest is already exempt from federal taxes and often state taxes as well, making them ideal candidates to invest in an IRA to lower taxable income without incurring extra costs.
Investors have access to an abundance of bond exchange-traded funds (ETFs), which provide exposure to different categories of bonds. A typical IRA portfolio should feature one or two low-cost core ETFs to provide broad exposure across U.S. stocks, bonds and global investing and provide investors with maximum returns over time.
Taxes
IRAs generally provide more investment options than their workplace equivalent, with major brokerage firms often offering an array of low-cost funds aimed at diversification. One popular choice among these funds is an index fund tracking the Standard & Poor’s 500 index; a collection of hundreds of large, stable companies which have provided investors with consistent long-term gains over time.
Growth stocks that generate investment income through dividends and capital gains make a great asset to hold in an IRA, however if you trade them within it the losses incurred may not be written off like they would in a taxable brokerage account.
Therefore, few active traders utilize their IRA accounts for trading; most investors would do well to stick with the buy-and-hold strategy which has consistently yielded superior returns over trying to outwit the market; index funds are therefore often best.
Diversification
Financial experts generally concur that diversifying across and within asset classes is crucial. For example, investing in stocks that span different sizes (large-cap, mid-cap and small-cap stocks), sectors and geographies (domestic and international) helps mitigate your risk.
Diversifying between taxable and tax-deferred accounts is also key. Since high portfolio turnover can reduce long-term returns, diversifying across both accounts makes sense; bonds should go in taxable accounts while stocks eligible for tax-deferred growth should go into an IRA.
Diversifying can be easy and inexpensive by investing in low-cost index funds or ETFs that track broad market indices. Target-date funds also make investing simpler, automatically allocating assets between stocks and bonds as retirement nears. Self-directed IRAs give even more options to diversify by investing in alternative assets like real estate, private equity, crowdfunding opportunities, Bitcoin/other cryptocurrency currencies as well as private mortgages/notes/precious metals.
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