Tax planning and compliance for investors
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By Kaye A. Thomas
Updated February 1, 2008
A few words about using mutual funds for your IRA or 401k account.
The tax law provides a variety of vehicles for retirement savings, including:
Any of these plans can be set up to permit investments in mutual funds. (If the plan is set up by an employer, the employer decides whether to offer mutual funds as an investment choice, and if so, which ones.) Often there will be a choice of several mutual funds. In choosing a mutual fund investment for your retirement savings it's helpful to understand the tax rules that apply here.
For investments inside a retirement plan, all forms of earnings are treated the same way. Capital gains are treated the same as dividends. Municipal bond interest is treated the same as interest on a certificate of deposit.
Example: You have a regular IRA and you choose to invest it in a mutual fund. Earnings from this fund include ordinary dividends, capital gain dividends and tax-free distributions. When you withdraw the earnings from the IRA you must treat the entire amount as ordinary income.
We can sum this up in a single sentence:
Inside an IRA or other retirement account, long-term capital gains and exempt income are no better than ordinary income.
When choosing a mutual fund for your IRA or other retirement plan, tax benefits are not a plus. In fact, the presence of tax benefits may be a negative factor. It would almost never make sense to buy a municipal bond fund in an IRA. You would get a lower return than in a corporate bond fund with a similar risk profile, but you would still have to pay tax on the earnings when you received distributions.
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