As someone who spent 16 years in the money management business – before spending the last 16 as a research analyst – I know there is a good chance you are doing the wrong thing in your IRA. As well as in your non-retirement accounts.

That’s because – if your experience is typical – your investment strategy is exactly backward.

Let me explain…

[ad#Google Adsense 336×280-IA]When people think about investing for retirement, they understandably think longer term.

And so they opt for conservative, long-term investments like equity index funds and individual stocks they plan to hold forever, like Apple (Nasdaq: AAPL) or General Electric (NYSE: GE).

Then, outside their IRA, they open a regular account – usually with a deep discount broker – where they do their short-term trading.

Big mistake.

Lower Obstacles
The conventional wisdom used to be that short-term trading is a waste of time because – even if you’re a great stock picker – your higher-return advantage will be lost to spreads, brokerage commissions and capital gains taxes.

Two of these hurdles have been eliminated. Spreads – which used to average one-eighth of a point for large stocks and a quarter of a point for smaller ones – are now just a penny or two. (Thank the high-speed traders who commentators like Michael Lewis condemn.)

Likewise, brokerage commissions – especially through deep discounters – are now negligible. A short-term trader shouldn’t be paying more than $7 a trade.

But taxes aren’t going away. And short-term capital gains taxes – which can run as high as 39.6% (plus state taxes in some areas) – can indeed gobble up your profits.

The Vanguard Group conducted a study revealing that the average investor gives up 2.5% of his annual returns to taxes.

But if you trade frequently, it’s much, much higher.

That’s why you should do the opposite of what most investors are doing. You should hold your index funds and long-term stocks in your nonqualified accounts – since these aren’t generating much or anything in the way of annual capital gains – and do your short-term trading in your IRA, where your realized gains will compound tax-deferred.

Taxes Destroy Wealth
Barry Ritholtz, chief investment officer of Ritholtz Wealth Management, made an interesting observation in a Washington Post column:

Imagine that 24 years ago, your best friend invested $10,000 in the S&P 500 and held on through last year. He would have amassed $76,266. That number included taxes paid annually on whatever dividends came his way at the highest tax bracket…

Had you put that $10,000 into a trading account that same year and annually crushed the S&P 500 by 400 basis points, you would have amassed an after-tax return of only $69,197.

Why? Because you forked the rest over to the IRS along the way.

However, Ritholtz failed to note something basic. If that $10,000 trading account had been an IRA, it would have turned into $257,829, smashing the return of the S&P 500 fund.

To clarify, the same trades made at the same time and generating the exact same returns would have turned into nearly four times as much in an IRA.

Uncle Sam Gets Paid
Granted, you would eventually have to pay taxes on that sum when you withdrew it from your retirement account. But even if you paid the maximum 39.6% tax on your $257,829, it would still be worth $155,728, more than twice as much as the S&P 500 fund in the non-retirement account.

And – remember – there is still a big capital gains tax due when you liquidate the S&P 500 fund.

True, you cannot deduct trading losses incurred in your IRA. But losses in a non-retirement account can be used only against realized gains and a maximum of $3,000 a year of earned income. (Although unused losses can be carried forward.)

In short, to maximize your returns, you absolutely need to tax-manage your portfolio.

That means your long-term, tax-efficient investments – like equity index funds and long-term stock holdings – should be held in your non-retirement accounts. And your short-term trading should be done in your IRA.

Especially if you’re any good at it.

Good investing,

Alex

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Source: Investment U