Jason Stipp: I'm Jason Stipp for Morningstar.
Investors have until April 17 to make contributions their IRA plans, and some may be wondering just what to put in and maybe what not to put in.
Here with me to offer some ideas as well as some specific investment names is Morningstar's Christine Benz, our director of personal finance.
Thanks for joining me, Christine.
Christine Benz: Jason, great to be here.
Stipp: So, Christine, investors do have until April 17 to fund these accounts for the 2011 tax year. What's the maximum amount that they can put into these accounts, and what's the benefit of using these accounts? Why should investors think about placing assets into them?
Benz: So, the first question, the maximum contribution is $5,000 if you are under 50, $6,000 if you are over 50, and really the advantages you get depend on the type of IRA that you choose. If you are opting for a traditional IRA, the key benefit that you get is tax-deferred compounding on your money, so you won't have to pay taxes from year-to-year on any assets that you hold in those accounts.
If you opt for a Roth IRA or do a backdoor Roth IRA, which I know is a popular concept among many investors right now, you are getting tax-free withdrawals in retirement as well as that tax-deferred compounding, so kind of a double benefit there.
Stipp: So, given that you do have that tax advantage, there are probably some assets that are better to place in these IRAs. What are those? Broadly speaking, what kinds of asset classes should we think about for IRAs?
Benz: Well, the starting point, I think, for a lot of investors [is bonds]. We are all getting older year-by-year, and a lot of people might look at their portfolios and say, "I'm light on bonds, probably, relative to where I should be, given my age."
So, bonds are a great addition to an IRA, because the income you receive from bonds is taxed at your ordinary income tax rate, and so it's beneficial to tuck them inside of an IRA, where you're not having to pay taxes as the years go by on that bond income.
Stipp: If I'm looking for a good core diversified bond fund, do you have any ideas there?Read Full Transcript
Benz: Well, we kind of have a favorite trinity: The Harbor Bond is a favorite; that's a Bill Gross/PIMCO-run fund. Met West Total Return Bond is another one that Eric Jacobson in our fixed-income team likes a lot, as well as Dodge & Cox Income. I would recommend these three simply because they are so flexible, and I think there is a lot of uncertainty in the bond market right now. A lot of our readers are concerned about what could happen amid rising rates. These portfolios wouldn't be invulnerable, but they do have some latitude to kind of jockey among different bond sectors.
Stipp: Another type of fixed-income instrument that's good for IRAs are TIPS: Treasury Inflation-Protected Securities. They're particularly good for tax-advantaged accounts. Why is that?
Benz: Well, they're particularly tax-inefficient, so you are paying taxes on the income from the bond and then you are also paying tax on the principal adjustment that you receive to keep pace with inflation. So, to the extent that you can shelter that income and shelter those principal adjustments, which are taxable, within an IRA, I think that makes a lot of sense.
A favorite fund of ours there is Harbor Real Return. I know this is the second Harbor Fund I've mentioned, but it's another PIMCO-managed fund that does invest in TIPS. Vanguard Inflation-Protected Securities is a very plain vanilla, very low costs spin on TIPS.
Stipp: Lastly, in the fixed-income space: high-yield. The name would certainly imply that it's going to be kicking off a certain amount of income you might want to shelter from taxes. Do you have any ideas for high-yield investors and what kinds of investments they might want to put into an IRA?
Benz: Vanguard's high-yield fund [Vanguard High-Yield Corporate] is one that I like an awful lot, and that tends to be a higher-quality spin on high-yield, which might be pretty attractive given the fact that high-yield has enjoyed a pretty good runup over the past several years; that's one idea.
Another idea is a fund we like, Loomis Sayles Bond, which has a slice of high-yield typically as well as some other bond types--emerging markets and so forth. So, that's maybe a more flexible version, but it does tend to be pretty low-quality and high-risk at various points in time.
Stipp: Another thing you have mentioned in the past, Christine, is that for younger investors they shouldn't just think that only fixed income could go into an IRA. There are actually advantages for [younger investors] to put equities in there; they would want [equities] for their asset allocation, but especially certain kinds of equities could also be good candidates just generally for an IRA.
Benz: Right. I would say dividend-paying stock should be front and center for investors right now when they are thinking about equities for their IRAs. The key reason is that, I am a little nervous about the currently favorable dividend tax treatment; it's set to expire at the end of this year, and dividends would once again be taxed like bond income, at your ordinary income tax rate. I think that's a strong incentive to shelter that dividend income within an IRA at this point in time in particular.
Stipp: Another type of investment class, real estate investment trusts. These also throw off a lot of income. Why are they good for an IRA?
Benz: Well, their income unlike qualified dividend income, is non-qualified, meaning that you are taxed on that income at your ordinary income tax rate. So, REITs have historically been a great choice for IRAs. Right now, I would say if you're moving into REITs, I would move very slowly, if you move at all. This is another asset class that has had a very good runup. And when we look at our equity analyst valuations, they are finding the sector pretty fully valued, if not overvalued, at this time.
Stipp: Also some special considerations for commodities in the way that they are taxed. Commodities could be also another asset class that you would want to consider for an IRA?
Benz: Yes, I think it may be. The key thing to keep in mind is that you are taxed on any capital gains; 60% of those gains from a commodities investment are taxed at your long-term capital gains rates, so that's a favorable rate, but 40% is taxed at the short-term capital gains rate, which is equal to your ordinary income tax rate. So, I think to the extent that someone wants commodities, IRAs are a good place to hold them, because you are able to obtain some shelter from that ongoing income stream.
Stipp: Lots of different ways to get commodity exposure. Do you have any ideas for someone who wants to keep it simple there?
Benz: Well, Harbor Commodity Real Return has been one of our favorites. There is also an ETF that our analysts like; the ticker is DBC: That's PowerShares DB Commodity Index Tracking is also one of our analysts' favorites.
Stipp: So, as great as the individual retirement account vehicle is, there are some things you might want to think twice before putting into those accounts. The first one has to do with another type of fixed income, municipal bonds. These certainly have different tax treatment and maybe not the best choice for an IRA.
Benz: Those are good choice for taxable accounts simply because you don't have to pay federal tax on that income. So, typically you receive a lower yield because you're getting that tax benefit. So, there is no need to shelter munis within an IRA, because you're already getting a tax benefit when you hold them outside.
Stipp: You basically would be doubling up in that case.
Stipp: There is a similar argument as well for annuities in IRAs, right?
Benz: Right. So, with variable annuities, you do obtain tax-deferred compounding, which can be an advantage in certain situations, but oftentimes you are paying higher fees associated with these accounts, so to the extent that you hold them, and you want to benefit from that tax-deferred compounding, holding in a taxable account I think can make a lot of sense versus putting them within an IRA.
Stipp: Christine, the last investment type to avoid an IRA is MLPs, master limited partnerships. These investments actually do kick-off a lot of income, but not the kind of income that you want to have in your individual retirement account.
Benz: Right. This is a somewhat unusual income-producing vehicle that you actually want to hold in your taxable account. They can be nice and tax efficient. The reason to avoid them within an IRA is that if the "unrelated business taxable income" coming from that MLP exceeds $1,000 in a given year, it can cause the IRA assets to be taxable. So, you want to keep them out of your IRA; keep them in your taxable account.
Stipp: Christine, some great tips on what to put and what not to put in your IRA, and thank you as well for the investment ideas.
Benz: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.