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Five Good Categories for 401(k)s and IRAs

So many tax-inefficient funds, so little space.

Russel Kinnel, 05/24/2010

There are a lot of ways to reach your goals in retirement accounts such as 401(k)s and IRAs. You don't need to go out of your way when looking for tax-inefficient funds that can take advantage of these vehicles' tax-deferred compounding. But if you are planning to buy a fund that's tax-inefficient, it makes sense to put it in your retirement account. With that in mind, I've selected five fund categories that are best held in a tax-sheltered account. I'll include a link to our Fund Analyst Picks for each category for Premium Members who want to cut to the chase. If you're wondering about a particular fund's tax efficiency, click the "Tax" tab when reading about any specific fund.

Convertible-Bond Funds
You don't need a convertible-bond fund--with its mix of stock and bond characteristics, it acts kind of like balanced funds--but such a fund does offer an attractive mix of risk and reward. You can see how that has played out by looking at a chart of Vanguard Convertible versus the S&P 500 Index over the past decade. By losing less in down markets, the fund significantly outpaced the stock market.

Because many hedge funds that used converts in their strategies folded in 2008, there has been more elbow room left for convertible investors. However, such funds are best kept in tax-sheltered accounts because convertibles throw off a lot of taxable income.

Conservative Long-Short Funds
Funds that take a market-neutral or close to market-neutral approach can offer a low-risk way to earn a respectable return that isn't closely linked to the stock market. By market-neutral, I refer to funds that have a strategy designed to move independently of the stock market. However, most of these strategies are very inefficient from a tax standpoint. They require high turnover and generate taxable income. Some funds use options, while others do convertible or merger arbitrage. There are a lot of weak funds in this group, so be sure you find one with modest costs and a proven record.

Commodities Funds
I like the combination of commodities funds and floating-rate funds because you are covering inflation risk and interest-rate risk by combining these two vehicles. However, commodities funds are horribly tax-inefficient because of the derivatives they hold. For example, PIMCO Commodity Real Return PCRDX earned 1% annualized pretax for the trailing five years, but lost 3.44% after a 400 basis-point haircut due to taxes.

Target-Date Funds
Target-date funds aren't horribly inefficient but they are designed for taxable accounts and they hold taxable bonds rather than munis. Target-date funds took some flak for losing a lot of money in 2008, but I'd imagine investors did worse picking funds on their own in 401(k)s than target-date funds did. Target-date funds address two key problems with most mutual funds. First, investors tend to chase performance and therefore overweight the most overpriced areas. Second, it's tricky to unwind a portfolio as you slowly move into fixed-income, but these funds do it smoothly.

Conservative Allocation Funds
Now that we've discussed some newfangled approaches, it's time to remember that plain, old conservative allocation funds are a dependable group. There are two main types of conservative allocation funds. One is the truly conservative fund with a big helping of high-quality bonds. The other is aiming to have a high yield and takes all manner of credit and industry risk to get there. As you might guess, I like the former and not the latter. Funds such as Manning & Napier Pro-Blend Conservative Term EXDAX and Vanguard Wellesley Income VWINX are nice, boring funds you can depend on. 

Russel Kinnel is director of mutual fund research with Morningstar.

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