Tue, 23 Feb 2016
Whether you're nearing retirement or still accumulating, these Morningstar analyst-approved holdings are great candidates for tax-sheltered accounts.
Note: This video is part of Morningstar's February 2016 Tax Relief Week special report.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. It's Tax Relief Week here on Morningstar.com. Here to talk to fund investors about how they should think about filling their IRAs is Christine Benz, our director of personal finance.
Christine, thanks for joining me.
Christine Benz: Jeremy, it's great to be here.
Glaser: First off, before we get into some specific fund ideas that you have, how should we even think about selecting investments that go into a tax-advantaged account like an IRA.
Benz: The key thing you need to think about is your time horizon for that money. So, for younger people who are accumulating assets for retirement and don't expect that they will tap that money for another 20 or 30 years or more, by all means they'd want to have their IRA predominantly invested in stocks. For people who are using their IRAs to take advantage of that tax-sheltered wrapper and maybe are getting a little bit closer to retirement--which would mean they might want to begin accumulating safer types of assets--IRAs are an ideal receptacle for bonds, because that bond income is taxed at your ordinary income rate. So, your taxable accounts tend to be a bad place to hold taxable bonds. IRAs shelter you from those year-to-year income distributions, so they're a good place to house income-producing assets.
Finally, I would say that investors who have already well-diversified portfolios and are using their IRA contributions to diversify the already well-diversified equity-and-bond piece of their portfolios, they might think about using their IRAs to use some diversifying asset types that are also tax-inefficient. Here, I'm thinking of categories like real estate perhaps, commodities, and other areas that diversify that plain-vanilla stock/bond portfolio.
Glaser: Let's start with investors who do have that long time horizon. What are some ideas of what they can put in their IRA today?
Benz: Well, one thing I would say is that if you have an equity philosophy that you believe in and that you are operating with, there is no reason to depart from it. So, maybe you're an individual-equity investor or maybe you're someone who really believes in the merits of indexing. Well, those are both pretty tax-efficient strategies, and there's no reason to go out of your way to be tax-inefficient simply because you are investing in an IRA. So, if you have one of those philosophies and you believe in it, by all means employ it within your IRA.
But one thing I would say is that, for investors who do want to take maximum advantage of the tax sheltering that you get with an IRA, you might want to think about holding dividend-paying stocks. The reason is that if you hold them in a taxable account, you receive those dividends and you'll owe taxes on them in the year in which you receive them. If you hold them inside of an IRA, you can reinvest those dividends. The only tax you'll pay if you are holding a traditional IRA is when you begin pulling money out of the account. So, that's one reason why I say if you like dividend-paying equities, you should think about holding them inside of a tax-sheltered account.
Here, I have a couple of ideas. One actively managed fund that our team likes quite a bit that has a dividend yield that is high in absolute terms is Vanguard Equity-Income (VEIPX). It's a fund that is about two thirds managed by the team at Wellington Investment Management, and the other third is managed by Vanguard's in-house quantitative-equity group. It's historically been a very strong-performing fund, in part, because it has very low costs. A lot of the yield that it kicks off flows through to shareholders because the lower expenses are being deducted from that yield. So, that's a good actively managed option.
For people who are thinking about some sort of an index product--certainly, indexing can be a good way to invest in dividend-paying equities, too--I might look at Vanguard High Dividend Yield (VYM). This is available either as a traditional index mutual fund or as an exchange-traded fund. Or you might consider Schwab U.S. Dividend Equity (SCHD). Both are really low-cost products that offer well-diversified exposure to the dividend-paying equity space.
Glaser: Let's turn to investors who maybe have a shorter time horizon who are looking to buy core bond funds in their IRA. What are some options there?
Benz: Well, here, I would think about some of the intermediate-term bond funds that our team likes quite a bit. These would be appropriate for people who are maybe getting into their 50s and 60s and starting to take some risk out of their portfolios as their retirements approach.
Among our favorites would be Dodge & Cox Income (DODIX), Fidelity Total Bond (FTBFX), Metropolitan West Total Return Bond (MWTRX), and Vanguard Total Bond Market Index (VBMFX)--those big, core funds that provide fairly well-diversified exposure. The Vanguard fund is obviously a total bond market index fund, while the other products are actively managed. They all feature, again, nice low costs, and bonds in general take good advantage of that tax-sheltered wrapper that you get with an IRA. If you own taxable bonds in a taxable account, you pay ordinary income tax on each of those income distributions. If you are sheltering those income distributions within an IRA, you won't pay taxes on them on a year-to-year basis.
Glaser: If you already have core bond exposure, would it make sense to maybe look at some satellite holdings in an IRA?
Benz: Absolutely--because when I look at the 401(k)-plan universe, for example, one thing that you often see is that 401(k)-plan menus usually do a good job about giving you that good, core fixed-income exposure. They've got that Vanguard Total Bond Market Index or they've got PIMCO Total Return (PTTRX) on the menu. So, you are usually covered if you're building out your portfolio primarily in your 401(k). So, investors may want to look to their IRA to be that sort of satellite fixed-income holding. A couple of ideas come to mind for that space.
One would be Treasury Inflation-Protected Securities. They tend to be a good security type to house within some sort of a tax-sheltered account because you pay taxes on their income distributions just as you would with any other bond fund. And you also pay taxes on the adjustments that you get to your principal value when inflation goes up. So, it's generally a good idea to think about housing them, just like any other bond-fund type, within a tax-sheltered account.
A couple of funds that we like in this space would be PIMCO Real Return (PRRDX) and I also like Vanguard's inflation-protected funds--both Vanguard Inflation-Protected Securities (VIPSX) as well as the relatively newer Vanguard Short-Term Inflation-Protected Securities (VTIPX). The Vanguard funds are low cost and generally kind of vanilla options in that TIPS space. But I think that TIPS, in general, are a good thing to think about when you are thinking about your IRA.
Glaser: Beyond TIPS, are there any noncore fixed-income types you'd recommend for an IRA?
Benz: Definitely. For the person who has that core piece filled out, another area that you might consider for an IRA would be some sort of a junk-bond fund. In fact, I think junk bonds in many ways are kind of the poster child for what you want to hold inside of an IRA. The reason is that their income distributions tend to be on the high side. So, it's particularly advantageous to think about sheltering them in some sort of a tax-advantaged wrapper like an IRA. So, if you're inclined to hold a junk-bond fund, your IRA is a good place to do it.
One of the funds that Morningstar likes is Fidelity High Income (SPHIX). You might also consider some sort of a multisector fund. Multisector funds will typically own some junk bonds. They might also own some emerging-markets bonds. Some of them actually hold some equities. One of the funds that we often recommend--and one that I hold in my model retirement portfolios--is kind of an aggressive kicker for the fixed-income pieces, Loomis Sayles Bond (LSBRX). Fidelity has a couple of good products in this space as well.
Another idea would be some sort of a dedicated developing-markets bond fund. We've seen yields tick up pretty nicely. It doesn't mean that they are necessarily cheap, but certainly investors have a little bit more of a margin of safety than they once did. Morningstar thinks that Fidelity's funds, again, are decent options within this space. Another idea would be TCW Emerging Markets Income (TGEIX). That's an emerging-markets bond fund that our analysts like quite a bit.
Glaser: Outside of bonds, for investors who are mostly investing in their 401(k), what would be some other options for an IRA?
Benz: Here, again, you could think about what are the investment types that tend to be pretty tax-inefficient and things that I wouldn't naturally hold in my 401(k) plan. Commodities might be an interesting idea. Certainly, it's a deeply unloved category; the performance has been terrible for obvious reasons. We've seen a lot of different types of commodities under a cloud; but this is a category that tends to be quite tax-inefficient. So, you do want to house it within some sort of a tax-advantaged wrapper like an IRA. A couple of funds that Morningstar likes would be PIMCO Commodity Real Return (PCRDX) or Harbor Commodity Real Return (HACMX). The Harbor fund is a no-load, near clone of the PIMCO fund.
Glaser: How about real estate? I know some people put real estate in that category as well.
Benz: Absolutely. Real estate is a terrific idea for an IRA portfolio. Here, again, it tends to be a tax-inefficient asset class. The income distributions that REITs make do not count as qualified dividends, so you'll pay ordinary income tax on them. So, it's a great idea if you're holding real estate to think about putting it in your IRA. A couple of the funds that Morningstar likes would be T. Rowe Price Real Estate (TRREX), which is an actively managed fund, as well as Vanguard REIT Index (VGSIX), which is an index product with very low costs.
Glaser: Christine, thanks for sharing these ideas today.
Benz: Jeremy, it was great to be here.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
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