Helping you create a sturdy financial plan, 30 minutes at a time, is the focus of my recent book,30-Minute Money Solutions. The following chapter, on selecting the right investments for your IRA, is an excerpt from the book.
"The Lord works in mysterious ways."
Uh-oh, I thought, as I read the first line of a letter from a Morningstar reader, who proceeded to regale me with an investment-related tale worthy of an O. Henry story.
A 50-something computer programmer, he was devastated when he lost his job in the financial-services industry back in mid-2008. With a mortgage and two kids hurtling toward college, the layoff obviously brought worries about what the future would bring.
At the time of his layoff, he was also panicked about his 401(k) portfolio, which included a healthy dose of stock funds as well as many shares of his employer's stock, which was quickly going from bad to worse.
Here's where the plot twist comes in: Shortly after the layoff, he had rolled over his 401(k)--the bulk of his retirement savings--into an IRA. Paralyzed by indecision over where to invest the money, he had left the assets sitting in an ultra-low-yielding, but ultra-safe money market fund. In so doing, his retirement portfolio was cushioned during the late 2008-early 2009 market sell-off, the worst since the Great Depression, which saw the S&P 500 dropping by 50%.
Even more fortuitously, he had also dumped his company stock at an opportune time. Soon after he sold the stock and rolled his money into the IRA, shares of his former company skidded from $25 a share down to about $3. He hadn't yet found a new job at the time he wrote to me, but he noted that his inaction toward his retirement portfolio had saved him far more money than he had lost in income from his job.
Yet, he didn't want to look a gift horse in the mouth. He knew how lucky he had been in sidestepping the market's troubles, but he also knew that his conservative portfolio could be left in the dust if the market rebounded. And indeed, when he wrote me in the spring of 2009, the major stock indexes were scoring huge gains each day. He wanted guidance, posthaste, on getting his portfolio invested for good.
It's easy to see why this programmer, as well as a lot of other would-be IRA investors, suffer from "analysis paralysis." Once you decide whether to invest in a traditional or Roth IRA, you then have to sort among an overwhelming array of options. You can put almost anything inside an IRA wrapper: individual stocks and bonds, money market funds, certificates of deposit, or mutual funds. Life insurance policies and investments made on margin--that is, those funded with borrowed money--are among the few mainstream investment types that can't go inside an IRA.
However, because IRAs offer either tax-free (Roth IRA) or tax-deferred (traditional IRA) compounding, it's usually a mistake to put any sort of investment that itself has tax benefits inside an IRA wrapper. Municipal bonds are a great example: You don't typically pay federal taxes on the income from municipal bonds or bond funds, but in exchange you usually have to accept a lower level of income than you'd have from a taxable bond or bond fund. For that reason, you're better off holding tax-advantaged investments such as municipal bonds and variable annuities (to the extent that you own them) in your taxable accounts, and only after you've funded your IRA and company retirement plan.
To identify the best investments for your IRA, you'll need:
- Statements for all of your retirement holdings: 401(k)s, 457s, 403(b)s, and other IRAs
- Morningstar's Instant X-Ray tool
Start the Clock
The first step in selecting investments for your IRA is to think about what role your IRA will play in your retirement portfolio. Will it take up a big share--either because you're just starting out and plan to make many more IRA investments in the future or because you've rolled over a large sum of money from your company retirement plan? If so, move on to Step 2.
If you consider your IRA to be more of a supporting player because the bulk of your retirement assets are elsewhere, either in your company retirement plan or your taxable account, go to Step 3.
If you already have a large sum of money stashed in an IRA--or expect that your IRA will grow to be a large share of your overall retirement portfolio in the future--you'll want your IRA to be well-diversified and populated with "core" investment types such as large-cap stock mutual funds and high-quality bond funds.
If you have other assets earmarked for retirement, in addition to the money that you're putting into an IRA, be sure to take those holdings into account when deciding what to put in your IRA. Morningstar's Instant X-Ray tool can help you size up your existing portfolio's stock/bond/cash composition and also shows you how well it's diversified across various investment styles. (The Morningstar Style Box provides a visual depiction of a portfolio's investment-style mix.) Simply enter the tickers for each of your holdings into the X-Ray tool, then click Show Instant X-Ray.
Compare the current allocations of your existing retirement portfolio with your asset-allocation targets. Once you've determined where you need to add, you can select the specific investments. If you're looking for core-type investments to populate your company retirement plan, Morningstar's Fund Analyst Picks in the large-cap equity (both international and U.S.), intermediate-term bond, world-stock, world-allocation, and conservative- and moderate-allocation categories can provide a good starting point. Some of my favorites are Dodge & Cox Stock (DODGX), Sequoia (SEQUX), and T. Rowe Price Personal Strategy Income (PRSIX).
Are you opening an IRA to augment retirement monies that you hold elsewhere? If so, you, too, can hold core-type investments in your IRA.
But you can also use the IRA to fill holes in your company retirement plan. For example, say your plan includes adequate stock funds, but its bond funds charge more than 1% per year in annual expenses--a princely sum that's sure to take a big cut of your long-term return. If that's the case, you can fill up your company retirement plan with the decent stock funds and leave the bond portion of your portfolio to an IRA. Again, Morningstar's Instant X-Ray tool can help you see where you've got holes in your existing asset mix.
And because the world is your oyster when funding an IRA, you can also include investment types not commonly found in company retirement plans, including funds dedicated to real estate investments, commodities, or Treasury Inflation-Protected Securities. All of these investment types do a good job of diversifying a portfolio that's composed primarily of stocks and bonds. They also can be a headache when held outside of a tax-sheltered account, because they generate a lot of taxable income, so they're ideal holdings for an IRA.
Morningstar's Fund Analyst Picks within those categories are good starting points if you're using your IRA to support core-type funds you hold elsewhere. Some of my favorite "supporting player" IRA ideas are Royce Special Equity (RYSEX), Third Avenue International Value TAVIX, and Vanguard Inflation-Protected Securities (VIPSX).
- To the extent that you hold bonds in your portfolio, it generally makes sense to hold them within tax-protected accounts such as your IRA or company retirement plan. That's because bonds tend to generate a lot of income, which is taxed at rates as high as 35%. Stocks, meanwhile, typically crank out less income. Also, the tax rate on capital gains and stock dividends is currently much lower than is the case for bond income, though that treatment is set to expire at the end of 2010.
- I tend not to be a big fan of mutual funds with high turnover rates, meaning that the manager makes frequent changes to his or her investment portfolio. However, to the extent that you're attracted to such a fund type, it makes sense to shelter it within the confines of an IRA, where you won't owe taxes on your holdings from year to year. That's because high-turnover funds often generate short-term capital gains, which are taxed at your relatively high ordinary income tax rate. (Long-term capital gains receive much more favorable tax treatment.)
Excerpted with permission of the publisher John Wiley & Sons Inc. from 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances. Copyright (c) MMX by Morningstar Inc.
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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.