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Benz: Good Candidates for Your IRA

Jason Stipp

Jason Stipp: I am Jason Stipp from Morningstar. It's IRA Improvement Week on, and today we are talking about good investment type candidates for the tax advantaged IRA account.

Here with me to offer some tips and insights on that is Morningstar's Christine Benz, director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So the IRA does have some tax advantages, however, taxes although an important thing to consider, aren't the only thing to consider in what goes into your IRA.

How should you think about that as you are putting together assets for this account?

Benz: I think it's key to think about what you are using your IRA for. So if it's going to form a large share of your overall retirement accounts, so maybe you have rolled over a lot of assets from a company retirement plan or you're just starting out and using an IRA as a core retirement vehicle, by all means populate it with those core categories, core stock funds, say a large-cap blend fund, or core bond funds like a good intermediate-term bond fund. You really don't need to monkey around with more specialized asset classes.

But where an IRA can come in handy and where you do want to stay hyper-attuned to which investments might be the best fit for an IRA is if you're using that IRA as kind of a supporting player in your overall retirement program. In that case you can seek out some of these investments that are especially tax inefficient, and that way you are taking advantage of that tax-deferred compounding that an IRA automatically confers.

Stipp: So along those lines, I think, the one that comes to mind first are investments that produce a lot of income or high-yield investments. How should you think about that in terms of the IRA and what types of funds might you consider there?

Benz: That's absolutely right, Jason. So income is taxed at your ordinary income tax rate, so that tends to be quite unattractive when you are holding such assets within the confines of a taxable account. So if you do shelter them within an IRA wrapper, you won't have to pay those taxes from year-to-year.

So a couple of ideas there, and if you're looking for specific funds, one that our analyst team likes an awful lot is Loomis Sayles Bond. This is kind of an eclectic, very aggressive, fixed-income holding, but one that does kind of have that go-anywhere focus. In fact, Morningstar analyst Miriam Sjoblom recently wrote that they were buying some Irish bonds. So, it's not for the faint of heart by any means, but it is a good higher-yielding IRA pick.

Another idea for people who want to own high yield specifically would be Vanguard High-Yield Corporate Bond, and this is a category in general that has had a very nice runup over the past few years. So, you do want to kind of tiptoe in, but the nice thing about this fund is that it tends to be milder than the typical high-yield fund. So, it's usually a higher quality portfolio than you usually see in the junk bond category.

Stipp: Some good ideas there. Another category that I think investors are increasingly looking to add to their portfolio is commodities. This is another one that's not particularly tax efficient, what's behind that?

Benz: Well, a couple of things, Jason, and first I would point out that there are some more tax efficient ways to invest in commodities. So, exchange traded notes that are tracking commodities are one way to do that if you want to own them within your taxable account, but a lot of the futures-based commodity ETFs and mutual funds are pretty tax inefficient, and the key reason is that any gains linked to those futures are taxed as 60% long-term gain, 40% short-term gain, and that short-term gain means that it will be taxed to your ordinary income tax rate.

So these funds have been a pretty bad deal from the standpoint of holding them within a taxable account. So if you are interested in this type of investment, and a lot of people have been looking at it as a way to hedge against inflation, the IRA would make a good wrapper for it.

Stipp: Do you have any ideas of good funds on that front?

Benz: One our analyst team likes is the PIMCO Commodity Real Return, and this one actually is particularly bad from a tax efficiency standpoint, because not only does it own futures and use them to obtain commodity exposure, but it also owns TIPS bonds with the remainder of its portfolio. So, it's been a very good fund, on a pre-tax basis, and we think one of the better commodity-linked funds out there, but not such a good bet for a taxable account. So, it's a great idea for an IRA.

Stipp: So, you mentioned TIPS there; this is another category that particularly has some tax inefficiencies. What's behind that on the TIPS front, and which TIPS vehicles might you recommend?

Benz: So, there are a couple of reasons why TIPS tend not to be a great bet for a taxable account. The first is like any bond or bond fund, you're going to be taxed on that ordinary income that it kicks off, and then you are also taxed on any principal adjustments that come with hikes in inflation. So, you do get that bump up in your principal value, but you also get taxed on that amount; that's why TIPS typically are best off in some sort of tax-sheltered vehicle like an IRA.

A couple of funds that come to mind, for plain vanilla exposure, Vanguard Inflation-Protected Securities is a very nice core type fund obviously with low costs, and then a PIMCO managed fund, PIMCO Real Return, or for no-load folks, Harbor Real Return is another way to get that Treasury inflation protected exposure with a few more bells and whistles that PIMCO brings to the game.

Stipp: So, Christine, you hinted at this when you spoke about high yield and the runup that we've seen there. We know that commodity prices have also been on the rise recently. What should investors think about the valuations in some of these categories, because it seems like they might be getting frothy?

Benz: Right, and I think that's a real concern with all of these categories that I've just talked about. People are concerned about what they've seen with TIPS, commodities as well, high yield also has had a great runup.

So, I would say, Jason, with all of these categories, rather than plunking down a lump-sum in an IRA, so maxing out right before April 18 of this year, maybe a better idea is to think about creating a dollar cost averaging plan to put the money in through the whole of the year, if you are looking at any of these categories that have seen a big runup and could be a little bit expensive at this point in time.

Stipp: That way to ensure that you're not buying right at the peak of the prices. All right, Christine, thanks for some great tips on maximizing the tax advantaged benefits of the IRA.

Benz: Thank you, Jason.

Stipp: From Morningstar, I'm Jason Stipp. Thanks for watching.