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The Best ETFs for Your IRA

Exchange-traded funds: They're not just for taxable accounts anymore.

Believe it or not, you can use exchange-traded funds in an individual retirement account. Admittedly, it doesn't seem necessary. ETFs rarely distribute capital gains, so they ought to be best suited for taxable accounts; there's no advantage to choosing them over their conventional mutual fund counterparts for tax-advantaged vehicles, such as IRAs. In reality, however, there are situations in which it's a good idea to use ETFs in IRAs.

Certainly low-cost, low-turnover, broadly diversified large-cap ETFs, such as  Vanguard Large Cap Vipers (VV), are ideally suited for taxable accounts. There are plenty of ETFs and strategies for using them that are ill suited for taxable accounts, though. Furthermore, tax efficiency, or lack thereof, shouldn't be your sole criterion when assembling a retirement portfolio. With roughly a month left to contribute to IRAs for the 2005 tax year, here are some situations in which ETFs are better off in a tax-deferred account.

Active Traders
We generally frown on frequent trading. It increases return-sapping transaction costs as well as the chances of making the wrong call. If you insist, however, on frequently trading or even rebalancing your ETF portfolio, it often makes sense to do it in an IRA. You'll still have to pay commission costs, which will eat into results over time. But at least your trading activity will be sheltered from taxes.