The Best Investments for Your IRA

Now that it's tax time, we probably don't need to remind you Uncle Sam can take a heavy toll on your pocketbook. Fortunately, there's plenty you can do to reduce your tax outlay in 2007 and beyond. And for some folks, it might still be possible to limit the tax collector's share for tax year 2006.

One tax-savvy move is to open an individual retirement account. Individuals under certain income thresholds can contribute $4,000 annually to an IRA, and those over 50 can add another $1,000 this year. You have until April 16, 2007, to contribute for tax year 2006.

It's worth noting that you can deduct your IRA contribution from your current income only if your income falls below a certain threshold. Roth IRA contributions, by contrast, are not tax-deductible, but qualified withdrawals will be tax-free, and the income limits are much higher than is the case for traditional deductible IRAs. (Individuals of all income levels can make a nondeductible contribution to a traditional IRA.) To learn more about investing in a traditional IRA, click here; you can read more details about Roth IRA investing here.

Deciding which investments to put inside your IRA requires a little bit of savvy. To be sure, there's no reason to deliberately choose investments that aren't tax-efficient, but if you're trying to pick between competing ideas, it's only sensible that you'd put the one that might cause the biggest tax headaches in your IRA and save more tax-efficient investments for your taxable account. Here are some issues to consider as you decide what to put in your IRA.

Stocks or Bonds: Which Are Better?
Conventional wisdom holds that investors should hold bonds in tax-protected vehicles like IRAs and stocks in their taxable accounts. Intuitively, that makes sense. After all, bonds throw off a lot of taxable income, which is taxed at rates as high as 35%. Meanwhile, stocks typically generate much less income, and that dividend income is taxed at a much lower rate--generally 15%. (Long-term capital gains from stocks enjoy the same rate.)

In this instance, however, the conventional wisdom has limitations. Stocks generally produce higher returns than bonds, and thanks to the magic of compounding, the differences in performance really add up over time. That's why the return from stocks can generate a much higher tax burden than bonds over the long haul.

Thus, if you're a long way from retirement (one study from T. Rowe Price suggested 15 years or more), it might make more sense to hold stocks in your IRA. Conversely, if you're relatively close to retiring, you're probably better off investing your IRA in bonds.

Not All Investments Are Equal
So you've got a while until you retire, and you've decided stocks are the right choice for your IRA. That decision only gets you so far. For an IRA, not all stock investments are created equal.

For example, index funds' popularity has soared over the past decade, thanks in no small part to these offerings' often-rock-bottom costs as well as the fact that so many active stock-pickers routinely lag their benchmarks. Such funds may also have the benefit of very good tax efficiency, because managers of large-cap index funds tend to buy and sell infrequently. In the same vein, actively managed funds with very low turnover often don't generate a lot of taxable gains, either.

Either fund type would work well as an IRA holding. However, to the extent that you own funds that do generate a lot of taxable capital gains, it makes sense to hold them in an IRA or other tax-sheltered account. In so doing, you take maximum advantage of the IRA's key attribute: tax-deferred (traditional IRA) or tax-free (Roth IRA) compounding.

For example, say you're considering adding an aggressive, opportunistic fund to your portfolio. Take  CGM Focus , for instance, where turnover clocked in at an eye-popping 333% last year, the equivalent of buying and selling the entire portfolio three times a year. The fund has delivered impressive results, but taxable shareholders have given up nearly 2.5 percentage points of their annual return to taxes over the past three years. The fund's big capital gains payouts haven't been a negative for those in IRAs, however, because such shareholders don't have to pay as they go, as do taxable investors.

Contrary to the common perception, worthwhile funds with high turnover and lackluster tax efficiency (and therefore good potential IRA candidates) don't all use growth strategies. True, many value managers keep turnover low, but in some instances, such as at  American Century Value (TWVLX), that's not the case. Management employs a strict valuation discipline and trades opportunistically when its holdings dip, resulting in far more turnover than most large-value funds. So while its pretax long-term returns are solid relative to its peers, they're underwhelming on an aftertax basis. If you're going to own this fund--and we do think it's a worthwhile offering--you'll want to be sure to do so in an IRA.

As for bonds, it almost goes without saying that municipal bonds don't belong in an IRA; such funds generate income that's exempt from federal and in some cases state income tax, and their yields are generally lower than taxable bonds as a result. Meanwhile, high-yield bonds are better contenders because they generate heaps of income, but IRA investors don't have to pay tax on those distributions. And because income from convertible securities isn't tax-advantaged, the same could be said for convertible bonds and bond funds.

Alternative asset classes--the likes of which are infrequently found in company retirement plans--may also make ideal IRA candidates. REIT funds, for example, pay out heaps of income from their underlying real-estate holdings, and none of it is tax-advantaged; thus, to the extent that you own such an offering, you'll want to be sure to stash it in an IRA or other tax-sheltered vehicle. Commodity mutual funds such as  PIMCO Commodity Real Return Strategy  also tend to be unattractive for taxable accounts but can make a good choice for investors looking to diversify within their IRAs. We'd note, though, that both real estate and commodities have been on a tear in recent years, and investors shouldn't buy them in hopes of big gains. But both are still good ways to diversify a portfolio and make sense in small amounts, especially if you don't have access to them through your 401(k).

Keep the Big Picture in Mind
Tax considerations are important, but letting them govern your investment strategy is putting the cart before the horse. How you split your portfolio between stocks and bonds should be based on your risk tolerance and time horizon, not what makes sense from a tax perspective. Your primary goal should be to find superior investments and then think about whether they fit best in a taxable account or an IRA. If you're a mutual fund investor, look for experienced managers, good long-term records, and low expenses, whether or not you're planning on holding the fund in an IRA. Remember, your goal isn't necessarily to avoid taxes, but to maximize aftertax returns.

What's more, just because an investment is a good choice for an IRA doesn't mean it's right for you. For instance, you might be uncomfortable with racy, fast-trading strategies, or your portfolio may already have ample exposure to them.

You should also be sure that the IRA investment you're eyeing fits in well with what you already own. One good way to do so is with Morningstar.com's free Instant X-Ray tool, where you'll be able to see where your portfolio lands in the Morningstar style box, its sector weightings, regional exposure, and asset allocation. If you notice your portfolio is light on large-growth stocks, for instance, then it might make sense to look for a large-growth fund for your IRA.

So where's the best place to look for investment ideas? One great spot for fund investors is our  Fund Analyst Picks, which represent our analysts' favorite funds in every category. For stock investors, our analysts' highest-rated stock ideas can be found  here. And if you want to customize your own specific criteria, check out Morningstar's  Premium Fund Screener and  Premium Stock Screener or the Basic Fund Screener and the Basic Stock Screener. (Our Basic screeners are free to all Morningstar.com users, while our Premium screeners--which let you screen on a broader range of investment criteria--are available only to Morningstar.com Premium Members. If you're not yet a Premium Member, sign up here for a free 14-day trial.)

A version of this article appeared on March 7, 2006.