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The Short Answer

The Best Investments for Your IRA -- Page 2

For IRAs, not all options are created equal.

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Not All Investments Are Equal
So you've got a while until you retire, and you've decided that stocks are the right choice for your IRA. That decision gets you only 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 (CGMFX), for instance, where turnover clocked in at an astounding 500% last year, the equivalent of buying and selling the entire portfolio five times over. The fund has delivered impressive long-term 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  Mainstay ICAP Equity (ICAEX), that's not the case. Management employs a strict valuation discipline and trades opportunistically, resulting in far more turnover--and therefore taxable capital gains--than most large-value funds. So 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, yet that income doesn't receive the currently low tax treatment that dividends receive. 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  (PCRDX) also tend to be unattractive for taxable accounts but can make a good choice for investors looking to diversify within their IRAs. Both real estate and commodities 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? My colleague Russ Kinnel recently discussed his eight favorite funds for an IRA. Another 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.)

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A version of this article appeared on Morningstar.com on April 8, 2008.

Christopher Davis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.