The Error-Proof Portfolio: What Not to Put in Your IRA

Do you hear the clock ticking?

As of today, you have a little more than two months to file your tax return. And April 18 is also the deadline for contributing to an IRA for the 2010 tax year.

The former deadline no doubt feels more pressing than the latter, particularly because funding an IRA won't necessarily help lower your tax bill for 2010. Only individuals with income below certain thresholds--$66,000 for individuals who can contribute to a company retirement plan and $110,000 for married couples filing jointly--can deduct at least a portion of their traditional IRA contributions.

But even though making an IRA contribution may not reduce your tax levy this year, funding an IRA now can deliver important tax-saving benefits down the line. Individuals who contribute to Roth IRAs will be able to enjoy tax-free withdrawals from those accounts in retirement--an important benefit if you think income tax rates are likely to be higher in retirement than they are now. And even if you have no idea what tax rates are likely to be when you retire (you can put me in that camp), putting money into a Roth IRA can help diversify the tax treatment of your retirement assets. Some of your savings (such as deductible IRAs, traditional 401(k)s) will be taxed upon withdrawal, while others (such as Roth IRAs and 401(k)s) will enjoy tax-free withdrawals.

The good news is that individuals of all income levels can get into a Roth this year. You can make at least a partial contribution to a Roth IRA if you're an individual earning less than $122,000 who can contribute to a company retirement plan; if you're part of a married couple filing jointly who can contribute to a company plan, you can make at least a partial contribution if your income is less than $179,000.

If your income is above those levels, you can think about making what I've been calling a backdoor Roth contribution. It may sound shady, but it's not. The basic idea is that you open a traditional nondeductible IRA--an option available to individuals at all income levels--then immediately convert it to a Roth. (Note: This strategy may not make sense for those who already have substantial deductible IRA assets; check with a tax advisor for guidance.)

Once you've made the decision to invest in an IRA, the next step is to figure out what to put inside of it--a step that can lead to analysis paralysis because there are so many choices. We'll be talking about our "best ideas" for IRAs later this week, but first let's talk about which investments should be off-limits for an IRA, either because you can't legally hold them within an IRA wrapper or because they're a bad idea for one reason or another.

Off-Limits
You can choose from a broad assortment of investments to stash within an IRA wrapper: individual stocks, individual bonds, certificates of deposit, mutual funds, exchange-traded funds, even real estate. (Note that specific rules govern what types of real-estate transactions are permissible within an IRA framework.) There are, however, some investments that are generally off-limits for an IRA. The short list includes collectibles: artwork, antiques, gems, stamps, and coins. Nor can you hold life-insurance policies within the confines of an IRA or buy securities on margin (and therefore you cannot short individual stocks within the IRA).

Niche Investments
If you're contributing to an IRA for the first time, or if you have just a small amount in an IRA, it may be tempting to think of it as play money--separate from and more speculative than the "real" retirement assets you hold in your company retirement plan. While it's a good strategy to use your IRA as a way to fill in holes in your company retirement plan--Treasury Inflation-Protected Securities are a good example of an IRA "do"--you don't want to go overboard with highly specialized investments. Because you're apt to be adding to your IRA over a period of years, it could add up to be a substantial sum if you play your cards right. For that reason, it would be a mistake to make it a grab-bag of one-off investments, such as risky individual stocks or region- or industry-specific funds.

Investments With Tax-Savings Features
When deciding what to put inside your IRA, there's no reason to reflexively avoid core-type investments that just happen to be tax-efficient, such as index mutual funds and exchange-traded funds that track a broad swath of the stock or bond markets. These investments tend to be naturally tax-efficient, but they're not surrendering performance in order to deliver good aftertax returns. So they're a good fit for either tax-sheltered or taxable accounts.

It doesn't, however, make sense to hold mutual funds that are explicitly tax-managed within the confines of an IRA. That's because the fund manager may make choices that reduce taxes for taxable shareholders but don't benefit IRA investors, for whom year-to-year taxes aren't a concern. Ditto for municipal bonds and bond funds. Nor does it usually make sense to hold investments with tax-deferral features, such as a variable annuity, within the confines of an IRA. That's because you're putting a vehicle that is itself tax-deferred within another tax-deferred investment (the IRA), and in so doing you may be paying extra for features you don't need.

A version of this article appeared March 15, 2010.

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