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Find the Best Investments for Your IRA

Whether your IRA will play a core or supporting role, learn to pick the right investments to stay on track to meet your needs.

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This article appeared on in February. In case you missed it (and because April 18, your deadline for contributing to an IRA for the 2010 tax year, is approaching), we're running it again as part ofTax Relief Week.

It's easy to see why would-be IRA investors often suffer from analysis paralysis. Once you decide whether to invest in a traditional or Roth IRA, you then have to sort among an overwhelming array of options.

You can put almost anything inside an IRA wrapper: individual stocks and bonds, money market funds, certificates of deposit, or mutual funds. (However, you'll want to take care to keep investments that have tax-savings features themselves, such as municipal bonds and variable annuities, out of your IRA because you may be sacrificing returns for an extra layer of tax efficiency that you don't really need.)

By answering the following questions, you'll be able to cut through the clutter and quickly identify appropriate holdings for your IRA.

Step 1: Evaluate the role your IRA will play in your overall retirement portfolio. Will your IRA take up a big share of your retirement portfolio--either because you're just starting out and plan to make many more IRA investments in the future or because you've rolled over a large sum of money from your company retirement plan? If so, move on to the next step.

If you consider your IRA to be more of a supporting player because the bulk of your retirement assets are elsewhere, either in your company retirement plan or your taxable account, go to Step 3.

Step 2: Identify worthy core holdings.
If you already have a large sum of money stashed in an IRA--or expect that your IRA will grow to be a large share of your overall retirement portfolio in the future--you'll want your IRA to be well-diversified and populated with core investment types such as large-cap-stock mutual funds and high-quality bond funds.

If you have other assets earmarked for retirement, in addition to the money that you're putting into an IRA, be sure to take those holdings into account when deciding what to put in your IRA. Morningstar's Instant X-Ray tool can help you size up your existing portfolio's stock/bond/cash composition and also shows you how well it's diversified across various investment styles. (The Morningstar Style Box provides a visual depiction of a portfolio's investment-style mix.) Simply enter the tickers for each of your holdings into the X-Ray tool, then click Show Instant X-Ray.

Compare the current allocations of your existing retirement portfolio with your asset-allocation targets. (Don't have asset allocation targets? Read this article.) Once you've determined where you need to add, you can select the specific investments. If you're looking for core-type investments to populate your company retirement plan, Morningstar's  Fund Analyst Picks in the large-cap equity (both international and U.S.), intermediate-term bond, world-stock, world-allocation, and conservative- and moderate-allocation categories can provide a good starting point. Some of my favorites are  Dodge & Cox Stock (DODGX),  Sequoia (SEQUX), and  T. Rowe Price Personal Strategy Income (PRSIX). This article also highlights some other terrific choices.


Step 3: Identify worthy supporting offerings.
Are you opening an IRA to augment retirement monies that you hold elsewhere? If so, you, too, can hold core-type investments in your IRA.

But you can also use the IRA to fill holes in your company retirement plan. For example, say your plan includes adequate stock funds, but its bond funds charge more than 1% per year in annual expenses--a princely sum that's sure to take a big cut of your long-term return. If that's the case, you can fill up your company retirement plan with the decent stock funds and leave the bond portion of your portfolio to an IRA. Again, Morningstar's Instant X-Ray tool can help you see where you've got holes in your existing asset mix.

And because the world is your oyster when funding an IRA, you can also include investment types not commonly found in company retirement plans, including funds dedicated to real estate investments, commodities, or Treasury Inflation-Protected Securities. All of these investment types do a good job of diversifying a portfolio that's composed primarily of stocks and bonds. They also can be a headache when held outside of a tax-sheltered account, because they generate a lot of taxable income, so they're ideal holdings for an IRA.

 Morningstar's Fund Analyst Picks within those categories are good starting points if you're using your IRA to support core-type funds you hold elsewhere. Some of my favorite supporting-player IRA ideas are  Royce Special Equity (RYSEX),  Third Avenue International Value (TAVIX), and  Vanguard Inflation-Protected Securities (VIPSX). My colleague Esther Pak also highlights some top-shelf supporting players for IRAs in this article.

Step 4: Take maximum advantage of the tax benefits.
As you populate your portfolio, bear in mind a concept that financial planners call asset location--essentially, putting assets in the vehicles that allow you to take maximum advantage of their tax-savings features (or lack thereof).

Bonds are prime candidates for the tax-sheltered part of your portfolio, like an IRA or company retirement plan, particularly when you're in the accumulation phase of your investing career. That's because bonds tend to generate a lot of income, which is taxed at rates as high as 35%. Multisector and high-yield bond funds, as well as those dedicated to Treasury Inflation-Protected Securities, are particularly good candidates for a portion of an IRA.

Stocks, meanwhile, typically crank out less income. Also, the tax rate on capital gains and stock dividends is currently much lower than is the case for bond income. Both factors can make stocks a good fit for a taxable account, but not in every case. Not all stock dividends qualify for the currently low tax treatment. For example, the income from real estate investment trusts doesn't qualify, and foreign stock dividends may not, either. Thus, both real estate investments and foreign stock funds with high dividend yields can make sense for an IRA.

Ditto for high-turnover stock funds: To the extent that you're attracted to such a fund type, it makes sense to shelter it within the confines of an IRA, where you won't owe taxes on your holdings from year to year. That's because high-turnover funds often generate short-term capital gains, which are taxed at your relatively high ordinary income tax rate. (Long-term capital gains receive much more favorable tax treatment.)

A version of this article appeared April 5, 2010.

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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.