Diving for Worthy IRA Picks

You have a few extra days this year if you want to squeak in an IRA contribution for the 2011 tax year--until April 17. That's because April 15--the traditional tax day--falls on a Sunday this year, and April 16 is a holiday in the District of Columbia.

But even though that date seems far off into the future (it sure does here on the wintery plains of Illinois), resist the temptation to wait until the last minute to fund your IRA. Take a few moments to X-Ray your portfolio, assess whether your current portfolio is in line with your intended allocations, and determine if you have holes you need to fill. New IRA contributions are limited to $5,000 for savers under 50 and $6,000 for the over-50 set, so funding an IRA might not be enough to move the needle, but it's a good start.

You can put almost anything you like inside an IRA wrapper, save for the vehicles I outlined in this article, and that breadth of choices can be a bit daunting. Here's one good starting point: otherwise-worthy investments that incur high tax costs from year to year and are therefore best held within the confines of a tax-sheltered wrapper such as an IRA or 401(k). Taxable bonds and bond funds, especially those that generate high levels of current income, such as high-yield and multisector funds, are therefore ideal IRA choices. The same goes for hybrid funds that invest in bonds, convertibles, or preferreds, the income from which is taxed at your ordinary income tax rate. Ditto for equity funds such as those that invest in REITs; their dividends don't qualify for the currently low 15% tax rate on dividends but rather are taxed as ordinary income.

With an eye toward worthy picks that are best held within a tax-sheltering wrapper, I turned to our  Premium Fund Screener. I started by screening on all equity and hybrid categories--the latter bucket includes balanced vehicles as well as more specialized investments such as convertibles funds. I winnowed down that very large universe by screening on those funds with Morningstar Analyst Ratings of Gold or Silver. To help identify which funds within that subset have been tax-inefficient, I screened on offerings with three-year tax ratios of 1% or more. (Tax-cost ratio shows the amount that a buy-and-hold investor in the highest tax bracket would've surrendered to dividend and capital gains taxes over the holding period.) I then added criteria to ensure availability for no-load investors with $5,000 to invest in an IRA.

The screen highlighted a manageable list of funds, three of which I've highlighted below. Premium users can click  here to view the complete output or adjust the screen to their liking.  

 Berwyn Income (BERIX)
Almost everything in this fund's portfolio screams "hold me in a tax-sheltered account!" A conservative-allocation vehicle, it holds bonds as well as dividend-paying stocks, REITs, convertibles, and preferreds. Managers George Cipolloni and Ray Munsch apply a value-biased approach to assembling the portfolio. Recently, for example, they held no Treasury bonds because they feel that the upside is limited at this point. Their attention to valuation and downside protection has held shareholders in good stead since the current team took the reins here in 2006, but the fund hasn't just been a bear-market prodigy. It also put up strong numbers in the market rebound of 2009.

 T. Rowe Price Real Estate (TRREX) 
Although fund manager David Lee holds the lion's share of assets in REITs and real estate operating companies, he also sometimes holds a small stake in convertibles, all of which generate a fairly high level of taxable income. Thus, the fund lends itself well to a tax-sheltered wrapper. In typical T. Rowe fashion, Lee employs an even-keeled approach to the sector, focusing on large caps, keeping turnover down, and periodically redeploying assets from areas that have enjoyed big runups into less-loved parts of the sector. One caveat is that the real estate sector has enjoyed a phenomenal three-year run since the depths of the bear market, and Morningstar analysts generally feel real estate firms are trading in line with or above their fair values currently. Thus, would-be investors should consider dollar-cost averaging into their positions.

 Vanguard Wellesley Income (VWINX)
Hold the cards and letters: I know this fine, income-rich fund is a favorite of many Morningstar.com readers. However, like Berwyn Income, it's a conservative-allocation fund, and its combination of bonds plus dividend-paying stocks means that it's best held within the confines of an IRA or a 401(k). Fixed-income manager John Keogh, like the Berwyn team, has recently been reducing Treasury bonds in favor of corporate bonds. On the equity side, manager W. Michael Reckmeyer's focus on dividend yield and valuation tends to insulate the portfolio from overheating areas. The only real wild card is what a prolonged period of rising interest rates could mean for this and other income-rich vehicles, a topic Morningstar analyst Dan Culloton explored in  his recent analysis of the fund.

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