Good Funds, but Better In an IRA

The April 17 income tax filing deadline is just around the corner and with it the deadline to contribute to an IRA for 2011. If you're a regular visitor to Morningstar.com, you already know the importance of saving for retirement, but don't overlook the value of an IRA as a destination for holdings that can have heavy tax consequences when held in a taxable account. Among funds that tend to be more tax-inefficient are those offering high dividends and those that buy and sell frequently, triggering capital gains distributions.

When you hold such investments in a taxable account, those capital gains and dividend distributions might boost your income enough to put you into a higher tax bracket. In addition, ordinary income tax rates, as well as rates on dividends and capital gains, are set to rise at the outset of 2013. That makes it all the more important to keep tax-efficient investments within your taxable accounts while locating tax-inefficient investments inside of an IRA.

To identify top-rated domestic stock funds that are tax-inefficient and thus good candidates for an IRA, we used Morningstar’s  Premium Fund Screener tool and searched for funds with trailing-12-month yields of at least 2% or turnover of at least 100%, minimum purchase levels of $5,000 or less for IRAs, and Morningstar Analyst Ratings of Gold or Silver. Premium subscribers can find the results  here. Below are a few of the funds we found, with a discussion of why each type might work better inside an IRA.

 Bogle Small Cap Growth  This tiny, quantitatively driven small-cap blend fund likes to keep things moving, as illustrated by its sky-high turnover rate of more than 300%. (By comparison, the average domestic-stock fund currently turns over about 73% of assets every 12 months.) For high-churn funds, there is a price to be paid in the form of increased capital gains from buying into and selling out of positions, adding to investors' tax bills. Manager John Bogle Jr. keeps sector weightings close to those of the Russell 2000 Index, but he tries to beat the index by picking stocks with improving balance sheets and low price/sales ratios. Morningstar analyst Greg Carlson lauds the fund's veteran, stable management team.  

 T. Rowe Price Real Estate (TRREX) (
)As with most real estate funds, this one offers a decent yield (2.04% during the past year) and exposure to the real estate sector. Investing in REITs and real estate-operating companies, along with convertible bonds on occasion, this fund keeps turnover low, and Morningstar's Rob Wherry likes its straightforward, actively managed approach. But because dividends from REITs are taxed at ordinary income rates, these securities are usually best held inside an IRA. Before investing in real estate, be aware that Morningstar's analyst team currently considers the sector slightly overvalued (Note: After clicking on the link, click on the Sector tab on the left and then click on Real Estate). 

 Vanguard Equity-Income (VEIPX)(
)This fund's 2.64% yield for the trailing-12-month period, along with its low 0.31% expense ratio, make it an attractive option for budget-conscious income seekers. However, such higher-yield funds and stocks might get more expensive in the years to come, from a tax standpoint, especially if the Bush tax cuts are allowed to expire at the end of this year. That would increase the tax rate on qualified dividends to that of ordinary income. Currently nonqualified dividends are taxed at the regular income rate. However, qualified dividends are taxed at 15% for those in the 25% tax bracket and above, while those in lower brackets pay no tax on them at all. So moving dividend-payers such as this fund into an IRA might be a smart move for the long term. Vanguard Equity-Income tends to hold more wide-moat stocks than other large-value funds, with an emphasis on those that pay above-average dividends at low valuations. Wide-moat names such as  ExxonMobil (XOM),  Pfizer (PFE), and
 Johnson & Johnson (JNJ) are among its top holdings. Morningstar's Dan Culloton likes the fund's high-quality bent and low fees.

Performance data as of March 26.