Traits Of The Best IRA Funds

When it comes to investing for retirement, asset location is important.  That is, because of the drag of taxes, whether you own a particular mutual fund in a taxable account or a tax-deferred account can make a big difference in the ultimate size of your portfolio.  Why?  Because certain types of mutual funds are more tax-efficient than others and certain types of accounts lend themselves more to certain asset classes over others.

Traits Of The Best IRA Funds

In an ideal world, all of your portfolio would be held in an IRA, 401k, or some other tax-advantaged account.  Reality, however, is that most investors will have a little money in a 401k, a little money in a Roth IRA, a little money in a taxable account, and maybe even a high yield CD or two.  The best IRA funds tend to have the following characteristics in common:

Derive A Significant Part Of Their Total Return From Interest Or Dividends

Taxable bond funds (as opposed to high-yield muni funds) that derive practically all of their long-term returns from interest payments are excellent candidates for a tax-deferred account because practically all of their yearly returns are taxable as regular income, which currently top out at 35% (and maybe more in the near future).  Taxable bonds probably should never be held in a taxable account unless you are in a very low tax bracket.

REIT funds are another example of an asset class that derives a large portion of their total return from dividends.  Since REIT yields have fallen significantly in recent years, we can probably expect REITs to be slightly more tax-efficient in the near future.  Still, probably half or more of a REIT’s total return comes from dividends.  And in exchange for paying no corporate tax, REIT dividends are fully taxable at your marginal tax rate unlike qualified dividends that are currently taxed at the long-term capital gains rate.

Stock Funds With High Portfolio Turnover

The cool thing about owning stocks is that you only pay taxes when you sell for a gain.  If you buy and hold a stock for 20 years, you’ll only owe tax on the sale when it’s made.  That’s a pretty good deal.  Unfortunately, lots of mutual fund managers prefer to trade in an out of stocks at a rabid pace, creating a tax nightmare for fund shareholders.  A mutual fund’s performance before and after taxes are taken into consideration can often be dramatically different.  Actively-managed funds are the usual high-turnover culprits while index funds tend to be relatively tax-efficient.

See my list of the four best IRA funds for some recommendations.