“What’s in your IRA?”
That was the question that drifted across the table in my direction at a recent family barbecue. I was grateful that the query had nothing to do with whether I racked up a nice profit in the LNKD IPO (I didn’t, nor do I even own LNKD) or what the hottest new ETF is—those questions, which are the kind of thing you get a lot if you work in the financial industry, don’t feel like the mark of a thoughtful long-term investor, and I’m not a big believer in investing by stock tip anyway.
Instead, this was a more useful question about how I decide where to place a particular investment—“inside” or “outside”, as some financial planners term the decision of whether put an investment in a tax deferred account. Minus a few interruptions for eating and drinking, the following is pretty much what I said.
In general, I try to put tax inefficient investments in my IRA. It’s probably easier to describe tax efficient investments than it is to do the opposite. Two good examples of tax efficient investments are municipal bonds and most index ETFs. In the case of municipal bonds, you generally avoid paying federal income tax on the income and in some cases avoid paying state tax as well.
In the case of most U.S. equity index ETFs, they have had a good track record of paying minimal capital gains distributions (our U.S. equity iShares ETFs have not distributed any capital gains in the past 10 years) and most of the dividends they generate have qualified for the lower qualified dividend income (QDI) tax rate of 15% (zero percent in some cases; you can read more about that here). So these types of investments, I generally put “outside” of my IRA.
There are a number of reasons why an investment might be tax inefficient. An investment in high yield bonds, for example, is going to distribute income on a regular basis that unlike the example above does not qualify for the lower QDI rates. As I’ve written about previously, actively managed mutual funds can distribute capital gains on an unpredictable basis, so I like to place them in my IRA to avoid surprises. Lastly, there are a few popular types of investments that have much more complicated tax calculation or filing requirements (REITs and TIPS are good examples), where it can be a hassle to hold them outside an IRA.
Of course, as you get older and your retirement savings grow, you may run out of room in your IRA for all of these types of investments. In that case, you’ll need to get the calculator out or consult your tax advisor to figure out how to prioritize your investments between accounts.
In fact, speaking of advisors, I would highly recommend spending some quality time with your financial and tax advisors, so that you can share your plans for retirement—i.e. where will you be living (higher or lower state taxes can make a big difference on planning distributions), how will your retirement income compare to your income when you worked?—which help allow you to ensure your current portfolio is organized in a tax savvy fashion for your future needs.
For more information on the differences between ETFs and mutual funds, please click here.
Disclaimer: Past performance does not guarantee future results.
All regulated investment companies are obliged to distribute portfolio gains to shareholders at year’s end. Trading shares of the iShares Funds will also generate tax consequences and transaction expenses. This material is not intended to be tax advice. The tax consequences of dividend distributions may vary by individual taxpayer. Please consult your tax professional or financial advisor for more information with regard to your specific situation.
Investment comparisons are for illustrative purposes only and are not meant to be all-inclusive. To better understand the similarities and differences between investments, including investment objectives, risks, fees and expenses, it is important to read the products’ prospectuses.