The Best Investments in IRA Accounts

So you still have about three weeks to file your 2006 income tax (this year’s deadline is April 17, 2007) if you haven’t done so already, what else can you do to save instantly on taxes? If you meet certain income conditions, you can open a traditional IRA account before the tax deadline, make $4,000 contribution for 2006, and deduct part or the full amount of your contribution. The deadline to open an IRA account and make 2006 contribution is April 17 this year instead of the last day of the calendar year. Therefore, there is still time to make the last tax-saving move.

While setting up an IRA account (traditional or Roth) is simple and can be done at almost every brokerage firm or mutual fund company, making the right investment choices so your hard earned money can grow quickly and steadily is by no means trivial. In fact, it’s the second most important part (the first one being opening an account) in retirement account planning. For tax sheltered accounts such as IRAs, a general rule is that securities that generate high incomes (interests, dividends, or capital gains) should be held in these accounts first. But there are much more to be considered when selecting what to invest. I came across an article on Morningstar.com yesterday which offers some advices how to invest in IRA accounts. The article, The Best Investments for Your IRA, by Christopher Davis, declares that for IRAs, “not all options are created equal.” So exactly what kind of investments should be held in an IRA account?

Stocks or bonds

Since stocks historically produce much higher return than bonds, it makes more sense to put stocks in an IRA account if you have a long time to go to retirement. On the other hand, if you want to hold bonds after all in retirement savings accounts (taxable or tax-protected), then they should go to a tax-protected account first due to the taxable incomes bonds generate. However, if you are close to retirement, the best strategy is to invest more in bonds to preserve your assets.

Not all stock investments are equal

Index funds usually generate less taxable incomes due to the passive nature of the funds. If you have your favorite actively managed funds that distribute lots of capital gains (funds with high turn-over ratio will generate more capital gains) and consider them for retirement purpose, these funds should be held in tax-sheltered IRA accounts to take advantage of the hefty distributions. The fund price usually drops after the distribution and if you set up dividend/capital gain reinvestment, the distribution will net you more shares.

Think the big picture

While we should always keep taxes in our mind when making investment decisions in retirement accounts, the only goal is to build a solid portfolio with the right asset allocation that meets your investment objective. As the article says

How you split your portfolio between stocks and bonds should be based on your risk tolerance and time horizon, not what makes sense from a tax perspective. Your primary goal should be to find superior investments and then think about whether they fit best in a taxable account or an IRA.

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