Best Assets For A Retirement Account

Investor's Business Daily ^ | Friday May 5, 7:00 pm ET | Donald Jay Korn

[BenLurkin]

Many investors have tax-deferred accounts like an IRA and 401(k) as well as taxable investment accounts. But how do you know which assets work best inside a retirement account and which should go on the outside?

"Put your least tax-efficient investments inside your retirement plan to make the most of tax deferral," said Chris Cordaro, chief investment officer of RegentAtlantic Capital in Chatham, N.J.

Say you are an active trader of stocks or stock funds. You frequently sell shares within one year of a purchase. Any profits from such trades are short-term gains, taxed at up to 35%.

Consider doing such trading inside a tax-deferred account. You'll avoid paying tax right away. If you use a Roth IRA, the investments grow tax-free and are not taxed when you take money out.

The same idea applies to mutual funds. If your mutual funds make large capital gains distributions in most years, it might make more sense to hold them inside a retirement account.

Capital gains distributions can generate tax bills. And some of those profits may be highly taxed short-term gains. But you won't have to pay cap-gains tax as long as the earnings stay inside the account. (You will have to pay income tax on assets removed from the retirement account later on.)

Mutual funds holding small-company stocks also often work best inside a retirement plan, Cordaro says. They may trade actively and generate gains for shareholders that are taxable if not held inside a tax-deferred account.

"Real estate investment trusts and mutual funds that hold REITs also belong inside a plan," Cordaro said.

Why? Many REITs have relatively high yields. The National Association of Real Estate Investment Trusts (NAREIT) recently put the average payout at 4.78%.

And most of the money REITs pay out to investors does not qualify for bargain tax rates of 15% or lower. Payouts are taxed as ordinary income, up to 35%. So the REITs and REIT funds should go inside a retirement plan, where taxes are deferred.

Inside Job

Corporate bonds should go on the inside where tax on their interest is deferred. That includes junk bonds.

The same holds for other bond-like investments, such as mortgage-backed securities. Ditto for mutual funds holding taxable bonds and similar securities. They should go inside your retirement account.

If those holdings are good for retirement accounts, what should go in your taxable account?

Stocks that you intend to buy and hold. If you seldom take gains, you will have little tax to defer. Holding them in a retirement account can waste the tax deferral.

Some stocks and stock funds pay dividends. That is especially true for large-company stocks.

But most dividends are low now. The average yield on the S&P 500 is around 1.86%.

And stock dividends usually qualify for a low tax rate, no more than 15%. Holding dividend-paying stocks inside a retirement plan can waste the plan's tax break.

In bonds, municipal issues go outside a retirement plan. The interest is exempt from federal tax and state levies on munis issued by the state in which you live. So there's no reason to hold them on the inside.

Treasury bonds also work well on the outside for investors in high-tax areas. Even though the interest is subject to federal tax, it is exempt from state or local income tax.

Cash reserves should be held in a taxable account. In case of an emergency, you'll want tax-free access to this money.

If your cash reserve is inside your IRA or 401(k), you'll have to pay tax to withdraw your funds.

And you can trigger a 10% penalty, depending on your age.

What about international stocks? If they generate few capital gains, they belong on the outside.

There's another reason to hold foreign stocks and foreign stock funds that pay dividends in a taxable account. Foreign taxes may be withheld on these dividends.

U.S. investors can get tax credits for withheld foreign taxes. But these credits have no value inside a retirement plan.

So you'd wind up paying double tax: first, the withheld foreign tax; then U.S. income tax on withdrawals from your retirement account.

"But small-cap foreign stock funds may belong inside a retirement plan," Cordaro said. These funds may not pay much in dividends, so withholding won't be a large issue.

But they may generate capital gains. Those can be sheltered inside a retirement plan.

Can Be A Challenge

Altogether, this inside-outside strategy might not always be easy to implement. If you are in a 401(k) or similar plan, you're limited to the menu choices. You may not have many options.

So you should choose the least tax-efficient choices for your retirement account. Then fill in your asset allocation outside of the plan.

Working couples may have two 401(k)s to choose between. This can improve planning opportunities.

Say one spouse has a REIT fund on the menu. That spouse can invest heavily in this fund to get the couple's overall real estate allocation in tax-deferred territory.

[GSlob]

The lazy solution is to go with index funds both for taxable and 401k/Roth accounts - due to the low turnover the distributions are pretty low [very good lesson from 2000], expenses are low, and no late chasing of hot segments. John C. Bogle - blessed be his name - taught that it is not only the lazy, but a pretty good solution in general.