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Fund Spy
The best ETFs for your IRA
Exchange-traded funds aren't just for taxable accounts anymore. But use them wisely.
By Morningstar
Believe it or not, you can use exchange-traded funds in an individual retirement account. Admittedly, it doesn't seem necessary. ETFs rarely distribute capital gains, so they ought to be best suited for taxable accounts; there's no advantage to choosing them over their conventional mutual fund counterparts for tax-advantaged vehicles, such as IRAs. In reality, however, there are situations in which it's a good idea to use ETFs in IRAs.
Certainly low-cost, low-turnover, broadly diversified large-cap ETFs, such as Vanguard Large-Cap Vipers (VV, news, msgs), are ideally suited for taxable accounts. There are plenty of ETFs and strategies for using them that are ill-suited for taxable accounts, though. Furthermore, tax efficiency, or lack thereof, shouldn't be your sole criterion when assembling a retirement portfolio. With roughly a month left to contribute to IRAs for the 2005 tax year, here are some situations in which ETFs are better off in a tax-deferred account.
Active traders
We generally frown on frequent trading. It increases return-sapping transaction costs as well as the chances of making the wrong call. If you insist, however, on frequently trading or even rebalancing your ETF portfolio, it often makes sense to do it in an IRA. You'll still have to pay commission costs, which will eat into results over time. But at least your trading activity will be sheltered from taxes.
Related news and commentary on MSN Money
Smaller-cap ETFs
Just because most ETFs rarely distribute capital gains doesn't mean they can't. ETFs, which currently are all index funds, can realize gains when they sell stocks to keep up with changes in their underlying indexes. Small-cap index ETFs, for example, typically make more of these changes and have higher turnover rates than their larger-cap brethren. That's because they have to sell stocks that grow too large to be included in their benchmarks. Higher turnover doesn't guarantee there will be capital gains, but it increases the possibility of distributions. The StreetTracks Dow Jones Wilshire Small Cap Value (DSV, news, msgs), for instance, has been a perennial capital gain generator.
Alternative asset-class ETFs
ETFs have gotten increasingly exotic in the last year with more new funds focusing on alternative asset classes, such as commodities. These offerings make widely available investments that heretofore have been the sole province of well-heeled and institutional investors. The new vehicles aren't as tax efficient as equity ETFs, though. For example, the gold ETFs -- StreetTracks Gold Shares (GLD, news, msgs) and iShares Comex Gold (IAU, news, msgs) -- must sell some of the gold bullion they hold to pay expenses. Any gain on those sales is taxed at a maximum rate of 28%, rather than the current 15% rate for long-term capital gains, because gold is considered a collectible.
Deutsche Bank's recently launched DB Commodity Index (DBC, news, msgs) ETF probably won't be tax efficient, either. It tracks its basket of goods with futures, so it doesn't have to put up much of its money to get exposure to its index. It invests the rest of its assets in bonds that earn taxable income. Furthermore, the ETF realizes capital gains as it closes old futures contracts and enters new ones, and 40% of those gains are subject to short-term capital gains taxes. So, if you decide to commit a small portion of your portfolio to funds like these -- and we suggest you keep it really small -- a tax-deferred account might be a good idea.
Bond ETFs
Historically, the received wisdom has been that you should keep bond funds in tax-sheltered accounts because of their higher yields. Studies in recent years, however, have shown that the best location for your equity and fixed-income investments depends on how long you have until retirement and what your tax bracket will be once you get there.
In general, keeping stocks in retirement accounts and bonds in taxable accounts looks like a better idea the longer your time horizon and lower your retirement tax bracket. Conversely, if you are closer to retirement and will be in a higher bracket, your fixed-income funds are better off in a tax-deferred account. If you are in the latter group -- say, 15 years away from retirement -- you can consider holding fixed-income ETFs in tax-deferred accounts and stock investments in taxable ones. The broadly diversified iShares Lehman Aggregate Bond Index (AGG, news, msgs) and iShares Lehman 1-3 Year Treasury Bond Index (SHY, news, msgs) are worthy options.
Disclosure: Barclays Global Investors (BGI), which is owned by Barclays, currently licenses Morningstar's 16 style-based indexes for use in BGI's iShares exchange-traded funds. iShares are not sponsored, issued or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in iShares that are based on Morningstar indexes.
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