Best Funds for Investing in an IRA to Minimize Taxes

Minimize Taxation By Investing in the Best Types of Funds for Your IRA

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Did you know that there are certain types of mutual funds that are best for investing in an individual retirement account (IRA)? Although your retirement goals and risk tolerance are determining factors in choosing the best funds for an IRA, there are other factors, such as taxation, to consider.

How Taxes Can Determine the Best Fund Types to Buy

Part of choosing the best mutual funds for investing will depend on what account type you are using to hold the funds. Remember that earnings on investments held in retirement accounts, sometimes referred to as tax-deferred accounts, are not taxed until withdrawal. Therefore you get to keep all of your earnings, dividends, and interest, rather than paying taxes on a portion .

Since there is no taxation of interest, dividends or gains while the investments are held in the IRA, it's smart to have a strategy for placing certain types of funds in you IRA, especially if you have multiple accounts. Mutual fund taxation works differently when the funds are held in a different account type, such as a taxable brokerage account.

Use These Funds Types in Your IRA and Other Retirement Accounts

Assuming you have a taxable brokerage account in addition to an IRA, It's wise to place tax-generating investments in the IRA and tax-efficient investments in the taxable account. If all you own is an IRA, you will allocate and invest in whatever way is appropriate for your goals and generally ignore this guidance (unless you are planning to open a taxable brokerage account in the near future).

Here are some fund types that are best for an IRA and other tax-deferred accounts:

  • Dividend Mutual Funds: Since dividends paid to investors are taxed as income in regular brokerage(non-retirement) account, mutual funds that pay dividends can be smart holdings for an IRA. This way the investor can avoid taxation from dividends while this fund type is held in the IRA.
  • Bond Funds: Bonds pay interest that is taxed as income. Mutual funds that hold bonds may also pay interest to bond fund investors. To temporarily avoid this tax investors can hold bond funds in a tax-deferred account .
  • Actively-Managed Funds: Mutual funds that are actively-managed tend to generate more capital gains distributions that passively-managed funds, such as index funds and most exchange-traded funds (ETFs). This is because actively-managed funds tend to buy and sell holdings more frequently than index funds. This trading activity may produce capital gains that are then passed along to the mutual fund shareholder .

These same tax advantaged may apply to other types of tax-deferred accounts. Other tax-deferred accounts include 401(k) plans, 403(b) plans, and the military service members'Thrift Savings Plan (TSP). These account types have similar tax advantages as IRAs.

Also be aware of trading costs and capital gains from selling mutual funds. For example, if you have a large gain from a particular mutual fund, and it's held in your IRA, you won't pay any taxes on the capital gain realized when selling the fund. If you have a taxable brokerage account, you owe taxes on realized gains .

To minimize costs in other ways, you may also consider placing fewer trades in taxable accounts and investing in mutual funds and ETFs with low expense ratios.

Bottom Line

Choosing the right funds for the right account types is part of a smart investing plan. To make your money work as hard as possible, be sure to locate the funds within your IRA that are taxed the highest. The types of mutual funds that tend to be taxed the highest include funds that pay dividends, bond funds, and actively-managed funds.

If you have taxable accounts, consider holding tax-efficient investments in them to minimize taxation. Examples of investments that are tax-efficient include passively-managed funds, such as index funds and exchange-traded funds (ETFs).

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.