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Be Tax-Savvy in Picking Funds for a Roth IRA

January 11, 1998|RUSS WILES | Russ Wiles is a mutual fund columnist for The Times

The Roth IRA, which gives large numbers of Americans a new tax break, comes with a problem: If you are putting mutual funds into it, what type of funds should you choose?

Investors face the same decision with a tax-deferred retirement account such as a traditional IRA or a 401(k). But because a Roth IRA's income may not ever be taxed, your choice has greater impact.

Only $2,000 may be placed in Roth IRAs each year. However, taxpayers with large traditional individual retirement accounts and an annual income of less than $100,000 may pull out an unlimited amount of money, pay taxes on it and move it to a Roth IRA. Because of the more favorable tax treatment, this may be worthwhile--especially for 1998, when special rollover rules will allow you to pay the taxes over four years.

The first type of fund that should be put in a Roth IRA or another tax-favored account is one that pays dividends or interest otherwise taxed at normal rates. Advisors generally suggest putting these funds, your least "tax-efficient" funds, into an IRA or 401(k). Other candidates include funds that trade stocks often, spinning off capital gains distributions that in unsheltered accounts are taxable to the fund holders.

This holds true even though equity funds benefit from a provision of the new tax law that cuts the top capital-gains rate on long-term investments from 28% to 20%. That means it is relatively "more attractive to keep funds likely to generate capital gains outside of retirement accounts," said Steve Janachowski, a Tiburon-based investment advisor and co-author with partner Kurt Brouwer of "Mutual Fund Mastery."

Janachowski recommends dividend- and income-oriented funds for IRAs. He likes Harbor Bond (no load; [800] 422-1050) for Roth IRA investors, assuming you want some bond-market exposure. This fund is managed by William Gross of the Pimco Funds group and invests in government and corporate bonds.

As another IRA choice, Janachowski suggests the real estate funds run by American Century (no load; [800] 345-2021), CGM (no load; [800] 345-4048) or Davis (4.75% load; [800] 279-0279).

These funds invest primarily in real estate investment trusts--companies that typically pay generous dividends but that also stand to grow as their properties appreciate. Real estate funds thus offer a mix of current income and long-term appreciation potential. Real estate stocks are reasonably valued, selling at average price-to-earnings ratios of roughly 11, Janachowski said.

Another approach to choosing funds for Roth IRAs comes from Sheldon Jacobs, publisher of the No-Load Fund Investor newsletter in Irvington-on-Hudson, N.Y. For investors who have many years until retirement and who are looking to build wealth, Jacobs' recommendations include such conservative stock funds as American Century Income and Growth, CGM Realty and T. Rowe Price Equity Income (no load; [800] 638-5660). For people nearing retirement, he favors funds with a greater bond exposure, such as T. Rowe Price Spectrum Income.

Although Jacobs generally recommends index funds, he stresses that these are already tax-efficient because they rarely sell holdings and thus are relatively better outside an IRA. Index funds buy and hold the same stocks contained in a stock index, such as the Standard & Poor's 500.

"Always keep an index fund outside a Roth IRA," Jacobs said.

But other advisors like the idea of placing stock funds, even tax-efficient ones, in Roth IRAs.

"Since the money is never taxed, I'll be looking for funds offering the best long-term growth," said Gary Bowyer, a certified financial planner in Chicago.

He recommends Third Avenue Value (no load; [800] 443-1021) and Tweedy Browne American Value (no load; [800] 432-4789) for Roth IRAs. Both funds offer good appreciation potential but should hold up reasonably well if the stock market struggles, he said. Bowyer also considers well-diversified foreign funds such as Artisan International (no load; [800] 344-1770) to be appropriate choices for Roth IRAs.

Janachowski and Jacobs agree that certain stock funds can be suitable for Roth IRAs. Janachowski noted that the required five-year holding period on Roth IRAs could help provide the discipline for people to stick with volatile funds on a long-term basis. Topping his list of favorite stock funds is Selected American Shares (no load; [800] 243-1575).

The decision on what to place in a Roth account also touches on issues other than taxes, including your risk tolerance, time horizon and overall mix of investments.

Alan Rosenfield, president of a Phoenix-based retirement-consulting firm called Expansion Funds of Arizona, suggests that people fill their Roth IRAs with funds they feel comfortable holding, looking at tax consequences as a secondary factor.

His recommendations range from bond choices such as Strong Corporate Bond (no load; [800] 368-1030) to conservative stock selections such as Scudder Growth and Income (no load; [800] 225-2470) to more aggressive picks, such as GAM International (5% load; [800] 426-4685).

But Rosenfield stressed that variable annuities--near cousins to mutual funds--should not be held in Roth IRAs. Variable annuities act like traditional IRAs for those whose contributions aren't deductible, providing tax deferral rather than tax avoidance. They are more complex than regular mutual funds and generally carry higher costs.

"Roth IRAs already are tax-free, so why pay the higher fees associated with annuities?" he said. "In a Roth IRA, they're ridiculous."

(For basics on Roth IRAs, see

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